What exactly is “transitory?” You and your wife may disagree on its meaning when your old friend asks if he can stay with you while he “Sorts things out.” The term is virtually worthless without some guiding context, as in “Honey, he’ll be out of here by Monday. Tuesday the latest.”
Last week, Federal Reserve Chairman Jerome Powell was asked to provide much needed clarity as to how this term applies to our current bout of much higher than forecast inflation. Given that much of the economic outlook rests on how quickly the surge subsides, his definition is hardly semantic. Based on his years of experience, and the mountains of data the Fed has collected, the Chairman offered this direct response when asked about the practical meaning of transitory: “It depends.” That’s about as much detail as he was prepared to offer.
Although Chair Powell has only had his job for a few years, he may be well advised to familiarize himself with the Fed’s checkered history with the term “transitory.” Back in 2006 and 2007, Powell’s predecessor’s asserted countless times that the troubles then arising in the mortgage market were “transitory.” As it turns out they were horribly wrong. More recently, the Fed has been similarly wrong in their predictions about inflation.
For much of the last decade monthly CPI increases consistently ranged from .1% on the low end to .3% on the high end. This January, the number was .3%, an increase from .2% in December of 2020. Nothing terribly alarming there. But in February the number was .4%, in March, .6% and April, .8%. In other words, month over month CPI increased five months in a row. That is a rare and alarming trend. More importantly, each month’s results exceeded the Fed’s forecasts. Many took confidence however in May, when the number came in at “only” .6%. While this result also blew out the forecasts at least it represented a dip from the .8% in April. But in June, we got a huge .9%, a number that exceeded the average forecast by 50%, and was the biggest monthly increase since the summer of 2008.
Adding up the numbers gives us a 3.6% increase in the CPI in just 6 months, an annual pace of 7.2%. But the trend shouldn’t be ignored. The bigger increases have been more recent. If we average the inflation rate for the second quarter for the remainder of the year, full year inflation will be well above 8%. The last time that inflation trended like this was in the Summer of 2008, when a falling dollar and soaring commodity and import prices pulled inflation up dramatically. But that crisis was averted, ironically, by the Financial Crash of 2008. The economic free fall in the last months of that year crushed demand and turned off the inflationary heat. The ensuing “safe haven” dollar rally, which took the dollar up from an all-time record low, also helped keep prices in check. But this time around, no such relief is in sight. In fact, opposite forces are gathering.
A new wave of fiscal stimulus is just getting underway. The extended federal unemployment insurance benefits, that are incentivizing millions of Americans to remain out of the workforce, will remain in place through September. (It’s possible that Congress will decide to extend it again). But the monthly $300 per child “earned income” tax payments began to be distributed last week by the IRS to tens of millions of families. Also last week the Democrats introduced their $3.5 trillion “Human Infrastructure” Plan, which would massively expand a grab bag of family and Medicare services. This plan would come on top of the $1.2 trillion Infrastructure Bill and the record $6 trillion 2021 Budget. While all these plans have yet to clear Congress, it’s safe to say that new torrents of inflationary deficit spending will be showered on the country in the coming years.
For decades Americans have benefitted from increasing global trade that has kept price increases for goods, which can be imported, far below the increases for services, which largely can’t be. The strong dollar and growing efficiencies overseas translated into lower prices at home. According to a recent Wall Street Journal report, between 1990 and 2019 “core” goods prices (which strip out food and energy) rose by just 18% over that entire period. In contrast, prices for “core” services rose by 147%. Now that benefit appears to be waning. In 2021 goods prices, which are up 8.7% year over year (the biggest yearly gain since 1981), are rising faster than service prices. But the free trade mantra that ruled Washington for much of the last 30 years is dead and has been replaced by rising protectionism. As a result, we should not count on a new wave of dirt-cheap imports to keep inflation anchored in the years ahead.
So, the big question is how long will above trend inflation have to persist before the Fed admits that it’s not transitory and does something to stop it?
For now, the Covid excuse will buy them some time. At least until the early Spring of 2022, the Fed will downplay the monthly numbers and instead focus on the year over year data which will factor in Covid. After that, the tap dancing will become much more frenetic. Surely, they will rely on their newly enacted policy framework that allows them to tolerate inflation above 2% “for some time” to balance out the years in which inflation was apparently below that level. But even the Fed apologists will have to admit that it won’t be “balanced” to tolerate inflation that is 2% or 3% above the target to compensate for a time when it was .2% or .3% below the target.
For now, the markets believe the Fed is vigilant and will act decisively if needed. You can see that in the way traders are reacting to higher-than-expected inflation data by selling gold and buying the dollar and U.S. Treasuries. Such moves seem counterintuitive. Higher inflation is supposed to be good for gold, and bad for the dollar and low yielding bonds. But traders believe that higher inflation will force the Fed to tighten monetary policy quickly and drastically. They are seriously misreading the situation.
The truth is the Fed is not likely to make any serious moves to control inflation. To act as a serious counterweight to entrenched inflation, interest rates are supposed to be “restrictive.” That usually means that they would be above the rate of inflation, at a level that would incentivize savings, and restrict lending, thereby cooling the economy, slowing the velocity of money, dampening demand, and lowering inflation. Interest rates that remain below the rate of inflation do none of those things. In fact, they encourage borrowing and spending and can lead to more inflation.
So, if inflation were to remain at the 4% or 5% level, the Fed would be expected to take rates to at least 5%, or more. That is not remotely realistic.
About 9 years ago the Fed embarked on a quest to move away from extraordinary policy accommodation that they had employed to fight the 2008 Financial Crisis. Their goal was to wind down the $85 billion per month in QE purchases that they had conducted since 2009, raise interest rates back to pre-crisis levels (most assumed that figure would be about 4% or 5%) and reduce the quantity of bonds held on their balance sheet by at least 50%. In retrospect, the campaign was a slow-moving train wreck that never got close to achieving its intentions.
Despite persistent market discomfort, in just about a year they wound down their monthly QE purchases from $85 billion to zero. A year later, they finally raised rates from 0% to 25 basis points. That move created even more market unease and the Fed was forced to delay additional hikes for another year. After that they started moving rates up slowly. Fortunately, the economic optimism spurred by Trump corporate tax cuts provided the Fed with much needed cover to eventually move rates closer to 2%. But even that proved too much for the markets, which reacted with a sharp sell off at the end of 2018, forcing the Fed to call off any further rate hikes. The last phase of the plan, the balance sheet reduction had to be cancelled after having achieved less than 25% of the planned reductions.
In our current circumstances, winding down QE and getting back to 2% would take at least 2 years, and that pace would be considered very aggressive. What if inflation is running at 5% or more the entire time? Talk about taking a knife to a gunfight. Harsher measures will be needed.
Powell assured Congress that even if inflation turns out to be less transitory than currently forecast, the Fed has the tools to prevent a repeat of the 1970s. He neglected to mention that the same tools were available to the Fed throughout the 1970’s, but they failed to use them for the same reason that Powell is failing to use them today: a reluctance to harm the economy.
But if the inflation problem doesn’t solve itself, Powell assures us that the Fed will use its tools, despite the economic damage. But the longer the Fed waits, the larger the asset bubbles become, the more the Government, corporations, and consumers will borrow, and the greater the cost will be when interest rates ultimately rise. If the costs of using their inflation fighting tools will be greater in the future, why should we believe the Fed will have the stomach to act then when they won’t now?
Because the Fed waited too long in the 1970’s, their eventual remedy in the early 1980’s was harsh indeed. But when Paul Volker raised rates to 20% to break the back of inflation, our economy still had a strong enough foundation to handle the stress (even though we passed through a severe recession as a result). We no longer have that strength.
Back in the early 1980’s our debt levels then were a fraction of where they are today and, and the stock, bond, and real estate markets had been trending downward for years. Now all those markets have been inflating for more than a dozen years and are vulnerable to collapse with the slightest pin prick. We are like astronauts who have been floating around in the zero gravity, zero interest rate environment for the better part of 15 years. Our bones and muscles have atrophied, and we can no longer stand alone in an environment with real gravity.
The Fed is asking the nation to believe, and betting the farm in the process, that the current episode of inflation is just a transitory, post-Covid phenomenon. The only way such a high stakes gamble makes sense is if the Fed realizes the inflation fire is already too big to put out without destroying the economy. The real inflation gamble was made in 2008. Since the farm has already been lost, the Fed’s only goal now is to delay the inevitable for as long as possible. That bluff will not be transitory.
© Euro Pacific Capital
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