It’s dawning on many investors that our post-Covid financial problems may not be as easily solved as Washington claims.
The latest clue that trouble is brewing has come from the sudden and dramatic arrival of inflation. On May 12, it was revealed that the Consumer Price Index (CPI) had risen 4.2% year-over-year, the fastest pace since 2008.
Some tried to downplay concern by pointing out that the gains resulted from the “base effect” of comparing current prices with the artificially depressed “Covid lockdown” prices of March and April of last year. But that ignores the more alarming trend of near-term price acceleration.
According to the Bureau of Labor Statistics, in every month this year the month over month change in prices has been greater than the change in the previous month.
In April prices jumped .8% from March, versus an expected gain of just .2%. Clearly if this trend continues, or even fails to dramatically reverse, we could be looking at inflation well north of 5 or 6 percent for the calendar year. That would create a big problem.
Despite Federal Reserve officials’ recent assurances that the inflation problem is “transitory,” many investors are concluding that the central bank will have to deal with this problem by tightening monetary policy far sooner than had been expected. This would make sense if the Fed cared about restraining inflation or, more importantly, had the power to do anything to stop it. In truth, we are sailing into these waters with little ability to alter speed or course, and we will be wholly at the mercy of the waves we have spent a generation creating.
Since the era of central bank activism kicked into high gear in 2008, with the quantitative easing programs created in the wake of the Financial Crisis, the U.S. economy has largely avoided the spike in consumer prices that would typically result from monetary stimulus. It is my belief that the injection of trillions of new dollars into the economy merely offset the downward trajectory of prices that should have occurred during a severe recession. But more significantly, the money the Fed created at the time flowed more directly into assets rather than consumer goods.
Interest rate suppression, which is the mechanism of quantitative easing, stimulates the economy through the financial system. Low interest rates encourage more borrowing and have the effect of pushing up asset prices, particularly for stocks, bonds, and real estate. That explains why the era of QE was particularly good for those people who owned lots of those assets (the rich). Lowering the cost of capital also helped businesses hire and expand, thereby increasing the supply of goods and services, keeping consumer price inflation in check. More importantly, a strengthening dollar from 2011-2020 helped keep import prices low and helped sustain rising trade deficits. This allowed us to “export” our inflation to our trading partners as the dollars printed by the Fed flowed out, while real goods flowed in. However, many of the dollars earned by our trading partners were recycled into our financial markets, namely into large cap tech stocks, adding fuel to the growing asset bubble.
But the stimulus we have seen in the post-Covid world works on a very different level. Although the Fed is currently engaging in a quantitative easing program that is almost 50% larger than it was at its peak a decade ago ($120 billion per month in bond buying now vs. $85 billion then), the real bulk of the Fed’s efforts now involve underwriting the Government’s massive direct stimulus program, which has totaled more than $4 trillion in direct payments to businesses and individuals since March of 2020. According to the CBO, in 2021 more than 40% of the $5.8 trillion expected to be spent by the Federal Government will be financed by debt issuance rather than taxation. The bulk of that debt is financed by Fed money creation. (These figures do not include the $2 trillion in unpaid for infrastructure spending that is currently working its way through Congress.)
Throughout much of the past decade, mainstream economists urged that stimulus effort needed to pivot from the “monetary stimulus” of quantitative easing to the “fiscal stimulus” of government deficit spending. Now we see that since deficit spending is simply financed by monetary expansion, the two are roughly one in the same. But each effects the economy in slightly different ways.
This current stimulus of direct payments to consumers, businesses, and governments, results in spending which creates demand for goods and services. The problem is that this demand is occurring at a time when the supply of goods and services is being artificially suppressed. Through a variety of enhanced unemployment benefits, child-care tax credits, direct stimulus payments, and increased welfare benefits, the government has created conditions where millions of low-income workers make the rational choice to stay home. Recent calculations by Bank of America estimate that workers who earned $32,000 annually before the pandemic could receive more money on unemployment than they would from actual work.
Under these pressures it should come as no surprise that the April jobs report showed only 266,000 new jobs created when almost one million were expected. Employers were looking to hire, but far fewer people were willing to work. This explains why the labor force is still eight million jobs smaller than it was before the pandemic, even as the economy has largely reopened.
So, we find ourselves in a situation in which the government is simultaneously increasing demand and reducing supply. This is the classic recipe for consumer price increases, and it is showing up in force. The bad news is that nothing on the horizon suggests that government policy will change to address the crisis. History shows that once consumer price increases take hold the cycle becomes very slow to change and hard to break. The experience we had in the last era of catastrophic inflation provides a harrowing example.
The average CPI increase from 1960-1965 was just 1.3%. But in 1966, because of the major increases in deficit spending resulting from the Vietnam War and LBJ’s Great Society, the CPI jumped to 2.9%. It did not fall below 2% again for any calendar year until 1986, a cycle of 20 years. During that period, the CPI (despite continual methodological adjustments which sought to minimize the results) averaged 6.4%. This meant that by 1987 prices had risen by a factor of more than 3.5 times from the base in 1965, causing the dollar to lose 73% of its value over that time.
But it is important to appreciate the extraordinary efforts it took to break the cycle. During the height of the crisis, which lasted from 1973 to 1982, and began after President Nixon ended the U.S. dollar’s convertibility to gold in 1971, the CPI averaged 9.0%. It peaked at a staggering 13.5% in 1980. Two things were needed to reverse the trend.
The most obvious factor was the Fed’s willingness to raise interest rates far above the level of inflation. The very high rates slowed the velocity of money, discouraged borrowing and consumption, encouraged savings, and restored confidence in the dollar. The tough medicine was delivered by Fed Chairman Paul Volcker who ignored the howls of protest from economists and raised the Fed Funds rate to an astounding 20% in 1981. And unlike prior Fed Chairmen, Volker did not relent from the high rates as soon as the CPI dipped. He kept them high until he knew the job was done. The Recession of 1980-1982, at the time the worst downturn since the Great Depression, was the price of the policy. But in the end, it paid off.
The other factor in breaking the back of inflation was the pro-market, lower marginal income tax rates, and anti-regulatory policies of the Reagan administration. The free trade boom over the next 40 years also helped keep price increases in check by tapping the US economy into the price cutting efficiency of the emerging markets.
But as we kick off the newest chapter of America’s dance with inflation, can anyone expect the type of serious monetary and fiscal responses that were required 40 years ago to be used, or even considered, again?
In 1980, when Volker moved boldly to contain inflation, U.S. Federal Debt as a percentage of GDP stood at 31%, a generational low. As of December 2020, those levels are more than 4 times that at 129%. More importantly back in 1980 the average maturity on the national debt was close to thirty years. The current average maturity is just over five years.
That means higher rates don’t just impact new deficits, but the entire accumulated national debt as low-yielding debt matures and must be refinanced at much higher rates. While the Congressional Budget Office now predicts that debt to GDP will hit 195% by 2050, I expect that level to be hit much sooner. Similarly, corporate, and personal debt levels in 1980 were a fraction of where they are today. This means that the cost of raising interest rates now will be far higher than it was in 1980.
Higher rates would also severely impact the stock market. We have seen time and again over the past decade just how sensitive stock prices can be to higher interest rates, which raise the cost of capital and cut into share buybacks and dividends. But in comparison to the overall economy, the stock market is significantly larger now than it was in 1980. As of May 2021, the market capitalization of the Wilshire 5000, the broadest U.S. stock index, was 227% of the size of U.S. GDP. In 1980 that level stood at just about 40%. This means that a bear market in stocks would hit the broader economy much harder than it did in the early 1980s.
The real estate market likely would be hit even harder than stocks, where homes are bought based on monthly payments, not price. Those payments are in large part a result of record low mortgage rates. As a result, home prices are now at record highs. A surge in mortgage rates would cause housing prices to drop, setting up a default levels that might be reminiscent of 2007 and 2008. This will create losses for government guaranteed mortgage lenders, which will require bailouts with more money printed by the Fed.
But suppose the Fed really were willing to bite the bullet and step out in front of inflation no matter the cost. Could it deliver? Bear in mind that the last time the Fed moved to tighten policy, its efforts were incremental in size and glacial in tempo. After running its quantitative easing program at full throttle for more than five years, the Fed finally began to “taper” its asset buying program in December of 2013. From that point it took almost five more years to fully wind down the program and lift rates from zero to 2%. (The 2% rates achieved in October 2018 resulted in the largest December drop in stocks since the Great Depression). If inflation took hold at 6 percent now, such slow and casual moves would be insufficient to make a dent. Does anyone really think the Fed could cancel its $120 billion monthly QE program and raise rates to even 2% in a year or two? Not likely.
On the fiscal side, we are in the opening bars of a crescendo of government spending and activism that will make LBJ’s Great Society look tame by comparison. The Biden administration has massively expanded the welfare state and looks poised to double down on these policies for years to come. Its tax policy will hamstring the American corporate sector and force businesses to relocate overseas. The lost economic activity will be replaced by government spending. But unlike 1980, we can’t expect Ronald Reagan to ride to the rescue. The fiscally conservative, free trade wing of the Republican party has been taken out and shot by big spending, anti-trade GOP Trump populists. Practically, this means that we have no defense against inflation, and once it takes hold and metastasizes, we will have little capacity to stop it from spiraling out of control. The result would be a falling dollar that diminishes the real value of Americans savings and investments.
President Biden has repeated endlessly that no American making less than $400,000 per year will pay more in taxes. That is a lie. Every American, regardless of income, will be hit by the “inflation tax” that will eat away at their savings and diminish the purchasing power of their paycheck just as surely as payroll or income taxes. This idea is explored in greater detail in our February report Taxed by Inflation.
Investors should do what they can now to protect their wealth from the effects of the inflation tax by seeking assets that will potentially hold up if the dollar does not.
© Euro Pacific Capital
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