The shock of record inflation is now impacting financial markets, politics, and society at large. Recent surveys suggest the “inflation issue” is now more important than the virus issue to most voters going into the 2022 midterm elections. Inflation data has generally run consistently above expected levels over recent months, with annual CPI growth climbing to another 40-year high of 7.5%. The recent inflation beat potentially prompted the Federal Reserve to plan an emergency meeting with the potential of pursuing a surprise rate hike soon, a double-hike in March, or an immediate end to Q.E.
Undoubtedly, the behavior and thinking of Federal Reserve officials have an extreme impact on markets today. This focus is understandable because the Fed’s QE policies since 2020 have nearly doubled the monetary base and enabled immense corporate and public debt growth through its zero interest rate policy. To a significant extent, financial markets have become addicted to “easy money” policies which have persisted since the 2008 recession. However, such policies are now directly contributing to significant inflation and are thus expected to end very soon.
In general, most economists today – those who work for the government in particular – have habitually argued that inflation is “transitory.” Early on, when the virus first became an issue, most economists were far more concerned with deflation than inflation. While I may not be what Joe Biden would refer to as a “serious economist,” it is worth pointing out that I first warned about persistent inflation in May of 2020 in “The Coronavirus Is Neither Inflationary Nor Deflationary,” stating (from the summary):
“COVID-19 has seen an immediate deflationary shock, but growing supply shortages spell a problem.”
“With too much money chasing fewer goods, it is likely that “grocery store inflation” continues to increase, while ‘non-necessity’ goods see much lower prices.”
“Unprecedented Federal Reserve stimulus could easily cause inflation to get out of hand.”
Of the predictions made in that article, the only area where I was incorrect was my view that the economy would enter a stagflationary recession with lower “non-necessity” (i.e., new vehicles) goods prices would falter as people reduced excess spending. Instead, stimulus and lockdown measures both persisted for far longer than I expected at that time, leading to more significant supply shortages (from lockdowns, etc.) and persistently high discretionary consumer spending (from the stimulus). However, as that stimulus ends, I suspect inflation will remain high for some time (as implied by rising commodity prices) while most economic segments slow.
At that time, I also did not foresee the key “Great Resignation” or “Lying Flat” trends which imply that the “non-material value of money” has declined for many people around the world. Around the world, the ongoing era of uncertainty has understandable caused many people to wish to work less and adopt a more minimalist lifestyle. In my view, this is a critical social trend to keep in mind since if more people no longer aim to maximize material wealth, then it is likely that global worker shortages will persist for a long time. Many economists struggle with this concept, clinging to the view that high wage inflation in industries with deficits will cause the gap to be filled. However, I would argue that growing feelings of political, social, and economic instability have caused many people to reassess their long-term goals. For example, if a person truly feels that the “sky is falling,” why would they want to stay at a job they sincerely dislike?
The Three Causes Of Inflation Persistence
Overall, I argue there are three interrelated causes of inflation, none of which can reasonably be “blamed” on any group or individual but are instead indications of broader societal shifts. First, years of low CapEx spending and labor investments into energy, mining, shipping, and food industries lead to low-to-negative commodity production growth and transportation capacity. This pattern is in line with the traditional “commodity supercycle,” whereby low prices (such as those of the 2010s) lead to lower investment and eventual shortages. This factor directly contributes to higher commodity prices today and is likely to persist for some years as it will take time for physical capacity to be restored. Most of these inflationary shortages may not fade even if there is a recession since demand for food and oil are highly inelastic (demand hardly falls when prices rise).
The second major inflation factor is undoubtedly the US and global monetary and fiscal policies. Efforts to artificially increase economic demand were largely successful at stopping a long-term recession but have created a large gap between supply and demand. This factor includes massive money-supply expansion reductions in the cost of debt which occurred in reaction to COVID, and those which occurred since 2008. Evidence suggests that much of this “injected” money went into asset prices instead of boosting demand for physical goods, boosting asset valuations but not necessarily increasing inflation. Additionally, suppose it were not for doubling the monetary base (and low rates) since 2020. In that case, likely, employment and the economy would never have recovered from the extreme negative economic impact of lockdowns.
In the future, the Fed will likely take measures to reduce economic demand through monetary policy, which will also encourage the U.S government to reduce massive deficit spending as Treasury interest rates rise materially. As the “easy money” era ends, highly indebted governments, corporations, and households will likely face issues as interest rate expenditures grow. This shift will most certainly slow the economy and may close supply-demand gaps for high-demand elasticity items. Of course, higher interest rates will not boost commodity production as is needed to normalize inflation and may even worsen it as commodity producers face steeper financing costs.
The last factor is the social issue of “lying flat” with growing avoidance of “boring” jobs and altogether reduced levels of worker ambition. This factor is the most difficult to measure and foresee in the future. Still, I believe it is far more critical than the other two since there is essentially nothing reasonable the government can do to make people like their jobs. While it may be hard for some to admit, the global economy benefits from people having a “rat race” mentality since it leads to higher hourly productivity and job demand. Economic segments with more extensive worker shortages see immense wage growth above the inflation rate. However, as primarily blue-collar employers pay more for workers, they’ll need to raise prices even more, to maintain profits – leading to even higher inflation.
Data Implying Continued Rise In Inflation
Overall, I believe those factors that have pushed inflation up are relatively straightforward. Most of those forces will persist, yet most economists believe that the inflation rate will decline to somewhat normal levels over the next two years. Indeed, this can be directly seen in the implied inflation rate, which can be found by subtracting the yield of a traditional Treasury bond from one of an inflation-indexed Treasury bond of equivalent maturity. These “Inflation-indexed” bonds pay a low and often negative “real yield” but are directly indexed to the CPI and hypothetically should have a very similar net return to “normal” non-indexed bonds (given no change in the inflation outlook).
While the Federal Reserve does not accessibly publish data for short-term inflation-indexed bond yields (otherwise known as “real yields”), they can be easily found in the holdings data of the iShares ETFs (STIP) (0-5 years) and (TIP) (5+ years) which directly states the real yield of each bond in the funds. In order to compare, I also analyzed the holdings data for the entire traditional Treasury yield curve through iShares ETFs (SHY) (1-3 years), (IEI) (3-7 years), (IEF) (7-10 years), (TLH) (10-20 years), and (TLT) (20+ years). The data is shown below:
Note the sample I used had a few bonds maturing in the 2032-2035 range, but those yields can be easily interpolated. Overall, we see a steep yield curve in the 2022-2025 (0-3 year) segment followed by flatness from 2025 to 2050. This implies that the market suspects a long series of rate hikes this year and the following years but is generally uncertain about the long-term with no material inversion or steepness in either the real or nominal curve.
A valuable data set can be found by subtracting the two curves, which give us the “inflation curve” or the market’s expected average inflation rate over time. See below:
Over the next six months, the current inflation breakeven rate is just about 4.9%, falling to 3.2% a year out. The long-term inflation breakeven rate is currently ~2.4% ten years out, down to “normal levels” of 2.1% two decades from now. Importantly, this is a measure of the bond market’s expected average inflation rate over these timeframes, so this is merely saying the expected average inflation over the next decade is currently 2.4%.
Overall, the market expects inflation to be somewhat transitory but still above “target” levels of <2.5%+ until 2-3 years from now. Of course, we must remember that the Treasury bond market may not correctly price inflation expectations. It is worth pointing out that the Federal Reserve has been buying inflation-indexed bonds and traditional Treasury bonds, so they may not be exactly responding to “free market” dynamics. Indeed, there is some evidence for this given the recent disconnection between the inflation breakeven rate and the commodity price index. Typically, there is a strong correlation between base metals (DBB), crude oil, and the inflation breakeven rate. See below:
This strong relationship exists because commodity shortages and gluts are the primary forward drivers of inflation. However, zooming in to recent data, we see an apparent disconnection between the inflation outlook and commodity price trends:
There has been a sharp rise in the agriculture, energy, and base metal commodity markets over the past three months (since December specifically). However, there has been a slight decline in the inflation breakeven rates over the same period. Typically, the two are closely correlated, so this dislocation, though yet not huge, is still notable. Bond traders have likely become more bearish regarding inflation due to the enormous ~1.5% rise in 2-year Treasury yields since last fall. As explained earlier, this rise in yields is unlikely to aid the commodity shortage though it will still likely restrict demand in more elastic segments of the economy. Thus, the disconnection between the inflation outlook trend and commodities is somewhat understandable.
Still, with the prices of many key commodities hitting new long-term highs, it seems quite plausible that inflation will remain more persistent than the bond market expects. While the bond market expects the Fed to take sufficient measures to normalize inflation over the next three years, it may not be possible without throwing a mighty wrench into the economy. Massive action in the bond market implies significant measures will be taken to combat inflation, as seen in the meteoric rate of flattening in the yield curve. See below:
The sharp flattening of the yield curve, stemming from the enormous rise in short-term yields, implies a rapid decline in real GDP growth. While the curve has not yet inverted (an extremely strong recession indicator), it will shortly if it continues to flatten at this pace. Again, I doubt the bond market, which is still benefiting from QE (as of Friday 2/11), is fully pricing in the recession risk of rising rates. Indeed, this is a risk pertaining less to the “bread and butter” economy and more to its more financialized components. This is explained in greater detail in “The Stock Market Crash Is Likely Only Beginning.”
The Bottom Line
At this point, given combating inflation may ruin retirement portfolios for a decade or longer, I do not know if the Federal Reserve is genuinely willing to do what it takes to stop inflation. They were indeed ready to “do whatever it takes” to stimulate the economy and asset prices in 2020, but I still subscribe to the theory that “there is no such thing as a free lunch.” To me, monetary policies like QE and ultra-low rates are a bit like strong painkillers – they alleviate the symptoms but don’t fix the core issues. Sometimes, they can even make more new issues if done too much.
I say this not to point fingers at any persons or group as I believe societal expectations of endless external help forced the Fed’s actions in 2020. As investors, it is perhaps best not to expect stimulus or rescue from external forces and instead place your money where you truly believe the best resiliency is found. For me, that is precious metals and a few other safe-havens.