In the 1800s, Colonial India had a snake problem. Venomous cobras were roaming Delhi and causing death and chaos. The British quickly devised a plan to deal with the cobras, offering cash rewards for every cobra killed and brought in to the government. Initially, it worked, but then some crafty people started breeding cobras for extra cash. When the British figured out the scam and ended the program, the cobra breeders retaliated by setting the captive snakes free into the streets. Later on, German economist Horst Siebert studied this and coined it the “cobra effect” as a cautionary example of government intervention gone bad.
The cobra effect is now especially timely because it offers a window into how US government policies have made the economic effects of the coronavirus pandemic worse and offers clues for how to fix it.
Was it a good idea to pay young, healthy people not to work? In hindsight, maybe not. To set policies that reduce the supply of domestic oil without creating an alternative energy supply? Again, bad idea. Doubling tariffs on Canadian lumber in the middle of a lumber shortage, and maintaining tariffs on Chinese chips in the semiconductor shortage? Not good. It’s not an accident that the worst shortages are in goods with barriers to free trade. Similarly, offering forbearance on student loans without incentivizing borrowers to pay down their loans is a perverse incentive – one study found that nearly 90% of borrowers spent the money on consumption rather than paid down their loans. They will be in no better position when forbearance finishes.
Of course, it’s easy to sit here and complain about the government. The overwhelming majority of people in power are not evil, and there was no grand conspiracy to mess up the economy. But expansive government policy that was drafted in a matter of days in response to the pandemic has acted to reduce supply and increase demand over the past couple of years, which royally messed up the economy. These policies need to go in order for our society to maintain the standard of living that it’s used to. These issues will not be solved overnight, but by reversing course, policymakers can put a substantial down payment on the process of healing and growth that needs to happen for the economy – and society at large.
Inflation is not transitory, but it’s curable and has been successfully beaten before. The inflation-beating economic playbook was last executed about 40 years ago by the Reagan Administration here in the United States and Margaret Thatcher’s government in the United Kingdom. Sound money, supply-side economics, and patience are the only way out. Inflation is fixable for the economy in the same way that fitness is for individuals – many do not have the willpower to do what it actually takes.
For what it’s worth, I actually do think they will successfully bring inflation down because it’s the No. 1 concern of voters, but it’s not going to be fun for the portion of the American public who thinks that the surest way to get rich is to take out as much debt as possible to buy stocks and real estate. For you as an investor, the main theme is to be cautious, avoid speculative areas of the financial markets, and make some investments that can do well in inflation, which I’ll discuss below.
The Weird World of CPI
All the random shortages I’m noticing here in Texas (like the Topo Chico shortage) are one reason I think this Thursday’s CPI inflation report might be higher than the expected 0.5% month-over-month rise (7.3% year-over-year ), with the other reason being the rising price of crude oil, which drives up transportation costs.
But it’s worth noting that the biggest component of CPI (and by definition, most household budgets) is housing, and that’s not good for the Fed’s mission to bring inflation down.
What’s quirky about how they count housing is the concept of owner’s equivalent rent. It’s not broken out on the graph, but rent only makes up about 8% of the total CPI, not because that’s what the typical person spends on rent, but because America is mostly a nation of homeowners, with around two-thirds of households owning their home. CPI measures the broad economy, and since most households own their homes, the government has to account for what it would cost them to rent a similar place to the one they own to avoid double-counting inflation. Owner’s equivalent rent (OER) accounts for about 24% of CPI (the remainder of the housing component is stuff like insurance, taxes, and short-term rental costs). The methodology is odd because they literally survey a bunch of homeowners for this, take the average, and their answers affect everything from the amount of people’s social security checks, contracts tied to CPI, and tax brackets. OER tends to create a lag in the rate of inflation between the conditions on the ground and the numbers in the index. Rent is up a lot, but OER is not up much yet.
I do not think this is a conspiracy per se like some people on the internet think it is, but it’s not a great way to measure housing inflation, and it has the effect of understating inflation in booms and understating deflation in busts. Decades ago, CPI counted home prices. It obviously overstates inflation to count home prices, since homes are an investment – it would be a bit like counting rising stock prices as inflation. When I was in school, this was always a debate I had with professors – a lot of mainstream economists think that CPI is a little overstated, while there’s an obvious conflict of interest that would encourage the government to understate inflation to keep taxes up and entitlement costs down. This was a big deal during the Obama years when his administration proposed using the so-called chained CPI to help control the growth of entitlement spending.
To these points, there was a highly-published Dallas Fed paper last August that made the case that CPI was understating inflation due to leases not coming due yet and big increases in the price of lease renewals and owners equivalent rent that were more or less baked in as soon as this time last year.
The Fed’s conclusion was that annual core inflation is likely to be as much as 1.2 percentage points higher than it would be by 2023 to reflect the reality that has already happened – even if nothing else goes up in price. My conclusion from reading the paper is similar. No matter what the Fed does, inflation numbers are going to exceed expectations for the next couple of years and inflation is going to be very stubborn to get down. How bad will inflation get? Inflation isn’t likely to reach extreme levels, but it’s going to be tricky for the Fed to try to get down. Having over a 5% rate of inflation for 2022 is not out of the question. When oil goes up, it filters into the cost of everything else because the cost to move goods rises.
The Fed likes to forecast core inflation rather than CPI because energy and food are more volatile, but the current forecast is for core inflation of around 2.6% for 2022. My guess? I doubt it. At a minimum, this is likely 100 basis points too low, just based on inflation we’ve already had that needs to filter into the data. If CPI comes in above estimates this month, expect a big move up in rates and a big move down for the Nasdaq (QQQ).
In the long run, things will work themselves out. It’s really not normal that population growth is the slowest it’s been in decades, yet rent and home prices are surging, while wages really aren’t. A lot of this is speculative activity, and it will take some time for the speculators to realize that the demand is only temporary. Housing starts are way up while population growth is not, and eventually, the energy supply issues will work themselves out. But the idea that the Fed can sit back and do nothing or not take much action and inflation will automatically fix itself is a dangerous fantasy (the current projected 1.5% cash rate for year-end 2022 does not seem realistic and is likely to be adjusted). Similarly, people buying Ponzi coins and meme stocks as their preferred path to wealth are not getting the message that the tide has turned against those who are forever counting on loose monetary policy.
What Will The Fed Do About Inflation?
A lot of traders are assuming that when the White House and the Fed say inflation is a problem that the government is lying and will not do anything to fix it because inflation is the true intended goal. This attitude is very common among young, highly educated & affluent people who benefit from inflation. Though I do not agree with it, I understand where people are coming from when they say they lack trust in the government because of the way the pandemic was handled. However, affluent people with tons of debt could be caught offside by not taking leaders at their word here. The broader public hates inflation, especially working-class people and older people on fixed incomes. This point is going to be driven home in the midterm elections as both political parties pivot their policy platforms to stop runaway inflation, which now polls as the number one concern that voters have.
The Fed is going to do what it needs to do to get inflation down even if their current forecasts understate what they may need to do. This is more important of a priority than making asset prices go up. Asset prices going up may not be a Fed priority at all anymore. The Fed is willing to shrink its balance sheet with quantitative tightening, which could quickly drive up interest rates to levels that will slow the economy and crush speculators. Ignore this at your peril. Of course, we might get lucky and inflation starts to slow on its own, reducing the amount of tightening the Fed needs to do to achieve its goals. But ongoing shortages and out-of-whack markets suggest that the Fed is at least a little behind the curve here and will need to catch up.
I’m thinking of a few asset classes that you might want to consider to hedge inflation here. One is the oldest asset class in the world, and the other is the newest.
- Of course, gold (IAU) is the oldest form of money in the world and a sound inflation hedge. I’d pick up 1-2% of gold in your portfolio for every 10% of bonds that you have.
- The world’s newest asset class is Bitcoin (BTC-USD) and I think it serves a similar purpose to gold for a small portion of your portfolio, with more upside but more risk. I’d own both crypto and gold, regardless of whether CPI comes in higher than expectations or not.
- Given what we know about CPI and how it’s calculated, I Bonds are another good play that will pay 7% annualized and offer protection against further inflation. As mentioned before, there’s a $ 10,000 per person per year purchase limit.
- Inflation does not affect all sectors of stocks equally, so here’s some research I found (republished from Goldman Sachs) on what sectors do best in times of inflation. Choose your sectors wisely.
The Fed should bring inflation under control sooner or later, but these hedges can help you hedge the risk of unexpected inflation.
This week’s CPI numbers will have a substantial impact on the direction of stock prices from here. Oil is up big from last month, goods shortages aren’t going away, and stuff like the Canadian truck strikes will make inflation a fair amount harder to stop in the medium term. My guess is that inflation is a little more entrenched than the Fed believes, but that it will ultimately be conquered. Many people are overpaying for assets on the basis that they expect the Fed to bail out the Nasdaq if asset prices fall, but this is a moral hazard and a highly dangerous assumption. I reiterate my call for a 2022 market correction concentrated in consumer-facing stocks and tech.
As hard as it may be, trust the democratic system here to slowly fix the issues at hand, and do not pay uneconomic prices for assets expecting to get bailed out. Also, look at some of the above ideas to hedge inflation.