20 Oct Immaculate Inflation
“Has the Federal Reserve engineered an inflation rate that will propel America’s economy ever upwards?” – The Lonely Realist
Why did America (and the world) experience an inflationary kick two years ago? More importantly, why did that inflationary kick accelerate economic growth? Will that growth continue?
From the depths of the Great Recession in 2009 through the COVID pandemic of early 2020, the U.S. pursued a policy of unprecedented fiscal and monetary expansion. The execution of that policy reduced unemployment from 9.9% in 2009 to 3.6% in 2019, one of the lowest unemployment rates ever achieved in America. Although many labeled the 20-teens an age of “Goldilocks Economic Management,” America paid a price, a price it will continue paying years into the future. Those 12 years of American prosperity were fueled by debt-socialization with Federal deficits averaging more than 3% of GDP/year super-charged by wave-after-wave of Quantitative Easing. Even so, annual GDP growth was anemic – ~2% during a period of extraordinarily low inflation (less than 2%/year). Goldilocks indeed!
When COVID struck, workers were told to stay home. Manufacturing, warehousing, transportation and shipping ground to a virtual halt. Supply chains became dysfunctional. White-collar workers were able to stay on-the-job by working remotely. Manual laborers could not, transitorily reducing the supply of goods. Supplies were further reduced when businesses (factories, airlines, delivery services, etc.) rapidly downsized. Doing so ordinarily would have reduced aggregate demand …, but not this time. The Federal government responded with emergency funding …, lots and lots and lots of emergency funding. The Federal Reserve was even more accommodative, initiating an enhanced round of extraordinary monetary policy initiatives. The combination of massive fiscal and monetary relief ignited consumer demand for goods and services to a level that more than offset the adverse economic impact of COVID. Fiscal and monetary policy already had been wildly expansionary prior to 2020. During COVID, it reached historically unprecedented peacetime levels. The result was rising demand in the face of collapsing supply. Unsurprisingly, inflation followed, reaching 9% in 2022.
That explains the cause. What explains the subsequent economic growth?
When you start with interest rates at zero, which was Fed policy for the 12 years following the Great Recession, raising interest rates by more than 5% starting in March 2022 as the Fed did doesn’t slow the economy. It stimulates it. Economic growth accordingly accelerated.
The higher interest rates increased household disposable income. Americans own more than $13 trillion of interest-bearing investments and have borrowed only $5 trillion of non-mortgage debt. The arithmetic implies hundreds of billions of Dollars of annual incremental interest income. Americans are investing that additional income in the stock market …, a principal driver of this past year’s transitory? bull market. In addition, since most homeowners locked-in fixed rate mortgages and, in the current inflationary environment, are disinclined to part with their highly-affordable homes, there is an inadequate supply of housing-for-sale that has increased inflationary pressures and expectations. This has incentivized spending. Not surprisingly, core retail sales figures for September (reported this past week) far exceeded estimates and provided further support for the conclusion that American consumers remain flush and are spending their excess cash, the very definition of “wage-price spiral.” Coupled with Federal subsidies from the inaptly-named Inflation Reduction Act, the Chips and Science Act, and the Infrastructure and Jobs Act, there also is plenty of money for businesses to invest in spend on infrastructure, inventory and additional capacity.
Although higher interest rates have raised the cost of doing business for those businesses that borrowed at a variable rate (with potentially catastrophic consequences to their bottom lines), they have had the opposite impact on America’s better-run businesses that locked-in long-term fixed rates. Inflation has given
those all businesses a tail-wind to raise prices – which consumers have easily digested –, resulting in a widespread increase in business profitability. This has led many businesses to accumulate larger cash balances that earn higher interest income that is only partially offset by lower fixed-rate interest expense, a net plus for profits. Rising stock market valuations have been a result.
Since both individuals and businesses are benefiting from higher interest rates, increasing income, profits and capital spending, and with the Federal government lavishing subsidies through the Biden Administration’s spending programs, America’s economy is growing. It will continue to grow as long as the Federal government continues to inject more Dollars into the economy than it receives in tax revenue. America currently is running annual deficits of ~$1.7 trillion (~6.3% of GDP) and is likely to continue running trillion dollar+ deficits for years to come. Growth accordingly should continue.
Is inflation therefore here to stay? Yes, it is …, the only question being “at what level?” – noting that, even with wars in Europe and the Middle East, the 10-year Treasury Note still carries an interest rate that is less than at any time from 1966-2002. The markets accordingly are not fearing an inflationary spiral. Should they be?
Because America experienced 9.1% inflation in 2022, social security benefits rose 8.7% in 2023. With inflation running at ~5% in 2023, benefits will rise 3.2% in 2024. Over the past year, 27 States and D.C. have increased the minimum wage (by between 2.28% and 14.29%) and in August the Biden Administration increased Federal worker wages by >5%. Because workers react to inflationary realities, they are asking for and receiving sizable wage increases …, and gearing their spending accordingly. Private employment costs have risen ~4.7% this year. America’s autoworkers are demanding even higher multi-year wage increases of 40% over 4 years, a raise that would mirror the >40% pay raise over 4 years recently received by pilots at American, Delta and United Airlines. Businesses naturally are passing their increased wage costs along to consumers. An incipient wage-price spiral is the result, signaling that inflation is not likely to settle down any time soon. The question is whether the Fed’s interest rate hikes, transmitted to the bond markets and reflected in mortgage rates, will contain the inflationary trend in 2024. Although the Fed’s goal is to balance QT to reach an inflation reset of 2%, real world realities are likely to interfere, making 2%
an unattainable a challenging goal. Deficits abound. Wage demands continue. Consumer spending isn’t yet slowing. Energy prices appear set for take-off. Spreading wars are inflationary (and the instability they create increases QE pressures). Rents and home prices are responding to rising demand and constrained supply. Even so, the American economy seemingly is balanced between relatively stable inflation and GDP growth of perhaps 3%. It is to be hoped that this balance can be sustained (although recessionary clouds loom). Fed oddsmakers anticipate perhaps one more interest rate hike this year. If so, inflationary pressures may guide the American economy to a soft landing. If not, America’s economy may be in for a shock.
An index of TLR titles can be found here.
Finally (from a good friend)