Inflation: The 800-Pound Gorilla – March 11, 2022

Inflation: The 800-Pound Gorilla – March 11, 2022
Morgan Lewis Posted on March 12, 2022

Inflation: The 800-Pound Gorilla

The themes of geopolitical, economic, and market turmoil continued unabated this week. While ongoing fighting continued, hopes of productive talks between Russia and Ukraine seemed to flare-up and fade on a daily basis. Western sanctions and Eastern counter-responses bounced back and forth between spheres like a ping-pong ball. US and global stock markets sold off, commodities began to correct some of the eye-popping gains seen recently, and gold tested all-time highs before pulling back. 

Notably on the week, credit markets are now seeing significant broad-based outflows while bond indexes and ETF’s are tanking even more aggressively than stocks. In fact, a vicious cycle of de-risking and de-leveraging seems to be taking hold in credit markets. As these markets tend to lead stocks, further downside in equities seems likely. 

While no one is paying attention, China’s distressed property development sector appears to be in full meltdown. 

Meanwhile, according to Bloomberg and Bank of America client data, despite declines across major stock indexes, this was the ninth straight week of feverish dip buying by retail investors piling into stocks. While retail dip buyers may catch a bounce, the folks at Elliot Wave summed up the situation best. “When the little guys climb over one another to buy the outbreak of war, it’s not just indicative of a top, it’s indicative of the top.”

Global markets are being driven by a number of critical factors that have established themselves and ripened over many months. The crucial market-relevant factors of the pandemic recovery cycle have faded and been usurped by a new set of dominant forces driving markets. The primary dynamics of the previous regime supported a bullish euphoria in equity markets. The new regime dynamics, on the other hand, are powerfully bearish. This major turning point has been playing out for many months, and the transition continues in volatile fits and starts week by week. At present, in the evolution of our unfolding bearish cycle transition, no factor looms larger than inflation.

Inflation takes hold as too much money chases after too few goods. As inflation accelerates, it has an increasingly negative impact on both consumer spending and corporate profit margins. The net effect of consumers and producers increasingly unable to keep up with the strain of rising prices is, eventually, a slowdown in economic activity. Unless inflation is reined in before it kills growth, the economic cycle can abruptly turn from boom to bust. This is precisely the risk we face presently in our global economy and markets.

This week, the last consumer inflation measure before next week’s pivotal Federal Reserve FOMC meeting was released. On Thursday, the Labor Department reported that the headline Consumer Price Index (CPI) reached 7.9% year-over-year in February. Core CPI, excluding food and energy, came in at 6.4% Y/Y. The results were in line with already elevated expectations, and both represented sizable increases over last month’s already smoking-hot readings of 7.5% and 6% respectively. The February CPI is the latest escalation in what is the sharpest increase of inflation since 1982. 


As if 7.9% weren’t bad enough, keep the following in mind when considering the actual magnitude of the inflation factor in today’s economic equation. The Bureau of Labor Statistics has altered its CPI methodology about 19 times since 1980. If re-adjusted, our current white-hot CPI readings would be double their current levels using 1980 methodology.

Ominously, the inflation now engulfing the economy is, at this point, almost certainly a harbinger of even higher prices still to come. Massive monetary policy stimulus, near zero interest rate policy, unprecedented fiscal stimulus that fueled robust consumer spending, a wage-price spiral, and persistent supply shortages have sent prices on an elevator ride to the top floor. What’s more, housing costs, which make up about a third of the government’s CPI, have risen sharply and will continue to rise as lagging Owners’ Equivalent Rent continues to play catch-up to higher market prices.

What is frightening and absolutely crucial to understand is that Thursday’s CPI report does not factor in the recent surge in energy and commodity prices seen in the wake of Russia’s invasion of Ukraine. Nor does it reflect the literal war of sanctions and counter-reactions continuing to mount by the day. Significantly, if inflation was being driven by transitory supply chain bottlenecks, as the Fed has long assured us, then we must now understand that sanctions and counter sanctions complicate and perpetuate global supply and supply chain issues. Rather than abate, supply and supply chain issues are now likely to spread, deepen, and last longer.

Reacting to the latest CPI reading, senior economist at AllianceBernstein Eric Winograd said, “The numbers are eye-watering, and there is more to come.” Winograd added that, “The peak in inflation will be much higher than previously thought, and will arrive later than previously expected.”

Inflation is now fully raging at an accelerating pace, and central bank policymakers have missed their window to deal with inflation before it matured into a lethal monster. At present, however, the signs are already mounting that the monster’s impacts are nearing the danger zone.

According to the University of Michigan Surveys of Consumers released on Friday, a full-fledged inflationary wage-price spiral is locked in. Survey chief economist Richard Curtin describes the dynamics colorfully when observing that, “Like the game of musical chairs, everyone continues racing around the circle of rising prices and higher wages. Although everyone knows the game will end, everyone still wants to obtain the highest income possible before they exit.” 

The “game,” however, is taking its toll. Consumer sentiment, already at low levels not seen in over a decade, continued to decline significantly in March “due to falling inflation-adjusted incomes.” For most Americans, especially those in the lower income brackets, inflation is running far ahead of the pay raises that many have received in the past year. Dr. Curtin added stunning and sobering clarity to an understanding of the current state of the consumer when reporting that, “Personal finances were expected to worsen in the year ahead by the largest proportion since the surveys started in the mid-1940s.” Consumers are badly losing the battle of inflation-adjusted income. As a result, unless something changes, it is only a matter of time before this fact manifests in an upended economy. This week, speaking to the significance of this reality, Bank of America chief strategist Michael Hartnett said that a US recession was likely incoming “if real wage growth remains negative by summer.”

Unfortunately, given the powerful price increases already teed up, it’s increasingly difficult to imagine a scenario where real wages turn positive anytime soon. As of Thursday, gas prices had skyrocketed by 60 cents on the week as the national average gas price set a new all-time record high for the third day in a row. According to AAA, gas hit $4.32 per gallon on Thursday. That’s up from $3.72 per gallon just one week ago. A month ago a stop at the pump cost you $3.48 per gallon, and the same fill-up a year ago set you back $2.81 for each gallon added to your tank. These increases represent a record heavy burden on the backs of consumers that is building at a record pace. Not only have we never seen gas prices this high, but we’ve never seen them rise so fast. With the recent increase in oil prices continuing to filter through to gas prices, analysts suggest that further gas increases are assured.

Tom Kloza, the head of energy analysis for the Oil Price Information Service (OPIS), which supplies data to AAA from 140,000 gas stations, told CNN this week that rising gas prices would continue. Analysts suggest that a national average of $4.50 per gallon is already in the pipeline. According to Kloza, “This is not the end of it… We’ll hit $4.50 a gallon… The risk is how bad this gets.” Kloza added that the situation is “absolutely out of control.” 

Furthermore, some analysts are suggesting that any oil price over $100 per barrel will translate to a national average gasoline price of at least $5 per gallon. In the event that oil prices surpass the 2008 record high and eclipse $150 per barrel, analysts see the possibility of national average gas prices at $6.50 per gallon or more. The impact of such high gas prices would almost certainly bring the economy to its knees in a hurry. A discomforting thought when considering that several weeks ago JPMorgan warned of the possibility of $185 per barrel oil.

In addition to gas, food prices are also set to rise further. On Friday, the UN’s Food and Agriculture Organization (FAO) warned that global food prices, already at record highs, could rise by more than an additional 20% as the conflict in Ukraine rages. On Friday, speaking of Russia and Ukraine, FAO Director-General Qu Dongyu said in a statement that, “The likely disruptions to agricultural activities of these two major exporters of staple commodities could seriously escalate food insecurity globally.”

Further complicating matters, recent HAI’s have red-flagged inflation expectations as being at a critical juncture. Inflation expectations are the Rubicon in the battle to avoid a full-blown outbreak of inflation psychology. If future inflation expectations continue to increase, inflation psychology will kick in full bore, and self-perpetuating inflationary behavior will follow. In the event that happens, inflation will graduate from crisis to catastrophe. 

Well, in this week’s UMich survey release, one-year inflation expectations vaulted higher after being stagnant for months. One-Year inflation expectations have remained elevated but stable in the mid to high 4% range since last May. The latest reading, however, collected over the last two weeks, jumped dramatically up to 5.4%. That’s the highest level the UMich survey has recorded since Kim Carnes topped charts with “Bette Davis Eyes” and Rick Springfield was pining over “Jessie’s Girl” back in 1981.

The breakeven rate is another measure of market-based inflation expectations, and we’re now also seeing forward inflation breakevens on the move higher as well. Both the 5-year and 10-year measures are now pushing to new multi-year highs. The 5-year breakeven has risen to 3.59% from 2.71% as recently as earlier this year, and similarly the 10-year breakeven is pushing towards 3% from the low 2% range seen earlier this year. 

These moves in future inflation expectations are extremely significant. Until now, the Fed has largely succeeded in keeping inflation expectations relatively in check by constantly promising that, if necessary, they will apply the necessary tools to subdue prices. The recent evidence, however, suggests that the Fed may be just starting to lose control of future inflation expectations as mounting facts on the ground overwhelm confidence in Fed promises. That is a possibility with distinctly unwelcome implications. As far as inflation goes, that would introduce a hard-to-fathom worst-case scenario.

In response to the dramatic events of recent weeks, Saxo Bank head commodity strategist Ole Hansen said, “We are going to face a period of extremely high inflation where central banks will be struggling to put up a defense because of other constraints.”

To understand what markets and policymakers are dealing with in our modern moment, one must understand the “constraints” Ole Hansen is referencing. In the Fed’s potential policy quiver, they are relegated to an ever-decreasing number of increasingly bad options. As Mohammad El-Erian has said, we have put ourselves in the “nightmare scenario” where our options come down to a “lose-lose” policy choice. Tackle inflation or attempt to protect growth. To protect growth, at this point, likely means perpetuating policies that almost certainly would ensure that inflation becomes secularly embedded, psychological, behaviorally entrenched, and, as a result, self-perpetuating and self-sustaining. 

On the other hand, implementing the policies and “tools” needed in sufficient doses to tackle inflation very likely means sacrificing growth, the economy, and markets. If significantly higher interest rates are part of the cure, as they almost certainly would be, then a world awash in debt would also face a debt crisis, with crippling interest payments swelling along with rates. Now, with inflation having greatly compromised the Fed’s decades-long preferred “kick-the-can” strategy, there are no easy answers left. As Former Treasury Secretary Larry Summers said, “This is a very serious moment, and it’s a moment when policymakers have great responsibility to do things that are not easy.”

Next week, Fed Chairman Powell and the FOMC will meet, initiate the first interest rate hike, and begin to implement a policy course that will aim to address impossibly difficult circumstances. I hope they rise to the occasion with wisdom, skill, and the ability to make the right tough choices.

Inflation was always the obvious risk of the bad economic policies we have long implemented. However, what was once future is now present. The bill has come due for the blithe promises and future-robbing-for-present-consumption of Keynesianism and MMT. Barring a last minute miracle, with inflation already having reached a 40-year high, the events of the last several weeks have likely sealed our inflationary fate for the foreseeable future. Ruinous runaway inflation on Main Street seems locked-in at this point, unless the fire is put out by an equally ruinous deflation on Wall Street. Again, “lose-lose.”

For decades, policymakers have chosen to take the easy way out of increasingly complicated circumstances. The favored course has been to ignore or deny the fact that, while promising economic nirvana, our policies compound long-term mounting structural problems. ‘Print, flood markets with liquidity, aggressively cut interest rates, and kick the can down the road’ has passed as viable policy. This has all been aided and abetted by the irresponsible sense that we’ll worry about any future negative consequences later. 

As Henry Hazlitt correctly reminds us all, however, “the tragedy is that, on the contrary, we are already suffering the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist yesterday urged us to ignore. The long-run consequences of some economic policies may become evident in a few months. Others may not become evident for several years. Still others may not become evident for decades. But in every case those long-run consequences are contained in the policy as surely as the hen was in the egg, the flower in the seed.”

The future is now. Our circumstances at present are akin to being surrounded by dangerous minefields that we have been creating for decades. On our present course, we will continue to face an increasingly deadly array of minefields of our own making until we address the fallacy of our approach to problem “solving.” If we can replace careless expedience with wisdom as the dominant foundational principal of our political and economic policymaking, then, on the other side of a rocky transition, there will be reason for profound optimism. Let’s hope we chart that course.

Weekly performance: The S&P 500 was down 2.88%. Gold was up 0.94%, silver was up 1.43%, platinum lost 2.53%, and palladium gave back some of last week’s massive gain—off 6.21% on the week. The HUI gold miners index was up 2.64%. The IFRA iShares US Infrastructure ETF lost 0.10% on the week. Energy commodities corrected some of last week’s gains. WTI crude oil was down 5.49%, while natural gas was off 5.80% on the week. The CRB Commodity Index was lower by 1.61%, while copper lost 6.33%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.59% on the week, while the Vanguard Utilities ETF was off 0.68%. The US Dollar Index was up again, higher by 0.47% to close the week at 99.13. The yield on the 10-year Treasury surged by 26 bps to end the week at 1.74%.

Have a great weekend!

Best Regards,

David McAlvany
Chief Executive Officer

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