nflation has displaced COVID as the number one news topic, at least for the moment. Consumers are feeling the pinch of higher prices at the gas pump, the grocery store, and at their favorite restaurants. As shown in Chart 1, the 6.2% increase in prices over the past year is the fastest pace of inflation since the 1990s.
The broad-based nature of price increases is especially concerning, with about 40% of reported prices rising by more than 4%. Investors should prepare for more bad inflation news. The statistical smoothing techniques used to calculate CPI mean that most of the rise in home prices and rents over the past year have yet to be reflected in CPI data.
We have been expecting inflation to become a problem in the US economy for some time. In our March 31, 2020, report “Modern Monetary Theory to the Rescue”, we warned that aggressive money printing by the Federal Reserve combined with pandemic related shortages would create the perfect conditions for inflation (too much money chasing too few goods) https://www.caravelconcepts.com/blog/modern-monetary-theory-to-the-rescue. Inflation represents the bill coming due for the extraordinary measures used to fight the COVID recession.
We believe some areas of the economy will see relief from elevated prices in the coming months, particularly gasoline, cars, and assorted “stuff” imported from China. Home prices will stay elevated but future appreciation will be much slower, in our opinion. Escalating labor costs and persistent labor shortages are likely to keep prices rising for services and labor-intensive products such as groceries.
The deteriorating inflation picture suggests to us that the Federal Reserve will need to shut down its printing press sooner than expected. In addition, the current bout of inflation could change the policy bias at the Federal Reserve away from a primary focus on fighting deflation. Such a change would make the investing landscape far riskier and more volatile, in our opinion.
A great deal of ink is currently being spilled blaming the Biden administration for the current escalation in inflation. An equal amount of ink has been spilled defending President Biden from those charges and blaming his predecessor. In fact, the blame for the current predicament falls squarely on the shoulders of basic economics.
Both President Trump and President Biden embraced COVID response packages that created unprecedented peacetime budget deficits. Both Presidents financed their massive spending packages through printed money from the Federal Reserve. The budget deficit for spending approved in the last year of the Trump administration was about $4.0 trillion dollars1. The deficit for the first calendar year of the Biden administration is estimated at about $2.1 trillion.1 These extraordinary deficits were made possible by the Federal Reserve printing about $5 trillion over the past 2 years and using that newly printed money to purchase government bonds.
The inflationary potential for such a large injection of newly created money is detailed in virtually every economics textbook. However, politicians and policymakers convinced themselves that deflationary pressures in the global economy (aging population, technology, globalization, etc.) would protect the US economy from inflation. They were reassured that Fed policy did not stoke inflation after the 2008 global financial crises, despite a similar money printing binge from 2008 to 2014.
We believe that policymakers overlooked a key distinction between the 2008 recession and the COVID crises. Inflation results from too much money chasing too few goods. The Fed printed a great deal of money in 2008, but the housing crises and subsequent recession meant that the economy was weighed down with surplus inventory of every description. Ample money was injected into the economy, but inflation could not take hold in an economy awash with unsold homes, cars, and other goods and services.
1-Adjusted for the $900 billion stimulus package approved in the final month of the Trump administration.
By contrast, major elements of the global economy were shut down during the height of the COVID crises. Idled factories inevitably led to shortages rather than surpluses, especially in a globally interconnected world with complex multi-country supply chains. These supply chains were not designed to be shut down. Restarting them in the middle of an ongoing pandemic has proven extremely difficult. The result is an US economy swimming in newly printed money but with too few goods and services to buy. Too much money chasing too few goods has inevitably produced inflation.
Since inflation requires two conditions, too much money and too few goods, it can be alleviated if one or both of those conditions change. The Fed has started to wind down its printing press, but currently plans to keep injecting dollars into the financial system until about June of 2022. That means any short-term relief from higher prices will need to come from alleviating shortages. Fortunately, in some areas of the economy we believe that relief from shortages is on the way.
The cost of filling up with gas is a clear and unambiguous data point for consumers about gas prices and therefore overall inflation. The COVID global economic shut down left most cars, planes, buses, and ships sitting idle instead of burning fuel. Collapsing demand pushed oil prices down to the lowest levels of the past decade. US oil producers rely on relatively high cost “fracking” technology to produce oil. Plummeting oil prices forced them to conserve cash by slashing investment in new oil well exploration. Oil exploration as measured by “rig counts” (how many drilling rigs are looking for oil) fell from about 800 to less than 250 at the lows of last summer.
Oil prices doubled in recent months and rig counts have risen nearly 80% thus far in 2021. However, this increased investment in oil exploration will take several months to impact the current supply situation in the United States. Also, last year represented the second time in recent years that fracked well investors suffered catastrophic losses (2015 saw similar losses). This history of losses may cause investors to be cautious about ramping up their fracked oil investments. Any “twice bitten, thrice shy” investor caution could slow the return of gas prices to more comfortable levels. However, we believe current prices will eventually prompt a flood of US oil production.
A similar story is likely to play out in the car market. Last year, automobile makers and their chip suppliers shut down production in response to COVID. These companies are finding it impossible to return to full production because of chip shortages and other snafus in their supply chains. Meanwhile rental car companies responded to COVID travel restrictions by selling off their rental car fleets. Now they are frantically trying to rebuild those rental fleets just as many consumers, flush with stimulus cash, are looking to buy a new car. The combination of exploding demand and virtually no supply has caused new and used car prices to skyrocket.
This spike in prices is rapidly reducing demand for new and used cars. Consumer surveys suggest that auto purchases will fall rapidly in the coming months. Rental companies are also starting to reduce purchases as they complete their fleet rebuilding. We believe car companies are close to resolving some of their most pressing supply chain issues. Early in 2022 the supply of new cars should dramatically improve. Falling demand and improving supply should bring auto prices back down early next year.
A final source of reduced prices for “stuff” is likely to be China. China is the epicenter for much of the current supply chain issues. COVID related production disruptions have been exacerbated by periodic power outages designed to help China meet its carbon emission goals. These transitory production problems are likely to be worked through over the next several months.
Longer term, Chinese President Xi has embarked on a risky strategy to curtail excess debt and oversupply issues in Chinese real estate. The result of these polices has been a 33% drop in new home construction over the past year, according to a November 15, 2021, report from Reuters. Construction accounts for about 25% of China’s GDP, so the drop in new construction will reverberate throughout the Chinese economy.
The sharp decline in new construction will create more excess capacity in construction related industries such as steel, cement, electrical fixtures, and furniture. Slowing economic growth and declining home prices could cause Chinese consumers to reduce their spending. Overcapacity problems could spread from construction industries to encompass a broad range of consumer products. This excess capacity is likely to be dumped on global markets at greatly subsidized prices, creating a potential deflationary headwind that current US tariffs might not be able to fully offset.
Millennials seeking to buy their first home might hope for some relief from soaring home prices. Homeowners, on the other hand, are fearful that the recent runup in prices is the precursor to another 2008 type housing market collapse. We think that real estate conditions in the US are completely different from 2008. As a result, home prices will remain elevated although price increases are likely to slow.
Housing economists estimate that the US needs to build about 1.5 million houses per year to meet long term demand. As shown in the chart below, the 2008 housing collapse was preceded by nearly a decade of building far more than this long average demand. The market absorbed this excess supply of housing by selling homes to people who could not afford them. Gimmicky loans such as interest only and subprime mortgages allowed people to buy homes thanks to artificially low initial payments. When payments on these loans reset upward the borrowers defaulted. As forecloses skyrocketed, the excess homes produced over the prior decade suddenly flooded the housing market. A collapse in home prices resulted.
By contrast, since 2008 the US has persistently produced fewer than the required 1.5 million homes. This dearth of supply coincided with the millennial age group, the largest demographic wave in US history, hitting their prime home buying years. Despite much speculation that millennials were different from their parents, millennials are moving to the suburbs for the same reason their parents did – schools and a yard for the kids.
Lack of new housing and a big upswing in demand is not enough to explain the dramatic rise in home prices over the past 2 years. The Fed’s money printing efforts have driven interest rates to the lowest levels seen in recorded human history. Ultra-low mortgage rates have allowed millennials to afford higher priced homes despite the very conservative underwriting standards now required by mortgage bankers.
Unlike 2008, this housing boom is anchored by solid demographics and sound credit. Housing supply is unlikely to accelerate anytime soon due to a lack of skilled masons, carpenters, plumbers, etc. As a result, we see little prospect of a 2008 housing bust. However, as the Fed shuts down its printing press interest rates are likely to rise. That should put a damper on future home price appreciation.
Although we see potential for “stuff” to come down in price, about 65% of the US economy consists of services. The primary input to services is labor. Since we see continued upward pressure on labor costs, we expect service prices to keep rising.
Thanks largely to the tsunami of cash the Federal Reserve has injected into the economy, home prices and the equity market have soared over the past 18 months. This sudden surge of wealth convinced more than 3 million Americans that they could afford to retire ahead of schedule. As shown in the chart below, retirements accelerated during the COVID pandemic far above their pre-pandemic trend. The 3 million excess retirements explain why the US currently has 3.1 million more job openings (10.4 million) than it has unemployed workers (7.3 million).
The only “quick fix” for such a large imbalance in the labor market is to reverse the cuts in legal immigration implemented by the Trump administration. We see little political appetite by either Democrats or Republicans for such a policy reversal. A more plausible way for the labor market imbalance to be addressed is for the Fed to tighten monetary policy too quickly. That would tip the US economy into recession and drive labor demand down. Absent such a policy mistake, we think labor markets are likely to stay tight and wages continue to rise. Service price inflation could become a persistent problem for consumers.
For most of the past 20 years, the Federal Reserve has acted under the assumption that deflation is the primary risk facing the US economy. The current burst of inflation combined with continued labor cost inflation could change the Fed’s approach to future policy decisions. The Fed might return to its historical practice of balancing between the risk of deflation and inflation. If so, then investors could no longer assume that the Fed will automatically ease monetary policy whenever markets suffer a correction. The US Treasury might not be able to call on the Fed to help finance extraordinary budget deficits.
Until the new Fed Chairman has been announced, we cannot possibly predict how this burst of inflation will change decision making at the Fed. However, investors should recognize the potential for inflation, even if it proves temporary, to alter the investment environment. If future Fed policy is increasingly shaped by inflationary instead of deflationary concerns, financial markets could become more volatile and unpredictable over the coming decade.
