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Guest Post by Jeremiah Jackson
The Biden Administration has unleashed a torrent of inflationary pressures on an unsuspecting American public.
Rising prices are putting increasing pressure on President Biden and the Federal Reserve to prevent inflation from derailing the recovery from the coronavirus recession.
A surge of consumer demand unleashed by government stimulus, improving vaccinations and fewer pandemic restrictions is putting a strain on global supply chains. Manufacturers and other hard-hit industries are struggling to get back up and running after a year of lockdown measures, causing supply shortages and raising costs.
All of those factors combined to push the consumer price index (CPI) up 0.8 percent in April and 4.2 percent over the past 12 months, the fastest annual rate since 2008, the Labor Department reported this past week. When stripping out the more volatile prices for food and energy, the index registered the biggest monthly increase since 1982.
While the ramped-up consumer spending is a sign of increased optimism, the Biden administration faces political risks as Americans find themselves dealing with inflation levels that the country hasn’t seen in more than a decade.
Deepening concern among Americans about inflation could derail not only Biden’s economic agenda but also the Democrats’ hopes of defending narrow congressional majorities in the 2022 midterm elections. [The Hill]
Inflation, when general price levels rise, is an insidious government tax on your income and wealth, since everything costs more. It has toppled governments all around the world.
The Trump Administration always knew that the medical marvels it incentivized via Operation Warp Speed would come along faster than all the naysayers expected, and, like flipping a light switch, turn the economy back on. The administration therefore wanted to do a series of smaller, incremental economic support packages, knowing that hitting the gas too hard would slam up against a reopening economy.
By the spring it was very clear the vaccines funded by the Trump Administration would succeed in quickly restarting the economy, allowing people to get back to normal life. Nevertheless, and in contrast with the Trump Administration’s sound approach, the Biden Administration proceeded with a $1.9 trillion “American Rescue Plan” (ARP) which threw money at all sort of Democratic special interests. Any halfway decent economist will tell you that the time for big stimulus — a huge sum like $1.9 trillion — is when you know there will be a large, and sustained, shortfall in GDP and employment, as we had at the start of the pandemic.
But by the start of the year, the Trump Administration had managed to decrease the unemployment rate from a horrific 14.8% to a run-of-the-mill level of 6.3%. The Trump Administration went big at the right time, with the right kinds of programs, stopped a Depression dead in its tracks, and ushered in the fastest economic recovery in US history. The time to go big was in March of 2020, which the Trump Administration did; the time not to go big was when the Biden Administration forced the ARP through Congress along partisan lines.
The most inflationary component of the ARP is the $300 supplement to unemployment insurance, and it’s scheduled to last until September. There is plenty of evidence that the $300 supplement raises unemployment benefit levels above what workers received at their previous jobs. Such high benefit levels invite an obvious question: why would you go back to your job, put in a hard day’s honest work, when you can stay home and collect a check from the government? It shouldn’t be surprising that many workers chose to stay home.
Too-generous subsidies that reward staying at home can form a toxic brew when combined with the sudden reopening of the economy. Everyone wants to eat out, and nobody wants to wait tables. The result is inflationary pressure in low-skill services where it hasn’t been evident in many years, and can therefore easily take the Fed and the Treasury Department by surprise.
For evidence, one merely has to ask the National Federation of Independent Businesses, whose small business members reported an all-time record difficulty in filling open positions. Or, consult the BLS’ job turnover data, which finds a yawning chasm opening up between job openings and the number of hires being made. By this metric, which measures the gap between labor demand and supply, the current labor market is tighter than it was at any point in the Trump Administration!
Large firms, too, are reporting inflationary pressures. The Institute for Supply Management’s prices paid index averaged across manufacturing and non-manufacturing firms tends to be a good leading indicator for CPI:
Even Menshevik economists like Olivier Blanchard and Larry Summers have warned the Administration, but their warnings have all fallen on deaf ears. Federal Reserve Chairman Jay Powell tirelessly repeats that he views all incoming inflation as “transitory,” driven by “base effects,” and one-off factors like supply shortages in auto production. Treasury Secretary Janet Yellen backs up her former lieutenant, claiming that there is no risk of inflation from the Administration’s spending.
This week’s data release should worry the Administration and its defenders. Core inflation — inflation minus volatile components from food and energy — increased at 3% year-over-year. This is the largest increase since the early 1990s. The White House claims that this increase consists of just “base effects” driven by anomalously low inflation levels from a year ago. This argument doesn’t hold salt. If one looks at the inflation rate over the last three months, it is at its highest rate since 1990. Events last year, in the depths of the pandemic crisis, are irrelevant, when one looks at the last three months alone.
We can expect more inflation as reopening continues apace. Microchip shortages will keep the auto market tight. Housing prices are continuing to see double-digit year-over-year gains, which will keep the very important rent components of inflation elevated for a year or two to com. Energy markets continue to be disrupted, which feeds through into expectations and other components. And there are still crucial supply chokepoints in any number of other industries, from lumber to chemicals. These phenomena will elevate inflation expectations, which will persistently boost core inflation.
It is true that a good deal of this week’s inflation surprise is due to supply bottlenecks like a special shortage of used cars, as indicated in the chart below. But what this means is that the real inflation — that from wages and services — hasn’t even started materializing yet! In the coming months, higher prices on everything from restaurants, to rent, to airfares will result in much more meaningful inflation than we are seeing now. In fact, we can expect more inflation than we’ve seen in decades. This week’s report is just the start.
In sum, this Administration’s policies are a perfect storm for inflation: slamming on the gas (stimulus) and the brakes (unemployment benefits and naturally small excess capacity as we reopen) simultaneously results in the car staying put but the engine heating up.
BIDEN’S FAULTY FRAMEWORK
Why does the Biden Administration believe it’s impossible for inflation to move higher? Like many dogmatists in positions of power, they’re fighting the last war. For thirty years inflation has been moving steadily lower, driven in large part by the American elites’ betrayal of the working class via globalization. Corporations, aided and abetted by our politicians, laid off their American workers and moved production overseas to cheaper locations like China. This process implied sustained lack of demand growth in the US as people’s incomes weren’t what they were in the past, combined with sustained supply growth as cheap products flooded the country from abroad. The result was persistent downward pressure on inflation; no matter what happened in the years since the early 1990s, significant inflation never materialized, and deflation was a continual risk.
However, the world has changed dramatically in the last few years. The Trump Administration launched trade wars in an attempt to check globalization. Between tariff risk and the shocks of the pandemic, companies decided that long supply chains spread across many countries are a risk. They began to move production home and build in redundancies.
On domestic drivers of inflation, too, policymakers are fighting the last war. In the 1960s and ‘70s, the Democratic party believed that government could endlessly spend, and the central bank would always be able to finance that spending. The result was the hyperinflation which peaked during the Carter Administration, only to be reined in by Paul Volcker and the Reagan presidency. After the scarring experience of sustained double-digit inflation, Washington developed a consensus view that deficits were bad, and that the central bank’s priority should be to contain inflation rather than enable fiscal expenditures. This consensus contained inflation for decades, at the cost of persistently disappointing labor market outcomes.
However, that consensus has now unraveled. Inflation has been absent for so long that people stopped believing in it, so their precautions against inflation have lapsed; the scarecrow was so effective the farmer stopped believing in crows. Biden’s policies have brought us straight back to the profligacy of LBJ and Jimmy Carter, and the Powell Fed is determined to accommodate them. Why is the Fed so eager to accommodate such bad policy decisions? Well, it is not nearly as technocratic as it pretends to be, and has always been a highly partisan actor. For example, for most of 2016 it forwent rate hikes in an attempt to aid Hillary Clinton’s political prospects, and at the end of 2016 launched a devastating series of rate hikes to try to end Donald Trump’s. The Fed only backed off when President Trump took his criticisms of the institution straight to the American people.
And so, we find ourselves back in the pre-Reagan days. Sustained inflation is right around the corner.
Moreover, Revolver has been informed that elements at the Treasury and the Fed are deeply concerned about the inflation outlook, but are repeatedly rebuffed by their politically appointed superiors. These brave individuals objectively point out that if the size of the output gap is small and the size of the spending programs are large, then inflation is the natural consequence, only to be told by the political leadership that inflation doesn’t exist. They experience regular political pressure to revise their inflation views downwards. The application of political pressure to tamp down on normal procedures of caution is an unpardonable scandal.
HOW TO ADJUST YOUR OWN HOLDINGS
Obviously the right time to hedge would have been months ago, before the inflation story really picked up. At current levels, it is a little more difficult, but here are some things individual retail investors can do to minimize the effects of inflation on their portfolios:
1) Reduce exposure to fixed income (bonds). In an inflationary environment, bonds which pay a fixed, low percentage yield, will suffer tremendously as yields move higher to compensate. Once the 10-year bond gets above 2%, maybe to 2.5%, they will be paying you a little bit more to compensate for inflation risk.
Reduce exposure to interest-rate sensitive equity sectors. That means Big Tech! Tech benefits enormously from low interest rates, because their sky-high valuations on expectations of enormous future growth become easier to justify when the opportunity cost of money is low. But once interest rates are meaningfully higher, it’s harder to justify keeping your money locked up in Big Tech for a promise of future growth. Moreover, Big Tech came off an extraordinary year when everyone was locked up and had nothing to do besides use tech products. Valuations that reflect the unique phenomena of 2020 and project them going forward are undoubtedly wrong. In general, we should see a sustained catchup of value stocks to growth stocks.
2) Hold some gold, which provides a good hedge to strong inflation. Or silver. Yes, Bitcoin and other cryptocurrencies also provide some value as inflation hedges, but their prices have already soared relative to precious metals. Gold should play some significant catch-up. Moreover, there is significant risk that the Biden Administration will attempt to regulate cryptocurrencies, which could send the entire edifice crashing down quickly.
3) Commodity plays more generally are having a moment, and as long as inflation fears persist, that’s likely to continue. Besides, if Biden succeeds in getting his “infrastructure” legislation through Congress, those commodities will be important for the stuff the government will build; materials like copper are useful both in building traditional infrastructure like bridges, and “Green New Deal” infrastructure like renewable energy sources. Traditional energy companies remain one of the best-yielding but most-hated sectors and remain a contrarian play with good inflation hedge properties.
4) The dollar is likely to sustain its medium-term cyclical downtrend. Allocate some funds to foreign stocks, so that you get the benefit of currency diversification. There’s no need to fret about a collapse in the dollar or loss of reserve status, but a normal cyclical downturn will continue.
SOME GOOD NEWS FOR THE FUTURE
There is only one silver lining to all this: the Democrats have a real problem on their hands. As inflation continues to be too-high for the rest of 2021 and into 2022, the Federal Reserve will be in a very tough position. Its three leaders — Chairman Powell, Vice Chairmen Quarles and Clarida — all have expiring terms, in February, October and January, respectively. Until those positions are confirmed, the current leadership are primarily campaigning to keep their jobs. The Fed is therefore on autopilot until Chairman Powell’s potential renomination. The Federal Reserve is liable to keep purchasing $120 billion of US government-backed securities until early next year, and only begin hiking rates in late 2022 or early 2023, given this calendar.
Until they hike rates, they will insist that inflation is transitory. By the time they decide inflation is not transitory, it will be too late to nip it in the bud, and they’ll have to hike higher and faster than they would if they had begun early.
The implications of this are that inflation will be uncomfortably high for the rest of this year and well into next year. That sets Republicans up nicely to take back the House and Senate in the 2022 election, given the blame for these policy mistakes rest squarely at the feet of Joe Biden and Jay Powell.
Since monetary policy works with a twelve- to eighteen-month lag, Fed hikes that begin in late 2022 will begin slowing down the economy in early 2024. The longer the Fed waits to start hiking, the harsher the hiking cycle will have to be to contain inflation, and the harsher the slowdown in 2024. They are setting up the economy and the market for trouble in 2024, and giving Republicans an important edge in the election. Republicans will have to come back into Washington and clean up the Democrats’ mess — good thing we have some experience in that already.
So if there is only one piece of good news in this, it is that it raises the prospects for Republicans to take back Washington in the coming elections, and for a return to economic policy that fights for the American worker instead of selling them out to foreign interests abroad and to the Big Banks at home.
Jeremiah Jackson holds a Ph.D. in economics and has experience both in the public sector as a policy maker and in the private sector as an analyst.