There Isn't Question, Inflation is Transitory. But, Real Risk is Bigger Somewhere Else and Wall Street Isn't Ready/Positioned.
The Federal Government, not the Central Bank, Created Inflation
The talk is all around the markets. Every day we see investors ask questions like:
Is inflation transitory?
How many times will the Fed hike rates?
Inflation is here to stay, will the Fed overshoot to combat it?
How will the effect stock prices?
What are the effects of what the Federal Reserve printing 40% of all money in circulation?
Inflation wasn’t caused by printing money but by the distribution of it. Investors should be cautious when positioning their portfolio for hyper inflation. There are key points many of the “economists” and Wall Street PM’s are missing when factoring in the cause and effect of inflation.
When factoring in the cause/effect of inflation, you will find that it is without question transitory. If the Fed hikes rates too quick and reduces the balance sheet, this could have grave economic consequences and all investors will pay the price.
The Forces of Inflation
We could go into the forces of inflation and could be its own publication but I feel compelled to talk more about the cause/effect. In this particular instance, it’s the cause and effect that Wall Street is missing when thinking about inflation expectations and their financial/economic projections.
Deflationary Forces:
Deflation is a constant secular force the government and the Federal reserve have to battle. But, don’t get me wrong, not all of it is bad. If not kept in control, it could get out of hand but some of it is healthy. We can sum up a few forces as:
Credit limits/control - think credit score or how much an institution is willing to lend someone.
Technological innovation - think about the self check out line at wall mart or the rise of the Robo-Taxi in the coming years, this replaces jobs which creates wage deflation.
Globalization - the world will never stop getting smaller with the rise of technological innovation and transportation innovation.
Population growth - this is a real concern. People aren’t having kids as they get older, especially in developed countries.
Debt - what we owe people puts constrain on our total spending ability. Specifically, when interest rates go up. It makes everything more expensive.
As you can imagine technological innovation, credit limits, and globalization are good, secular, forces of deflation. On the other side, it’s not hard to imagine that debt and declining population growth are the bad type of deflation. If there are less people, that’s less people to work or produce goods/services. If people cannot pay their bills, this increases default rate on loans. The real concern comes in if we ever have to ask the question if the government can’t pay their debt. Notice how each tax payer is liable for $238.5k each? Most people’s total net worth isn’t even $200k.
Inflationary forces:
This one is important, because we’re currently experiencing rapid inflation. In 2021, it was 7%. But, this article is focused on showing that if measures are made too fast, it can go too far. You’re going to notice a theme here, none of them really have to do with money printing but more the distribution of money.
Credit increases - think easier lending practices
Government spending - think the massive fiscal stimulus the GOVERNMENT spent.
Wage increases - this is an important one and ties directly with government spending.
Increased demand - very important, we’ll talk about this too. Demand is currently very high.
Fortunately our inflationary problems don’t have much to do with credit increases or easier lending practices but it does have to do with lower rates, somewhat. What I’m going to pull from this specifically is: Government spending, wage increases, and increased demand.
The Real Cause of Inflation
If there’s one thing we have learned in 2021, it’s that MMT ( modern monetary theory) doesn’t work. The cause of inflation was U.S. Government Spending and the unprecedented fiscal stimulus we experienced in response to the COVID lock downs.
Originally, to combat deflation during the COVID-19 pandemic, they sent out $2,000 stimulus checks to everyone and substantially raised Covid-19 unemployment benefits. If you think about it, they locked down the economy which led to laying off thousands of people or “furlough” (a fancy work for temporary lay off). This stimulus was obviously needed to prevent a great depression for the economic shock. What happened after that, passing trillions more in stimulus in 2021, created inflation.
The Average American Consumer
To really understand exactly where inflation came from, we must think about the average American consumer. The average American makes roughly $65k per year at their job. Of this $65k, roughly 30% of it is taxed depending on what state you live in. This ends up being $19,500 taken away in taxes alone. This leaves roughly $45.5k of disposable income. Of that disposable income, you can roughly think to yourself that expenses they’d have on an annual basis would be:
Vehicle @ $4,200 ($350/month)
Mortgage/rent @ $18,000 ($1.5k/month)
Cell phone @ $1,200 ($100/month)
Student loans @ $4,800 ($400/month)
Vehicle insurance @ $1,200 ($100/month)
Utility expenses @ $4,800 ($400/month)
Gas @ $1,000 ($80/month, this is highly variable to what you drive)
After basic living expenses, excluding food, you are now left with $10,300 for the entire year. Or, approximately $858 per month to live off of for food, car repairs, dog/cat expenses, doctor bills, vet bills, etc. I think you’re getting the point, it’s expensive to be an American and just be productive in society.
On a household basis, the average American house hold makes about $82.5k pre tax. After tax this is roughly $61.3k assuming a 25% tax and $57.75k assuming a 30% tax, both Federal and State. Average expenses per household average roughly $63,036 which exceeds gross income on both accounts.
The number one take away here, the American lifestyle is over leveraged and too expensive which creates crushing debt that limits the consumers buying power on any normal year. I must add, when you include kids/animals into these figures, it’s a miracle how we’re still moving forward as a society from a fiscal perspective.
COVID-19 Stimulus Bill in Early 2021, the Likely Culprit
The stimulus that we injected into the economy likely saved us from a great depression but it is what created inflation. The stimulus alone wasn’t enough to create inflation though, because it likely helped the American consumer. It was how it incentivized the average American. Let me explain a few major factors/benefits that Americans had since the bottom of the 2020 pandemic.
Enhanced unemployment: This ended up being, on average, $900/week. Multiple this by 52 weeks you get $46,800. When you think of this as gross income, this is the equivalent as making $67k/year before taxes. Americans made $67k/year to do nothing for OVER one year.
Student Loan Forbearance: Like my example above, the average student loan payment is nearly $400/month. This ends up being approximately $4,800 on an annual basis. Student loan forbearance is still in effect but ending in the coming months.
Child Tax Credit: This ends up being approximately $300/month deposited into parents accounts per child. Essentially, in the 2021 bill parents were payed hundreds of dollars extra if they had dependents under the age of 17 on their tax filing. The average American house hold has approximately 2 kids, which ends up being $600/month. On an annual basis this is $7,200/year (untaxed). They’ll receive larger credit’s during this tax season as well.
Rent/Mortgage Forbearance: I assumed the average rent/mortgage for someone who owns a home or rents to be around $1,500. This is assuming you don’t have roommates and you’re not living in States like California or New York. In the latest bill, Americans didn’t need to make payments on their home/rent if they filed for exemption. For renters, they didn’t need to make payments at all and landlords could not legally evict them.
Stimulus checks of $2,000, $600, & $1,400: A wave of capital was injected to average Americans everywhere. These stimulus checks went to good use because Americans spent their money. They bought durable goods, VEHICLES, and paid down debt or invested.
If we broke it down, in 2021 an American could get paid the equivalent of nearly $80k/year if they had kids AND they didn’t need to pay for their house/rent or student loans. They could do this all while not working. In many cases, this created stress on the supply chain as truckers/workers/operators realized they could get paid more or just the same if they lived off the government stimulus.
It’s easy to draw a conclusion that this created a “shock” to the system.
The Government Artificially Inflated Demand and Incentivized People to Stay at Home in 2021
Per the law of Supply/Demand in a free market economy, the Government passed stimulus that increased demand but reduce supply. The supply constraints came in the form of labor force participation. With constrained, disincentivized, labor force participation but increased demand, prices rose artificially.
If you reduce the expenses of the average American and increase their income through government stimulus, you get inflation. But there’s a problem here.
The Plea to the Central Banks and What the Bond Market Could be Seeing too.
In 2022, all forms of stimulus will come to an end. At the back half of 2021, the rent/mortgage forbearance ended. At the start of 2022, the child tax credit officially ended. Student loan forbearance was extended to May 2022, from December 2021. Enhanced unemployment ended last year in September, 2021.
All this stimulus is ending and so will the effects of it. This has become increasingly apparent when you look at the Personal Savings Rate of the U.S. consumer. This should tell everyone that the consumer is has less available liquidity to put into their retirement/savings plans because of increased pressure from expenses.
The Yield Curve Continues to Flatten
If you look at the prices of bonds, they are pricing in the expected rate hikes. But, there’s something alarming that investors have began to notice and that’s how the yield curve continues to flatten. Flattening means that the 2 year becomes more expensive than the 10 year. An inverted yield curve is when the 2 year becomes more expensive than the 10 year, usually signaling economic trouble ahead. The shaded areas represent recessions.
When looking at the yield curve today, this is saying to all of us, “warning, something may not be right”. It’s not flashing recession, yet. But when the Fed becomes more hawkish, it clearly trends in the direction of a flattened yield.
I am Absolutely Convinced that There’s Danger on The Horizon and it’s Not Inflation
If the Fed aggressively hikes rates and tightens their balance sheet without seeing the effects of the consumer, first, without “training wheels” (government stimulus) we could be in trouble. The reason why; when the Fed hikes rates this makes everything more expensive especially when it comes to borrowing to buy vehicles, homes, durable goods, etc.
In other words, this is demand destruction to bring equilibrium back to balance
I think the Bond market is seeing the same thing.
The Fed is better off ending QE (more QE is not needed at this moment) and slowly raising rates, following the data, and NOT over reacting to political pressure. If politics interfere with the Feds plan, because of upcoming midterms, the markets will crash and the economy will head toward a recession. The American consumer’s buying power and pocket book has not fully stabilized, yet. We should see stabilization by summer. By this time, I expect inflation to show signs of stabilization and increased work force participation. People will need to work again.
What I Think the Fed Will Do
Predicting an unknowable future is a quick way to set yourself for failure. But, It’s becoming increasingly apparent that markets appear to be dead set on 4 rate hikes this year. The problem is, the markets are almost never right in predicting rates, ever. It’s actually funny that markets get it wrong so often, trying to predict rates.
With that being said, I think rate hikes are likely needed but not necessarily to combat inflation. It’s likely needed to “normalize” policy and be less accommodative to provide them “tools” in their toolbox to combat the next deflationary event. 2 rate hikes in 2021 and a few more, gradually, over the coming years to maintain and facilitate an ongoing economic expansion seems right.
There are a lot of good factors that came from inflation as well. On a positive note, the Fed finally got it after years of underperforming the 2% mark they have set. In addition, wages finally increased for hourly workers and blue collar workers because of artificially created labor force supply/demand. I think, if the Fed is really expecting 3% inflation, we could see a gradual tightening due to wanting to achieve their “maximum employment” mandate.
Summary
The American Consumer is the piece of the puzzle Wall Street and many commentators are missing in this equation. I am convinced they’re missing this piece to the equation because they don’t necessarily know, or are not talking to, the small business owner who runs a restaurant, trucking company, or any entry level work. People haven’t needed to work for nearly 2 years and this created a massive shock to the supply chain that will need to be worked on over time. But, with costs of everything substantially higher and expenses coming back to light, this will put pressure on inflation to subside dramatically. Demand will naturally slow and supply will naturally balance.
Looking forward, my biggest concern will be how the American consumer can fare with everything being a higher price. How will this impact the wealth gap? Did the American consumer buy/borrow too much when money was easy? How will economic growth fare?
I hope this publication gave everyone something to think about. I appreciate all of the readers out there!
Stay Tuned, Stay Classy
Dillon
There Isn't Question, Inflation is Transitory. But, Real Risk is Bigger Somewhere Else and Wall Street Isn't Ready/Positioned.
Jeff Currie from Goldman on the smarter markets podcast had some positive things to say about commodity inflation, in that it is a sign that poor people are doing better. Silver linings and all. :)