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We thank readers for comments about my Sunday, January 22, discussion of dealing with inflation and the Fed over 50 years of Cumberland’s history. (See “50 Years of Inflation & the Fed” (https://www.cumber.com/market-commentary/50-years-inflation-fed.) Many thoughtful responses and questions appeared in my inbox in the hours after the commentary was published, and I tried to answer as many as possible.
We have compiled some of the responses, and a number of commenters gave us permission to identify them by name. The list below is a 10–12-minute read that contains some strong views about the outlook for inflation and for the Fed. Please enjoy mulling fellow readers’ assessments and insights.
Independent international market economist and GIC board member J. Paul Horne responded,
I think you could also mention one very important aspect of today’s inflation problem, perhaps the most fundamental one going forward.
That is the non-inflationary potential growth rate of U.S. GDP over the medium term. As you know, the CBO has been steadily reducing that rate until today it is less than two percent. The reasons for this basic speed limit are fundamental and result from long-term choices made by our society and political leaders.
The first is the most intractable: The slowing growth of the labor force which has been caused by the decline of the fertility rate as American women have been increasingly empowered by The Pill (since 1960) and growing participation in the labor force.
This demographic slowdown had been offset by net immigration – as Bill Clinton liked to point out. But the hostility generated by the arrival of immigrants, perceived as “different” and “illegal”, produced anti-immigration policies that slowed net immigration. It is conceivable that the recent flood of immigration, if it were to continue, might boost growth of the de facto labor force, even if it were to be largely due to illegal immigration.
The second reason for the 2% limit on growth is the continued slowing of productivity growth, notably Total Factor Productivity. The last time TFP grew enough to keep the non-inflationary growth potential well above 2% was in the 1990s when double-digit growth of capital spending (plus statistical recognition of the previously under-counted contribution of the computer) boosted TFP.
Given the non-inflationary growth limit of less than 2%, the cumulative fiscal and monetary stimulus pumped into the economy since the Trump tax cuts had to be inflationary. I reckon total cumulative fiscal and monetary stimulus since 2017 was close to 50% of GDP. (The Fed’s balance sheet most recently rose from $3.9 tn to $9 tn; and it maintained negative real interest rates for a long time.)
This meant too much stimulus was forced into an economy with a non-inflationary limit of 2%. And then the situation was aggravated by the sudden breakdown in our global JIT supply chains caused by the Covid pandemic.
I think markets, seemingly encouraged by easing of some underlying inflation pressures, are wishfully ignoring these fundamentals. I hope the Fed is not.
David Blond, founder and president of QuERI International, pointed out the role of supply in price formation:
I noticed that not once in this discussion, like so many discussions about price formation, which is of course at the heart of the argument (the issue of how companies or markets set a fair and reasonable price) is there any discussion of what economists who teach microeconomics use to show how prices are revised and balanced, i.e. price-driving supply changes. Most of the commercial economic models — be they from Wall Street chartists or companies like Global Insight or Economy.com or others (I used to know all of them, but there have been so many changes) — work with the demand side of the price formation question. This is the case too of the Fed despite their efforts at trying to measure capacity utilization in the crudest form. The monetarists’ mantra that it is money chasing few goods that causes price inflation assumes there is some magical price that is set by finding the solution to MV=PQ. I wrote a paper once, when I was flacking for the Reagan Pentagon spending and tax cuts, that showed that Volcker’s problem was that he was just setting M based on the US economy without taking into account the demand for dollars to fuel global trade and the price of petroleum which was transacted in dollars, so the right amount of money growth needed to take into account the world economy as well. By setting it to 2% inflation and 2% growth to get the price to fall enough, he forced the collapse of global trade and the shortage of dollars for transacting foreign trade in oil and other goods forced the dollar to revalue hurting the US exports. He managed to get his recession but at what cost?
You are probably correct on the 5% target, nice simplistic, but the Fed has no more ability to manage the economy with any precision than anyone else. If they get to 5% and stay there, then when the economy tanks, which it will, as [the] supply of housing will fall, homeowners’ equity will tank as prices fall, companies will respond thinking — best to get things going and lay off some unneeded workers, then in about a year or so, the pressure will build for the Fed to — cut the rates. It’s a stupid, wasteful cycle.
I did my Ph.D. at NYU in the 1970s. My primary advisor was Fritz Machlup, one of the old school Austrian international economists. I remember once having an argument with him about some policy that was being pursued with respect to the exchange rate that would likely lead to cutbacks in employment and higher unemployment. Fritz noted that this was what was supposed to happen to get the policy response, prices to fall. I argued that he was ignoring the social costs, pleased more with the idea that economic theory worked as it was meant to. It would be good to get economists to focus as much on people and effects as on theory.
Note: David Blond has indicated that If any Cumberland clients wanted detailed data on specific sectors or countries, that we could put them in contact with him and he'd be happy to send what he has on the subject.
David (Danny) Blanchflower, Bruce V. Rauner Professor of Economics at Dartmouth (and a fellow fisherman):
My bet is that the CPI drops by 1 percentage point a month for the next six months in a row as the bad effects drop out.
Last six months’ CPI inflation was 0.4%; the prior six months it was 6.1%.
So it will be below 2% in May and below 0.5% in June.
So the Fed will be in reverse gear by March… noting that none of the rate increases had had any measured effect on inflation or output yet.
Many surprises for the markets who don’t understand base effects.
So I totally disagree…
[Kotok response: We’ll see if market agents care about base effects. I’m not so sure. Second oil shock may be coming faster than most expect (by autumn). I see some expectations for $100 plus, because oil has little room to cushion upward demand.]
John H. Abeles, MD, president and founder of MedVest, wrote:
Together with the over-reaching (in my opinion) raising of Fed rates (while ignoring major labour shortages causing spuriously very low unemployment rates), with bond sales (QT) and now the major trend described in the link above, we may be heading for a hard landing recession, if not a depression — unless the Fed changes course.
Bill Kennedy, GIC Board Chair and CEO/CIO of Riskbridge Advisors, responded:
The Kansas City Fed published this insightful report on the growth of reverse repo agreements (RRP, +30% y/y). It’s worth reading as to “why.”
I believe the party bus that dropped off fracking, Airbnb, 22,000 cryptocurrencies, and SPX 4600 has left the station. The policy experiment is being unwound. History will eventually judge if Bernanke’s or Powell’s policies were the most damning.
The “creative destruction” will be painful in the short term, but new opportunities for society to innovate, grow, and advance will evolve. Capital will find its way to companies and fund managers who earn stewardship rights. Not everyone will get a blue ribbon. Active > Passive? Maybe.
The chart below is net-negative for market liquidity. Shrinking liquidity is ominous. On the flip side, the global money supply is growing at a 6mo annualized rate of change of +8% (USD basis).
Here’s our current “house view” of possible paths forward. The most significant risk to this heuristic is that the 20% probability for an inflation rebound may be too low, per David’s $100 bbl crude oil comment.
Harvey wrote,
Few people understand that everything is transitory. Especially inflation. Comes, goes and always comes back.
As George Bernard Shaw said, “Custom will reconcile people to any atrocity.”
A final Kotok comment: I don’t see any easy path for the Fed to restore the balance in the labor market. We still have 5,000,000 more job openings than we have job seekers. That hasn’t been the case for many decades. That is why I believe the Fed will deliver the prescription outlined by Cleveland Fed President Loretta Mester during my interview with her on February 16th at the GIC-USF conference. She warned the listeners about the need for the Fed to stick to its guns on the 2% inflation target, and she outlined why that would require a protracted period of interest rates at higher levels than many market agents want to accept. We believed her when she said the Fed is “resolute.”
We’re sticking with our mid-5% target for Fed funds for the entire year of 2023.
David R. Kotok Chairman & Chief Investment Officer Email | Bio
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