The Breakdown - What’s Actually Happening with Inflation Right Now

Episode Date: August 18, 2020

There is perhaps nothing more important or contentious in macroeconomics right now than the question of inflation.  On the one hand, there is a growing concern that rapidly growing money supply and increasing central bank balance sheets will inevitably lead to inflationary pressures. On the other, critics of that point of view point to significant counterveiling forces such as the 10% unemployment rate and growing savings rate among consumers.  So who is right? What are the specific narratives trying to say?  What is the evidence and data actually telling us?  And how are real people experiencing inflation today?

And I think if I have to point to something specific, the reality is that you can unwind consumer demand shocks faster than you can unwind government balance sheets. And I think that is at the heart of why people who are concerned about inflation are concerned about it. When it comes to what happens next, maybe not in the next month and not six months, even the next 12 months, it's still less of a time horizon than when it comes to ultimately that debt being due. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, BitStamp, and nexo.io.

And produced and distributed by CoinDes. What's going on, guys? It is Monday, August 17th. And today on the breakdown, we are talking inflation. Specifically, we're asking the question, what the hell is actually? happening with inflation right now. Before that, I'm not actually going to do a brief today. I've got a long brief coming for you tomorrow with a bunch of different topics, but I want to mostly focus on this main topic, this main conversation. However, I do want to go back and just put a little

addendum on something that I talked about last week. On Saturday, as we were reflecting on the week that had been, I talked about Dave Portnoy, Davy Day Trader Global, the guy who had just gotten into Bitcoin thanks to the meeting with the Winklevoss twins as an absolute agent of chaos. Well, today, crypto, Twitter is absolutely shaking their heads as Dave pumps out meme videos with him just absolutely pumping a bag full of shit coins and doing it proudly. He even talks about in a clip how much he loves crypto pump and dumps because it's encouraged. So anyone who thought they were going to be able to control this force is feeling what it's like to try to get a genie back in a bottle right now. But with that, let's focus on our main conversation. What's actually happening with inflation

right now? First, let's set the scene. To read the headlines, you'd be forgiven for coming away, not having any real idea whether we should be worried about inflation or not. Here's a sampling of headlines just from the last week. One, don't sweat a temporary spike in inflation. 2. Markets are fixated on the wrong boogeyman. Deflation remains the bigger danger from the collapse in global demand rather than a surge in inflation. Three, inflation is higher than you think in the COVID era. Four, what if inflation isn't dead? Move on over to Twitter and it gets no clearer. Mark Dow last week tweeted the QE equals currency debasement cry is making a comeback. Currency debasement is a rapid protracted decline in purchasing power of goods and services and a depreciation of your currency.

This chart shows why they're wrong again. To which Luke Gromman responded, I think your followers would love to hear how you've been able to get your bills for groceries, rent, child care, health care, property taxes, and college tuition to decline versus what they cost in 2008, as your argument implies they have. I, for one, would love to save all that money. So what's going on here is that there is a massive debate. It's a debate that's taking place on Twitter, in op-ed pages, and even in the highest levels of policymaking. On the one hand is the narrative and they fear that inflation is coming because the money supply is increasing so rapidly. On the other hand, is an argument that it is in fact deflationary forces that are the thing to be concerned with. Those concerned

about inflation point to the radical increase in the balance sheet of central banks around the world led by the Fed. Those concerned about deflation focus on the fact that while there may be more dollars, they're far from chasing fewer goods. In fact, there's reduced demand, there's no wage growth. And what's more, the Fed has had trouble over the last 10 years reaching its 2% stated inflation goal. So what is it? Is inflation something to be concerned about or should we be more worried about deflation? Is there some middle? Could it in fact be both? An LSC paper that we're going to talk about more a little bit later, interestingly shows that it could in fact be both. They write, The Great Lockdown entails a combination of substantial shocks to both demand and supply. It is therefore

plausible that the crisis may lead to deflation, disinflation, or higher inflation. Falling aggregate demand due to heightened uncertainty and reductions in incomes and liquid wealth may lead to deflationary pressures. Conversely, inflationary pressures may arise from increases in production costs due to interrupted supply chains and to the impact of social distancing restrictions on labor supply. By shutting down some sectors of the economy, the Great Lockdown may lead to changing patterns of demand that translate into shifts in the degree of market power firms exercise, which will affect equilibrium inflation. So this episode is all about trying to piece some of the this out trying to look at what the narrative says, what the evidence says, and what markets are saying

about it. Let's start with the narrative. On the one hand, the meta-narrative has been long-term unconcerned about inflation. An op-ed in Morningstar, what if inflation isn't dead, put it this way. Quote, that investors have become nonchalant about inflation may be witnessed by the distinctly muted reaction to the federal government's recent stimulus efforts. In 2009, an $800 billion dollar recovery bill prompted widespread unease about growth in the federal debt. In contrast, this year's $2 trillion CARES Act, accompanied by the suggestion of an additional stimulus bill, has elicited few complaints. I shared with you before Mark Dow's very kind of mainstream opinion, I think, that in fact QE does not equal currency debasement. And then the editorial board of the Financial

Times wrote a piece just recently called, The Economy is Too Weak for Inflation to Return. At the same time, there is certainly the counter-narrative as well. I'll take just one really notable example to make this point. Last week, David Kelly, who's J.P. Morgan's chief global strategist, said that investors should, quote, take inflation seriously. He said, you can finance the rising debt if interest rates are very low, but if inflation begins to come up and long-term interest rates begin to go up, that's going to put real pressure on the federal budget. So I think there's a real issue there, and should take inflation seriously. This gets us to what the actual concerns of what could trigger inflation are, even for people who perhaps aren't worried right now. The first and clearest is that

the dollars that have been sitting on the sidelines move in, increasing the velocity of money alongside the supply of money. What this basically gets to is the idea that the savings rate has increased significantly in COVID because people aren't going out and spending dollars. they're shifting their behaviors right now. They're trying to be more cognizant of potential future changes. They're trying to be more resilient, and that means less consumption. That less consumption is a countervailing force to this increase in the money supply. So even people who are putting their nose on that point, who are putting their finger on that

point and saying that this is all about demand, not just supply of money, it's all about velocity, not just supply of money, are worried about what might happen should everything, return to normal and all of that money starts to pour back in. For them, that's a place that inflation could trigger even if you don't see inflation now. A second concern is the idea that government might decide to inflate their way out of debt. Another quote from that same Morning Star op-ed. Also worth considering is that eventually, global developed governments may decide to inflate their way out of their national debts. They did not make that choice after the 2009 financial crisis, but debt levels were lower then. For example, in 20th,

2010, the United States had a debt-to-GDP ratio of 54% as opposed to 101% currently. And of course, regular listeners of this show will know that we've seen debt-to-GDP ratios of as high as 137% according to some. The point here, and this goes back to what a lot of people have talked about on the breakdown, is that eventually you either have to tax your way to pay back debt and use austerity to pay back debt, or you have to debase the currency such that the debt is actually worth less than it would have been. That's how you get out of it. That is, in fact, the fear for many people, like Preston Pish, who was on the show just last week. Coinciding with that is the potential for

government pressure and the independence or the threat to the independence of central banks. That same editorial that I mentioned from the Financial Times, the economy is too weak for inflation to return, made the caveat that if central banks bow to government's prices could eventually sore. And the point that they're making is that raising rates is likely to be unpopular politically, and so we'll have a lot of headwinds going into it. In other words, interest rates are likely to be kept low for too long. You'll notice I'm not even keeping the sort of most extreme bit-o-koyer type narratives or gold-bug-type narratives to this. I'm just really focusing on the mainstream narratives. And right now, within that narrative, there's a lot of competition.

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PPI on the whole is less clear. It's down 0.4% in the last 12 months. The core PPI was up 0.3% last month, which was the third straight gain. it was driven largely by oil increases, and in fact we saw food go down slightly even after being up previously. Now, a bigger indicator for some is the consumer price index, which numbers came out last week. It was up the most since 1991. Now, this was a sharp month-over-month rise, but not necessarily a huge year-over-year rise. Mike Sheldock, aka Mish, summed it up, and I'm just going to go through his quick hits because he did such a good job. He writes, The Consumer Price Index for all urban consumers increased 0.6% in July on a seasonally adjusted basis,

the same increase as in June. The Gasoline Index continued to rise in July after sharply increasing in June, and accounted for about one quarter of the monthly increase in the seasonally adjusted all items index. The Energy Index increased 2.5% in July as the gasoline index rose 5.6%. The Food Index decreased 0.4% in July, with the Index for Food at Home declining 1.1%. The index for all items less food and energy rose 0.6% in July, its largest increase since January 1991. The index for motor vehicle insurance increased sharply in July as it did the previous month. The indexes for shelter, communication, use cars, and trucks, and medical care also increased in July, while the index for recreation declined. The index for all items less food and energy

increased 1.6% over the last 12 months. The food index increased 4.1% over the last 12 months, the index for food at home rising 4.6%. Despite increasing in July, the energy index fell 11.2% over the last 12 months. Now, don't forget this analysis or this summary from Mish because we're going to come back to his particular take on it in just a minute. But first, I want to turn to a new Harvard study about why the CPI gauge is so flawed. Specifically, the study points out how unable to adapt the CPI gauge is when it comes to the relative weighting of different items. For example, in the official CPI gauge, groceries receive a weight of less than 8% while transportation gets around 15%. Those numbers don't reflect the COVID consumer reality.

Based on consumer credit and debit transactions, a more appropriate weighting, according to this Harvard study, would be something like 11% for groceries and 6% for transportation. So already right there, even just based on what they do measure, the weighting is totally off. Speaking of credit and debit card transactions and just measuring inflation through other means, an LSC London School of Economics study from Xavier Ajaravel and Martin O'Connell looked at live scanner data and found that inflation was much higher than this reporting. Here's the way that they summed things up. Lockdown coincided with unusually high inflation, which was experienced by almost all

households and in almost all product categories. This finding is noteworthy given financial markets expect the COVID-19 pandemic to be a disinflationary shock. The pervasive nature of the inflation, along with the fact that it is observed even in product categories with declines and output, point towards a risk of stagflation. It is naturally too early to say for sure whether persistent stagflation will materialize. While the higher price level has persisted for several weeks, the inflation spike coincided with a one-time event, the beginning of lockdown. In addition, we do not observe the entirety of household consumption baskets, e.g. rents and services are not included. So now we have this additional dimension to the conversation, which is not just

whether this is going to be an inflationary or a disinflationary event, but also whether whatever that is, is it going to be long-term or short-term. But what I think this LSC study also brings up is that when we talk about inflation, we have to be able to talk about it both in terms of the indices that governments use, but also in the context of how people experience it in their real lives, which is, of course, what Luke Gromman was getting to in his snarky response to Mark Dow's kind of dismissal of the QE equals currency debasement inflationary conversation. Miss Sheldock puts this really crisply. He writes, These indexes are supposed to measure inflation. They do nothing of the kind. These indexes do

not include home prices, only rent. The purported medical inflation is a joke. Anyone who buys their own medical insurance will tell you their costs are up way more than the reported 5.9%. Anyone in college has not been pleased with the rising cost of tuition and rent in college towns, and anyone with an ounce of common sense knows that the current stock market bubble is a measure of inflation. I think Mish's frustration here is widely shared and is something that is held across a variety of different types of people, even who have very different diagnoses of what to do about it next. But that brings us to our next point, which is, what are markets doing? We've talked about narratives, we've talked about evidence,

but ultimately, the job of markets is to turn narratives and evidence into behaviors. Well, I think the main thing this year that's hard to ignore is the move into commodities, precious metals, gold. Perhaps most notably is Warren Buffett's big move into the gold space. He has historically been extremely off of gold, but just last week, he bought shares of Barrett, which is the world's second largest miner. Now, even within that, there is narrative competition. There are a ton of people who immediately tweeted, look, Buffett's in gold. He changed his whole opinion. While others pointed out that Buffett's critique of gold had to do with the fact that it didn't actually have dividends, it wasn't a working asset that was spitting off any sort of return or yield, whereas Barrick, as a company,

actually is, so it's a way to be exposed to the gold space without actually holding the underlying. Still, even for people who are making that clarification, it's hard to ignore the narrative significance, and frankly, Buffett's not the only one who's moving into gold. Global Net inflows to gold ETFs reached almost $40 billion in the first half of the year, which, according to the World Gold Council, is significantly above the highest level of annual inflows previously. They also said that inflows for the first half of this year are, quote, significantly higher than the multi-decade record level of central bank net purchases seen in 2018 and 2019. Gold is up overall 27 and a half percent or so on the year. Silver has also seen a big uptick. Global holdings are up 10%

in the first half of the year, and silver ETF holding surpassed previous records for a full year according to the Silver Institute. And then of course there's Bitcoin, which in some ways its largest narrative moments this year have been around this inflation hedge question. You had Paul Tudor Jones moving into the space a couple months ago talking about the great monetary inflation to come, and you had the micro strategy news last week, which if you want to get deeper into that, go check out the interview again with Preston Pish. We talk a lot about just how significant that is in terms of its symbolism to the rest of the market. So what are the takeaways from all of this? I'm sure that you're feeling a little bit like, well, I still don't really know whether inflation is here or not or whether

we should be concerned or not, but maybe this will try to help sort that out. The first is that one of the key questions is the velocity of money, right? It's not just a question of money supply that makes inflation, but whether that money is actually moving around the system. Right now, the money hasn't been moving around the system because people are kind of on their guard. They're waiting to see what happens. As I mentioned, the savings rate has jumped from 7% in February to like 20% now. And some reports suggest that only half of the CARES Act money has been actually spent. Outstanding consumer credit is down $106 billion. So people are, as you would expect, turtling. They're getting in their shell and they're waiting to see what happens next. So the key question might be a velocity of money

and the key question for velocity is demand. Now, of course, if you want to go one layer deeper, the key question of demand is jobs. We still have a 10% unemployment rate. And so with that context, in the immediate term, there's good reason why people are less concerned about inflation right now, because that's such a powerful force on the other side. A second takeaway is that right now the data is really noisy. And the reason for that is that the forces competing are really noisy. You do have this massive run-up of government balance sheets, and the highest or new highs in government debt to GDP ratios. On the other hand, you have exactly the types of forces that I was just talking about. People who are saving more and spending less because they're nervous,

rightly so, about the future. In some ways, I think that we're going to have just an unending debate about this until one of those different forces starts to give way to a different one. And I think if I have to point to something specific, the reality is that you can unwind consumer demand shocks faster than you can unwind government balance sheets. And I think that is at the heart of why people who are concerned about inflation are concerned about it. When it comes to what happens next, maybe not in the next month and not six months, even the next 12 months, it's still less of a time horizon than when it comes to ultimately that debt being due. A third takeaway is that when it comes to markets and what market behavior is, narratives matter as much as observed data right now.

In fact, you could argue that narratives matter even more given just how noisy the data is, given how little confidence in the way the data is measured we have. A fourth takeaway is that when it comes to people's lives, indexes don't matter as much as lived experience. This is helping contribute to the growing narrative of an inflation concern because it just rings hollow when people say, don't worry, don't worry, when the things that you actually have to spend money on like food have been going up in noticeable and dramatic ways. And lastly, and I think this is really important, it doesn't take a failed state-style hyperinflation to make people's lives really much harder and to make them want to seek alternatives, to make them frustrated, to make them look for

alternatives either in politics or in something else. That to me is what it feels like is starting to happen right now, is people know that something feels off, and it's coinciding or dovetailing with a decade of having these other bigger ticket items, right? The college tuition, the housing prices, et cetera, also feel like they are getting further and further out of reach, more and more difficult to deal with. Those two forces are coinciding, and ultimately, the question is whether the market is going to actually react to what people are feeling, or whether it's going to stick really closely to what the Fed and other government agencies are telling them. And that is, I guess, the last note that we'll end on is that there is a change in the air

around Fed policy. I've said before on this show that the Fed has made it clear that they're not planning to react to inflation until it is now observed above 2%. It used to be that they would act when they were projecting inflation above 2%. And presumably, there's a less between when monetary policy is enacted and when it actually has an impact. So even if they were trying to unwind inflation because they had observed it above 2%, it was going to take some time for that policy to actually get there and actually do its job. So you could see significant growth between when it's observed at 2% and when monetary policy can actually kick in to get it back lower. What's more, you're also seeing more and more indications that the Fed is comfortable with

higher than 2% levels. The Dallas Fed President, Robert Kaplan said last week that he'd be comfortable with 2.25% or even 2.375% inflation. So for now, this remains an unresolved question, but one that has real implications for people's lives even as the narrative is debated. Hopefully through this conversation, you now have a slightly better ability to see the different sides that are competing to shape the narrative, to interpret the data, and to ultimately shape the response and remediation of this issue, whatever the issue is. So with that, I'll wrap. I appreciate you listening. And until tomorrow, guys, be safe and take care of each other. Peace.