Is inflation over? Will interest rates be coming down soon? Some economists reading their stat sheets and perhaps their tea leaves are pointing to future trends that will be bringing inflation in many of the G7 countries under control by the end of the year. However, central bankers have thrown a damp towel over investor enthusiasm about tame inflation and correspondingly lower interest rates. They point to a still hot job market with rising wages. What does it all mean?
Inflation’s Background: The Covid Pandemic of 2020 dampened demand as many countries locked down to deter the rapid spread of the disease. When the disease showed signs of waning and economies started back up again, the U.S. government in particular put forth a massive fiscal stimulus package that mounted a huge demand from the spending public. This demand included imported merchandise from other parts of the world that were slower to recover, thereby overwhelming those supply chains. In many places workers had decided to retire during the pandemic creating a shortage of experienced employees in key positions or industries. All these factors added up to the beginning of the worst inflation most of the world has seen since the 1970’s.
Leading Indicators Returned to Normal Ranges: At its apex, the price of oil went from the $70-$80 a barrel range, up to nearly $140 a barrel. Gasoline in California went from about $4.25 a gallon to about $6.75 a gallon and in some places over $7. Food prices spiked aided by the advent of bird flu that required the culling of chicken flocks in order to combat that disease. Egg prices went up as more eggs went to be hatched to increase the reduced supply of chickens. In due time, these prices have mostly returned back to their norms. But some inflation measures omit food and energy, as these two commodities are often volatile as a result of circumstances that are not a part of core inflation.
Along Came the Ukraine/Russian War: Just as the news of inflation became a reality, Russia decided to invade the sovereign nation of Ukraine. This action was met with sanctions from Western countries and a decoupling of the energy supply chains that ran from Russia into Europe. Amazingly, the two warring parties agreed not to block each other’s supply lines of wheat that’s exported to many other parts of the world. A huge spike in the price of something as basic as wheat could reap havoc in many third world countries that rely upon imported wheat to prevent mass starvation. The war is continuing and may settle down to a protracted war that could take years to resolve. Until that time comes, more price spiking should be expected.
It Takes Higher Interest Rates Time to Cool the Economy Down: At inflation’s inception there is often a lag for the Central Bankers to sort out a strategy to combat it. Higher interest rates are generally the main component, but from the inception of the tightening cycle to the softening of inflationary factors a period of a year or longer may transpire. In the case of the Fed, the lag from inflation’s onset to the first interest rate hike was about eight months. The strategy was complicated by the need to unwind Quantitative Easing (QE) first, as the process of continuing to increase the money supply in the economy while pushing up interest rates would conflict with each other. Newer research seems to believe this lag time of a year could wind up being a shorter period of perhaps six to nine months.
Looking For a “Soft Landing”: History shows that when inflation is as serious worldwide as it is these days, it will likely be followed by a recession of some magnitude as the controls needed to cool the economy down can cause too much cooling off and put the economy into a recession. The so-called soft landing refers to the economy cooling down without a recession. It would be more reasonable for investors to consider that a mild recession of two quarters late this year into next could be a good course for the economy to follow. Recessions are not always bad or severe, but skilled handling by the Fed of the interest rate tightening cycle along with good management of Quantitative Tightening or QT (the reduction of the money supply or the opposite of QE) would be needed to provide a soft landing.
The Irrepressible Job Market: In the middle of this robust inflation, we’ve seen the U.S. economy generate 517,000 new jobs in January alone—more than five times what was expected by many, if not most, economists. This comes in spite of some rather large layoffs by tech companies such as Facebook and Microsoft. For each of the last ten months dating back to April, 2022, economists have under-forecasted the growth of the job market by 100,000 or more jobs. Economists as well as politicians could welcome the growth in the number of available jobs, but the accompanying excessive wage growth points to an extension of inflation in excess of targets. This excessive wage growth is a major indicator of inflation to central bankers and often provides the catalyst for increasing interest rates.
Don’t Repeat the Mistakes of the 1970’s: The inflation of the 1970’s provided a good workshop for how to deal with, and how not to deal with, runaway inflation. During the 1960’s President Johnson decided that “we can afford two wars,” meaning the war on poverty as well as the war in Vietnam. This fiscal policy course created a wave of strong demand on the economy and hatched inflation in the middle of that decade. In 1972 President Nixon tried a variety of methods to stem inflation including wage/price controls on the population. But at the same time Nixon cajoled the Fed Chairman, Arthur Burns, to keep interest rates low while he ran for reelection. President Gerald Ford took every step he could to reduce excessive spending by the Congress, but his efforts using fiscal policy as a tool were only partially effective. Later in the decade Professor Milton Friedman’s theories on monetarism pointed out the importance of monetary policy in fighting inflation. This came to be the recipe used by Fed Chairman Paul Volcker in the early 1980’s to finally knock inflation out with interest rates that reached up as high as twenty percent.
Conclusions: The most dangerous terminology when discussing inflation is the word “transitory.” This provides the strong implication that when inflation is transitory, it will pass by itself just like bad weather. Effectively fighting inflation requires strong medicine, the kind that politicians do not want to use. Responsible fiscal and monetary policy are required to work together for the benefit of the economy that in turn benefits the population. Inflation will not be considered over until it is reduced to the prescribed lever of two percent.
Sources: The Economist, A Hard Road, February 18th, 2023.
Wikipedia, Arthur F. Burns.