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Two issues that have filled pages on the internet: inflation and “Demand Side Economics”

April 04, 2022

I just got back from Israel and the markets have been up pretty much the entire time I was gone. But it is time to talk about two issues that have filled pages on the internet: inflation and “Demand Side Economics”. Hopefully, this will help you understand the nuances of the current market. 

Inflation is a political lightning rod. As a result, there is a good deal of misconception about it. The Consumer Price Index (CPI) is up 7.9% from a year ago and will likely peak in the 8.5 - 9.0% range sometime in the next couple of months, the highest since 1981. Politicians blame war or COVID, but the simple explanation is just too much money creation.

Others think inflation will be temporary and point to "core" inflation, which looks tamer. Core prices, which exclude the normally volatile food and energy sectors, are up 6.4% versus a year ago and will likely peak near 6.5%. 

There is a reason to exclude some prices when there are very special factors at play...but food and energy prices have been going up for over a year. And just because more of the inflationary impact of the surging M2 measure of money (up more than 40% since the start of COVID) shows up in food and energy prices, or even used car prices, isn't a reason not to count them.

Others argue that the government is grossly underestimating inflation and is hiding the scope of the problem. One online analyst says that if we used the pre-1980 methodology to measure inflation it's already running north of 15%. I don’t think this is reality.  

The government figures on inflation are not perfect. The main ones are the CPI, the PPI, and the PCE Deflator (the Fed's favorite!). All of them measure slightly different things and so the numbers are different, as well. But the inputs and methods to make these calculations are publicly available. There is not a conspiracy to dupe the American people. And every government measure of inflation is up. It's pretty clear the Fed is going to have trouble wrestling inflation back down any time soon.

Economic theory

Intellectuals and politicians often try to verbally summarize or justify conventional thinking in pithy ways. Milton Friedman (in 1965) and Richard Nixon (in 1971) both said different versions of the phrase "we are all Keynesians now." 

John Maynard Keynes, one of the most famous economists of all time, supported deficit spending and government manipulation of economic activity. Friedman and Nixon were describing the thoughts behind the implementation of Great Society redistribution programs and an inflationary monetary policy designed to offset the cost of those programs.

If the economic policy was Keynesian in the 1960s and 1970s, as policymakers stopped believing in free markets, we are certainly all Keynesians now. COVID spending and monetary policy are a clear continuation of this economic thinking.

It all began in 2008 when the Bush and Obama administrations combined spent $1.5 trillion of taxpayer money to "rescue" the economy and the Federal Reserve started Quantitative Easing. That blueprint of policy response to the Panic of 2008 was used to respond to COVID shutdowns. This time the Federal Government borrowed at least $5 trillion to spend and the Fed increased its balance sheet by over $4.5 trillion. 

As a result of the Keynesian policies of the 1970s, the U.S. experienced stagflation (slow growth and high inflation) – with both unemployment and inflation peaking in the double digits. Right now, inflation is 7.9% and the unemployment rate is 3.6%. So while inflation is clearly here, signs of stagflation are harder to find.

That doesn't mean economic growth isn't being impacted. There are multiple forces to analyze and untangle to understand everything that lockdowns and government largesse have done. 

First, the US economy was artificially boosted by borrowing money and distributing it through PPP loans and pandemic benefits. Case in point, retail sales are up 25.2% between February 2020 and February 2022, while industrial production is up just 2.3%, and the US has 1.6 million fewer jobs than it did pre-lockdown. The good news is that, unlike the Great Society programs, the spending done in response to the Financial Crisis and COVID-19 are not all permanent increases in entitlements. Some of our COVID response spendings is likely to be permanent, but not all of it.

Second, the M2 money supply has increased more than 40% since February 2020, as the Fed renewed QE and monetized deficit spending. In other words, a great deal of that spending was paid for out of thin air. 

The impact of these policies was like giving morphine to an accident victim. The economy was dramatically damaged by the lockdowns, but the morphine masked the pain. All that pain-killer stimulus boosted sales and profits. This year, without new spending legislation and as the Fed starts to reverse course, the economy will lose its morphine drip.

On the surface, this suggests that the economy could be in trouble...and with the 2-year Treasury yield now above the 10-year Treasury yield (an inverted yield curve), many think the US faces a recession this year. 

But this ignores the impact of the third factor in play – the reopening of the economy. It is clear, at least to us, that very generous pandemic unemployment benefits had a massive impact on employment. In fact, the "Great Resignation" (people just dropping out of the workforce) had a lot to do with these benefits. While it was never the case, many thought the Build Back Better spending bill would keep the checks coming. Now that BBB appears dead, those people are heading back to work. In the first three months of 2022, 1.69 million jobs have been filled. This year will likely total 4 million jobs or more. 

So, even though the Fed will be lifting rates and Keynesian deficits will be smaller, the economy will expand in 2022 and profits should continue to rise. Unfortunately, our forecast is that real GDP growth will remain under 3%, while inflation remains over 5%. This is reminiscent of the 1970s, and once the reopening from lockdowns is over, the full impact of these policies will be felt. 

The inversion in the yield curve suggests the bond market thinks that if the Fed lifts short-term rates to 3% or so, it will be forced to cut rates again. This may be true, but we think inflation will prove a more persistent problem than the Fed or the bond market has priced in. 

The US is now stuck in a Keynesian dilemma of its own making. The way out is to cut spending, cut tax rates, cut regulation, and tighten money enough to stop inflation. Because in the end, Keynesian policies don't create and open markets do.

Hopefully that economic lesson was not too complicated. It is meant to understand all the rhetoric around a collapse in the market or a deep recession…neither appears to be on the horizon. 

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