Inflation is reaching very high numbers – for example, the CPI is at its highest level since 1982. But what is driving it? Some blame too much money in the system. Others say it is consumer demand. Still others say that a shortage of goods and labor is driving up the price of everything. Or all three.
It is important to identify the reasons for rising prices in order to formulate an appropriate response. If the money supply is the problem, the Fed should remove liquidity from the system and raise interest rates. Extreme heat demand requires consumers to spend less. And ending the supply shortage will, obviously, depend on luck.
The liquidity argument can be exaggerated
It is true that the Fed injected mountains of money, but much of it returned to the Fed in the form of additional bank reserves. More importantly, the velocity of money (which measures how fast money moves through the economy) is now at an all-time low—that is, money hasn’t made it that far into the economy.
It doesn’t matter how much money the Fed injects if it has nowhere to go. Private household investment, for example, was a much lower percentage of GDP in the past 12 years than in the previous 12 years, even though money has been injected into the economy since 2009. Many people including us have argued that too much money has been received. Financial assets have their way, stocks contribute to the bull market but not much else.
The strength of demand is mostly about grabbing consumers
At first glance, consumer demand may seem very strong. Individual consumption has peaked in dollar terms and as a percentage of GDP.
On the other hand, its annual 7-quarter growth rate (since pre-pandemic levels) is just 2%, unremarkable by historical standards, below the 2011-2019 average and well below pre-financial crisis levels. On top of that, recently released figures show that December 2021 retail sales declined by 2.3%.
The real issue is supply chain
Even assuming that excess liquidity and consumer behavior may be factors driving inflation, it is clear that sharp disruptions in production, supply channels and labor patterns are driving prices up. Ten-fold increase or five-fold increase in container fee Fertilizer price hike, for example, cannot be attributed to too much money or overactive purchases.
Stubborn transportation barriers are famous, such as the record times for ships waiting at anchor at major ports around the world. The sight of vacant lots at car dealerships has become a common sight; Dealerships, meanwhile, are turning away from astronomical margins to offset cratering sales volume, placing the burden of shortfall on car buyers. US car inventory last counted at just 40,000, a record low and a fraction of 560,000 just before the pandemic.
The Fed Responds, But Maybe It Shouldn’t
Fed Chairman Jay Powell announced that since inflation is no longer considered “temporary,” the Fed’s long-term housing policy will end. But it can only address issues of liquidity and consumer demand. Withdrawal of liquidity or hike in rates has no effect on containing the outbreak of COVID-19 that Closes a major Chinese port, nor can it reverse the ban imposed by China on exports of synthetic nutrients, the reason why fertilizer prices are so high, nor tempting people to come back and fill the 2.6M private jobs that have been vacant since February 2020, prompting employers to employ workers Had to wash my hands.
It follows that multiple rate hikes or rolling out billions of dollars worth of bonds from the Fed’s balance sheet will have little to no impact on inflation if the supply crunch does not ease. If this happens, then inflation will come down. If it doesn’t, it won’t.
If that happens, the Fed may avoid doing too much. At least that’s what Chairman Powell and other Fed officials say – their policy will be “flexible.”
If that doesn’t happen—and experts agree that supply issues will last well into 2023—the Fed will either not respond, if it finds its policies to address supply-driven inflation mostly useless, or Repeat efforts. it down.
It is unlikely that the Fed will be reticent if inflation persists. Inaction will cause an uproar from politicians who distrust the Fed’s independence and prefer to blame the Fed for anything. But in the absence of better supply conditions, a forceful response runs the risk of reducing demand too much. This, conversely, can bring down inflation, but only by reducing consumption so much that the reduction will no longer matter.
Therefore, the Fed faces an incredible task. It waited as long as possible for supply conditions to improve, but it’s taking so long that it can no longer afford the optics of doing nothing. It will take a lot of skill to do it enough And Maintain public trust. The risk of the economy slowing down too much is real. This wouldn’t be the first time the Fed would overshoot.
On the other hand, the Fed may actually be thinking that too much demand is the main cause of inflation. If that’s the case, the only way to make it cool is for people to spend less. Which they will do if they feel less wealthy because the value of their savings drops or their income drops. This means that real estate and stock prices must fall, or that there are fewer jobs or that real wages have declined.
Hence, the outlook for the stock is bleak unless the supply opens up soon. This means hoping that Covid-19 will not turn into a dangerous form and that it will disappear in the next few months, geopolitical tensions will ease and logistics channels will open up.
This is, in fact, the clear consensus of today. Omicron spread is considered “mild” and is probably the virus’s last gasp. Some are discussing how Russia’s intimidation campaign against Ukraine, let alone aggression, could affect oil and natural gas prices. The market is shrinking due to the increasingly high numbers of ships waiting to dock at the Port of Los Angeles or ship rush in shanghai (world’s largest port) due to lockdown in ningbo (world’s third largest).
So all the elements to a stock market decline are, well, the fact that market participants seem complacent, that can quickly change. If they are right that everything will be fine, then we will be lucky. Otherwise, the long bull market will eventually die at the hands of the Fed.