Last Wednesday, I watched a panel of central bankers, including Federal Reserve Chair Jerome Powell and European Central Bank (“ECB”) President Christine Lagarde. Not more than one minute into my viewing of the video – about 50 minutes into the chat – I heard a comment that made me want to scream.
Here’s what Powell said on the topic of inflation at an ECB forum on central banking while seated between an interviewer on one side and Lagarde and the chiefs of the Bank of England and the Bank for International Settlements on the other…
Powell: “I think we now understand better how little we understand about inflation.”
Interviewer: “That’s not very reassuring.”
Powell: “Honestly, this was unpredicted.”
Sure, unpredicted by him and those of his ilk.
Powell went on to say that one year ago, in a survey of 35 “professional forecasters” – evidently an important group to the Fed that I’ve never heard him mention before – 34 of them projected inflation below 4% for 2021.
Powell also said that “everyone had the same model.” He mentioned the Phillips curve, which central bankers have used for decades to project the correlation between unemployment and inflation.
But that model leaves out a critical factor, as Powell finally acknowledged today long after he should have. That’s the influence of a supply collapse – one big problem that started with the pandemic and is still unresolved more than two years later.
What [the model] was missing was something that’s completely missing in the data for 40 years, a collapse in the supply side. You had very strong demand hitting effectively a vertical supply curve.
What did we get wrong? That supply-side issues would be resolved relatively quickly. That didn’t happen.
Money-supply growth is the definition of inflation, not increases in prices. Many people misunderstand this.
Inflation is caused by the Fed printing new money into circulation out of thin air an exchange of nothing for something.
It’s true that prices of certain things (like oil and baby formula) have gone up recently because of supply shocks. But that’s not “inflation”.
Inflation is the general rise in all prices across an economy caused by the expansion of the money supply. Increases for certain goods because of supply shocks are just noise in the overall inflation numbers.
The late, great Nobel Prize-winning economist Milton Friedman explained it best…
“Inflation is always and everywhere a monetary phenomenon.”
Don’t let anyone tell you differently.
When it comes to inflation, we should listen to Friedman. He spent his career studying it across many centuries, countries, and types of economies. He was a big critic of the Fed’s monetary policies in the 1970s that led to that decade’s rampant inflation.
There’s always a lot of smoke and mirrors around the subject of inflation. Neither the Fed nor the mainstream financial media is giving you an honest explanation of what it is or what causes it.
Friedman is very clear about it. He says inflation is always caused by the same thing – a more rapid increase in the money supply than in the output of goods and services.
According to Friedman, inflation has always been accompanied by a rapid increase in the quantity of money. And a rapid increase in the quantity of money has always been accompanied by inflation.
The Fed – through its monetary policies – caused today’s inflation. It’s as simple as that. Of course, the Fed will never admit that. It will blame anyone or anything else it can.
It has already blamed supply-chain disruptions… the war in Ukraine… and pandemic lockdowns. I’m sure it will blame others in the future, like greedy businesses that are jacking up prices to cover their rising costs, or employees whose wages have grown too fast.
Don’t believe any of it.
If you study the money supply, it’s apparent inflation isn’t dropping anywhere near the Fed’s 2% target anytime soon.
Here’s why…
The last time the money supply even approached today’s pace of growth was the 1970s. From 1970 to 1972 and again from 1975 to 1977, the money supply grew about 30%. The Fed printed the money to fund the Vietnam War and an expansion of Social Security.
Now take a look at the chart below… It shows the money supply per unit of output, as measured by real gross domestic product (“GDP”) versus inflation as measured by the consumer price index (“CPI”) over the decade of 1970 to 1980.
You can see that inflation (the black line) always tracks the increase in the money supply (the blue line). Friedman shared a similar chart in a lecture explaining the country’s high inflation back in 1977.
It takes about a year for money-supply increases to start making their way into the economy. What’s important is the two lines eventually meet. Either inflation has to rise… or the money supply has to decrease.
By 1972, the money-supply increases had finally made their way into the economy. Inflation continued rising to more than 12% by 1974. It took two years and the Fed raising interest rates to 13% to bring inflation down to 5%.
But the Fed didn’t learn its lesson and kept printing. Inflation started rising again over the next few years and didn’t peak until 1980 at nearly 15%. This time, it took more than two years and Fed Chair Paul Volcker raising interest rates to nearly 20% in 1981 to bring inflation back down.
Let that sink in… It took the Fed at least two years of raising interest rates each time to tame inflation. And the Fed had to raise interest rates higher than the rate of inflation just to bring it down to 5%, more than double the Fed’s 2% target today.
Now, here’s the scary part. Here is the same chart over the past 10 years…
This might be the most important chart you see all year.
This is the chart Milton Friedman would be looking at today to forecast inflation. The blue line shows the explosive growth in the money supply immediately following the pandemic.
Again, this increase didn’t show up in inflation immediately after the Fed switched its printing presses into overdrive. It took about a year before we started seeing the effect in inflation numbers.
Since then, inflation has been following the upward path of the money supply. But as you can see, it hasn’t caught up yet.
That’s why I believe inflation will continue to stay elevated.
Dr Copper
Economists sometimes call the metal “Dr. Copper” because its price is so closely tied to economic cycles. Copper demand tends to rise—and fall—with construction and industrial activity. We see in this chart copper did indeed rise strongly as the world moved out of the initial COVID-19 disruptions in mid-2020. Then in mid-2020 it entered a mostly sideways pattern around the $4.50 level… until recently.
Copper prices dropped sharply over the last few weeks. Maybe not coincidentally, higher mortgage rates are starting to bite the US housing boom. There’s also increasing concern the Fed’s tightening campaign will push the economy into recession. Copper is still up strongly over the last year, so this may just be a correction in an ongoing trend. That would be more consistent with inflation expectations. Dr. Copper is reliable but not perfect.
US Economy
- New home sales surprised to the upside.
- But analysts see the rebound in demand as temporary.
- Buyer traffic and mortgage rates:
- Inventories remain elevated diverging from unsold existing homes.
- The U. Michigan Consumer Expectations Index hit the lowest level since 1980.
- High gasoline prices have weighed on sentiment.
- Consumer sentiment has significantly decoupled from the unemployment rate, similar to what occurred in the 1970s.
- Job postings on Indeed are drifting lower.
- A survey from the Dallas Fed shows executives expecting supply chain issues to last more than 12 months.
- Britons view their financial future as hopeless.
- US durable goods orders topped expectations, with business investment holding up well despite the headwinds
- Inventory growth has been outpacing orders.
- The Citi Economic Surprise Index bounced from the lows after the durable goods orders report.
- The Dallas Fed’s regional manufacturing index tumbled this month, as demand slumped and outlook collapsed.
- Order backlogs have melted away.
- Pending home sales were better than expected last month but are still down 12% vs. last year.
- The upside surprise was driven by stronger sales in the Northeast.
- Market-based inflation expectations have been drifting lower.
- The CPI is now at its long-term downtrend resistance.
- Hospital inflation could accelerate in the months ahead as labor costs surge.
- The pace of global corporate defaults has slowed so far this year compared to the previous five years.
- The Conference Board’s consumer confidence report came in below forecasts, with the expectations index tumbling to levels not seen in nearly a decade. This was one of the triggers for last Tuesday’s 2% drop in the S&P 500, as recession concerns mount.
- The Conference Board’s inflation expectations index hit a record high.
- Consumers are increasingly gloomy about the stock market.
- Consumers are becoming concerned about job prospects going forward. The “future employment” component is now a drag on the overall confidence index.
- The Conference Board’s sentiment indicator remains well above the U. Michigan’s survey.
- The Richmond Fed’s regional manufacturing index plunged this month, as demand deteriorates. Sounds familiar? This trend is playing out across the country.
- Supply chain delays are easing, and order backlogs are depleted, as demand slows.
- Factories expect fewer hours for workers in the months ahead.
- Despite weaker demand, manufacturers are still boosting prices.
- The regional Fed indicators point to manufacturing contraction at the national level this month.
- The market still doesn’t expect the Fed to raise rates much above 3.5%.
- Home price appreciation hit a new record in April according to the Case-Shiller housing price index.
- The breadth of the rally in home prices has been unprecedented.
- S&P Global Ratings expects home prices to keep climbing, albeit at a slower rate.
- The divergence between home prices and wages continues to widen.
- Robot orders have increased alongside rising wages.
- Mortgage applications to purchase a home dropped sharply last week and are now down 24% vs. last year.
Market Data
- The Nasdaq 100 held support at the 200-week moving average.
- Most commodities, especially base metals, are in a bear market.
- Oil is rebounding.
- Over the past five weeks, the S&P 500 has swung by 5% or more four times. That’s tied for the 2nd-most volatile stretch since 1928. Fewer than 2% of its member stocks were holding above their 50-day averages; now more than 20% are.
- It has been a tough month for cryptos.
- Profit margin growth consensus estimates are much too optimistic.
- Analysts’ earnings forecasts tend to be overly optimistic around recessions.
- Should we expect a 70s-style multi-year sideways market?
Quote of the Week
“In theory, theory and practice are the same. In practice, they are not.” – Albert Einstein
Picture of the Week
All content is the opinion of Brian J. Decker
