In April this year, the US producer price index was 11% higher than one year earlier, while the consumer price index was 8.3% higher. Increases of these magnitudes have not occurred since faraway 1981. These large increases in the cost of living and producing have a significant immediate impact on real incomes and profits, so it’s natural that concerned citizens and managers ask themselves: What happens next?
Since 1982, inflation, as measured by changes in these two price indices, has been low, never reaching double digits in all the many intervening years. This contrasts with the years before 1981, when since the late 1960s inflation was chronically high. Many credit the Chairman of the Federal Reserve during Regan’s first term, Paul Volcker, for taming the beast of inflation and ushering in what is now referred to as the Great Moderation: a time of low inflation and, seemingly, endlessly falling interest rates. Is the Great Moderation over? Did the monetary authorities of recent years unchain the beast from the cage in which Volcker put it?
Inflation, pure and simple, is an absolute decline in the purchasing power of one dollar. (Strictly, this is dollar inflation, with an equivalent definition for every other currency from Bitcoin to the Hryvnia.) This is equivalent to an increase in the average price of everything, including consumption goods, labour and industrial goods like machines. Economists usually contrast inflation, an absolute change in all prices, with relative price changes: Apples can become more expensive after a bad season, but if not much else does then the relative price of apples to say one hour of an office worker just went up. Office workers need to work harder or consume less other stuff if they want to consume the same quantity of apples, but if they’re happy to substitute bananas for apples they are a only a tiny bit worse off. Relative price changes are important: they signal to the world that everyone should produce more apples. Absolute price changes, inflation, do no such thing.
Strictly speaking, the recent large increases in price indices mostly reflect relative price changes, as opposed to pure inflation….at least so far. One of the world’s biggest energy exporters (Russia) just invaded the world’s biggest food exporter (Ukraine). Russia got slapped with a raft of sanctions, with more to come, making oil and gas, still an important source of energy consumption, much scarcer and therefore more expensive. Because of Russia’s blockade of its ports, Ukraine is unable to export much of its huge food output, making staples like wheat and corn much scarcer than usual as well. These events have caused a big jump in energy and food prices. On its own the war explains about half of the jump in the PPI.
Looking further afield, the world is recovering from the lockdowns imposed because of the coronavirus pandemic. The immediate consequence of these lockdowns is to have made labour much scarcer and less reliable: Fewer people are in the labour force after the pandemic than were before, many must cancel work at short notice because of testing positive (in the West) or being locked down again (in China). Further, many companies (e.g. hotels or airlines) fired lots of workers in the early stages of lockdown in order to survive a lengthy period with no business and are struggling to rehire.
Third, China is no longer going to be the workshop of the world. Having moved almost all of their manufacturing production to China in the decades before 2020, many Western companies are reconsidering how and where to manufacture their products, so called re-shoring or friend-shoring, for many reasons, but especially increasing hostility between China and the West and China’s endless lockdown making it a less reliable manufacturing partner.
All of these factors drive an increase in the cost of making stuff, getting to work and so on. But these are one-offs. In time, Western firms will re-shore, workers will return and more reliably, profitable alternative sources of oil and gas will arise, particularly in the US, which due to the shale revolution may well become Europe’s biggest supplier. In the longer term, we won’t need nearly as much oil and gas any more: probably no later than the end of this decade.
If that’s all it is, the current rise in the price index is probably just a relative price change and will not last. But that’s not what we are worried about. Back in the 1970s, inflation was also driven by big oil price spikes. But the inflation became locked in and persistent because workers’ wages rose in lockstep to keep the relative price of labour roughly equal to the relative price of industrial inputs. All prices, including the price of labour, rose at double-digit rates, and did so persistently for over a decade. This only ended when Volcker increased interest rates to levels that drove the US into deep recession, halting wage rises and taming the beast of inflation. Will that happen again?
In the 1970s, inflation was sustained by accommodative monetary policy, low interest rates, at least until Volcker took over at the Fed. Nowadays, most important central banks are independent from government meddling and have a mandate to keep inflation moderate. Although the Federal Reserve oversaw a vast increase in the stock of high-powered money (cash and bank dollar reserves at the Fed) after 2008, so-called quantitative easing, this had almost no effect on price indices. The Fed has now announced a rollback of quantitative easing together with a series of (likely) interest rate increases through the remainder of 2022 which should start to raise real interest rates sharply from their current negative level. Other things equal, this makes it harder for employers to pass on their cost increases to customers and grant higher wage settlements to their workers, which ought to prevent the large relative price shocks of the past 12 months from turning into persistent inflation.
Today, the real danger more likely comes from accommodative fiscal policy. Voters with big energy bills may eject incumbent politicians, and so the incumbent politicians may feel like giving handouts. In doing so, they may be encouraging inflation to persist, by allowing nominal incomes to keep up with the big relative price shocks and so turning them into persistent inflation. The US is at record levels of employment, so there is little spare capacity in the economy to absorb any further increased demand. President Biden’s two massive spending bills passed through Congress in the last two years look like pouring fuel on the fire.
So, will this current round of price increases persist? The first place to look are the bond markets. Long-term bond yields are not quite expectations of future short-term bond yields (a whole topic for another day), but they’re a plausible candidate: the US 10-year bond yield is 2.8% and the 30-year bond yield is 3%. If long-term investors think that inflation is likely to remain near 10% for many years, they ought to be asking an awful lot more than that. The implied break-even rate between Treasury Inflation Protected Securities (TIPS, whose coupons are adjusted upwards by the change in the CPI) and nominal bonds is 2.6%, which is (not quite but roughly) the markets’ best guess about average inflation over the next 10 years. This is not high forecast inflation by people who are investing their money, in enormous amounts, on that bet. Quite the contrary.
It's the ‘enormous amounts’ that gives me pause. Last week I explained how foreign countries with savings have nowhere to bank their savings than US bonds. Those flows into US bonds may be dumb money, dwarfing the impact of the smaller outflows due to inflation fears, and those outflows may be better informed. It reminds me of how bookies’ odds (which are dollar-weighted) ahead of the Brexit referendum in the UK predicted an overwhelming win for ‘Remain’, while the sheer number of small bets was overwhelmingly in favour of ‘Leave’. (If no-one knows what’s going to happen, but everyone knows how he himself is going to vote, equal-weighted is much more informative than dollar-weighted.) I’d like to see an equal-weighted estimate of recent flows into TIPS before I feel sure that the bond market is telling me the right number, but such data are unavailable.
How good were the bond markets at foreseeing the inflation in 1970s back in 1974, just before inflation hit 11% (before going on to hit 13.5% in 1980)? In January 1974, 10-year bond yields were around 7%, much higher than today, and had been at or above 6% since the late 1960s. That seems reassuring: the bond markets underestimated inflation in the 1970s but ‘only’ by about 40%, so if bond markets today are similarly wrong, our forthcoming inflation shouldn’t be as bad as the 1970s. Once more, however, there was less price-insensitive demand for US government bonds back in the 1970s, and more people were investing their own, as opposed to other people’s, money.
Even if the mainstream forecast, right now, is for price increases to moderate in the next year or two, for the Fed to do its job, and for inflation to be contained, there is a lower probability but very bad scenario that is also plausible. The US government debt to GDP ratio is about 105% (avoiding double counting of money the government owes itself), which is much higher than at any point since World War Two. Most contemporary economists no longer believe that the money supply is what determines inflation. Instead, they emphasize the total stock of government debt (including high-powered money) relative to likely future government incomes. Instead of defaulting, governments which can no longer sustain debt issued in their own currency inflate.
At current interest and growth rates, 105% is sustainable, just, but at higher interest rates and lower growth rates, it isn’t. Any event which kicks off a jump in bond yields from the current 3% to say 7% would render the US government hard-pressed to service its debt without rampant inflation. Watch the bond markets: you might make up one morning to read about a failed Treasury bill auction or a sudden big jump in Treasury bill yields. If so, that could be the only early warning you ever get of a run on the dollar, which is exactly what dollar inflation is.