The Inflation Genie Has Escaped Its Bottle — Inflation Is Back

The Inflation Genie Has Escaped Its Bottle — Inflation Is Back

While Australia’s economy is stuck in lockdown, again, the world’s largest economy and its reserve currency are dealing with a very different problem. Inflation is back with a vengeance.

It’s notoriously tough to get inflation back under control once you unleash it. That’s why turning points in inflation are so important. Especially to investors who are trying to preserve their wealth, which means adjusted for inflation. And especially in the global reserve currency, in which all traded goods are effectively priced.

If inflation does roar in coming years, we’ll look back at last week as the turning point. The moment when we wonder how we didn’t see the inflation disaster coming…given it was already here.

But even with the recent surge in inflation data, the case isn’t so one-sided. Some deflationists claim the genie is very much stuck in the bottle. First, though, let’s review the data out of the US, which was released last week…

The US Consumer Price Index (CPI) rose 0.9% month-over-month and 5.4% year-over-year. The monthly increase was almost double the expected amount of 0.5%.

Core CPI, which strips out highly volatile prices like food and energy, was also up 0.9% month-over-month and 4.5% year-over-year. That’s the largest increase in 30 years.

Goods prices, which people notice disproportionately, are soaring much faster than services, up 8.7% year-over-year, the fastest since 1981.

Bank of America’s inflation indicator hit its highest possible level of 100 on the data dump.

Now, you might think all this goes some way to settling the raging debate between inflationists and deflationists. Those who think we’re in for years of surging prices and those who think prices will continue to be subdued.

But each side of the inflation versus deflation debate was able to see in the data what they wanted to. It’s a case of confirmation bias spiking as much as inflation.

Discover the three steps you could take today to ‘recession-proof’ your wealth. Download your free report now.

Deflationists argue the year-over-year data is going a little haywire because the year of comparison is 2020, which was a little unusual. In support of this claim, the biggest contributors to the surging CPI are items especially badly hit by the pandemic like flight prices.

As economist David Rosenberg pointed out, ‘about 90% of the core CPI was +0.2% in June (+2% YoY), and 10% of it jumped over 5% (+20% YoY). Autos (used, new, rentals), airlines, movies, hotels — there’s your inflation. The skew is unprecedented.’ Used cars are the poster child of this skewed inflation, with used car price increases leaving even the ‘70s data in the dust.

The problem with this argument is cleverly summed up by this sarcastic comment, which is circulating on social media: ‘If you exclude all the things with rising prices, there is no inflation!’ Indeed…

The inflationists do acknowledge the poor comparison to 2020, though. But they point out the accelerating rate of month-over-month inflation, which isn’t subject to the problems of comparing to 2020. It compares June 2021 to May 2021, not June 2021 to June 2020.

What does a monthly view reveal? Well, if inflation continues at the June pace, the US would have 11% annual inflation! We’re talking about a double-digit inflation rate. Suddenly that 0.9% isn’t so small, is it?

More importantly, the monthly inflation data seems to be accelerating fairly steadily:

Jan: 0.3
Feb: 0.4
Mar: 0.6
Apr: 0.8
May: 0.6
Jun: 0.9

Bloomberg pointed out that ‘In the three months through June, the core CPI increased at a more than 8% annualized rate, the fastest since the early 1980s.’ In other words, if inflation continues at the same pace as between April and June, which are unaffected by the base year effects of year-over-year data, we get 8% inflation.

To put it simply, devastating rates of inflation are already here. The question now is whether they’ll continue.

Part of the answer lies in producer prices, leading to consumer prices as companies pass on the burden. Well, last week, the data revealed US producer prices soared 1% month-over-month and 7.3% year-over-year. That’s faster than CPI.

In the last 10 years, the Producer Price Index has only managed a year-over-year high of just over 3%, so we’re more than double the previous decade’s highs.

Interestingly, while services prices for businesses rose less than a per cent month-over-month, goods prices surged 1.2%.

That’s a review of the data. Next came the kerfuffle over the reaction.

Should central bankers pump billions into financial markets and keep interest rates near zero when inflation is at 5%? Some would call it insanity.

US Federal Reserve Chair Jerome Powell admitted that tapering QE was being discussed, which was enough to send stock markets stumbling, for a while.

But Chicago Fed President Charles Evans said ‘inflation upside risk is not as strong as I’d like it’ and ‘more persistent inflation wouldn’t be bad’. This is an odd statement given inflation is more than two and a half times the 2% target on a year-over-year basis and five and a half times the annualised June increase.

At some point, if inflation continues, central bankers will be forced to raise interest rates. But when?

Because financial markets effectively price future outcomes, it’s possible to derive the presumed probability of various events based on the market price of assets. And the ‘market-implied Fed rate at end of 2022’ measure was at 0.5%, having doubled since January. That means the market expects one rate hike in the next 18 months.

After an initial spike on the day inflation was revealed, the yields on US bonds ended up falling even lower over the subsequent two days. With inflation rates above 5%, the 30-year treasury yield dropped below 2%…

Investors are losing money on loans to the US government. Not to mention savers getting even more pitiful interest rates.

So, why isn’t the terrible inflation data leading to carnage in the bond market? If inflation is reducing the value of money, then surely lending money to the government for 30 years at less than half the rate of inflation is a bad idea?

There are plenty of arguments to suggest why bonds are not crashing.

The first is that inflation is transitory. It’ll go away by itself, don’t worry. There’s plenty to this argument because of things like demographics and debt.

Another possibility is that if interest rates rise, it’ll trigger another financial crisis because there is now simply so much debt that the world cannot afford higher rates. In such a crisis, people flock to government bonds. And that suppresses yields. So the low bond yields are in anticipation of a crisis…from higher yields…

The alternative theory is something called financial repression. The idea that the bond market’s interest rates are being kept low by central banks while they engineer higher inflation. Why? To save governments from their debts by inflating away the burden without letting interest rates on government bonds spike.

Whatever the reason, and whatever the timing, it seems to me that the inflationary endgame is finally peeking over the horizon. And it’s coming our way.

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

PS: Our publication The Daily Reckoning is a fantastic place to start your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here.