Is Current Inflation Temporary? Today’s Most Consequential Economic Debate
In his latest corporate finance column, Les Nemethy examines the use of the word “temporary” by U.S. Government officials, market reaction to the June 10 inflation announcement, and the risks going forward.
On March 4, 2021, Fed Chair Jerome Powell announced “inflation will pick up in the coming months, but it would likely prove temporary and not enough for the Fed to alter its record-low interest rate policies.”
Sure enough, on June 10, the U.S. Department of Labor announced that Consumer Price Inflation (CPI) had reached 5% in May, the highest rate since 2008, as noted by the Wall Street Journal. However, the U.S. Fed maintains that this inflation spike is “temporary” in nature.
Milton Friedman, the storied American economist and proponent of the Chicago School of Economics, once said, “Nothing is so permanent as a temporary government program.” His cynicism is not without foundation. Here are just two of the most blatant and consequential misuses of the word “temporary.”
• On August 15, 1971, Nixon announced the “temporary suspension” of gold convertibility, ending the Bretton Woods agreement. To this day, gold convertibility remains suspended. By any definition, that is a rather long “temporary.”
• To combat the Great Financial Crisis of 2008, the U.S. Fed announced a quantitative easing program, known as QE1, in November 2008 as a temporary measure. Since then, there has been a QE2 and a QE3; we now seem to be in a “QE permanent” mode, with the Fed constantly adding USD 80 billion-120 bln per month to its balance sheet. It just recently surpassed the USD 8 trillion mark; the amount has doubled since January 2020, according to figures on the federalreserve.gov website in the monetary policy section.
It seems that the markets, for the time being, are taking Chairman Powell’s comments at face value; in other words, they seem to believe that inflation will subside. In support of this thesis, here are two economic indicators.
After the June 10 announcement, 10-year treasuries notched lower by more than 10 basis points, to 1.43%; not the behavior of a market expecting a rise in inflation. Secondly, the price of gold has moved down by more than 2%. Gold prices typically go up when inflation expectations arise, especially when real yields are negative, and the real yield is now lower than it has been in a long time.
To my mind, the only plausible explanation for why Treasury yields and gold prices have declined is that markets believe that the inflation spike announced on June 10 is temporary.
The announcement of a new statistic or an article by an influential economist could change market sentiment suddenly, and everything from Treasury yields to the price of gold could swing very rapidly.
Moment of Truth
In other words, there could come a moment of truth or an inflection point when markets suddenly react to the past accumulation of data. This could make market reactions all the more sudden and extreme, damaging to everything from bond and equity valuations to mortgage rates housing starts.
Meanwhile, the debate among economists about whether today’s inflation is temporary rages on. Influential economists, such as David Rosenberg, argue very persuasively that deflation is a much bigger risk than inflation.
Nevertheless, as I have stated in an earlier column, “What’s in our Future, Inflation or Deflation?” (December 11, 2020 issue of the Budapest Business Journal), I believe, on balance, that inflation is the larger risk. There are a number of powerful structural changes occurring in the world economy.
• China is no longer the pool of almost infinite cheap labor. It is facing a demographic implosion of its own. (Some of my Central European clients tell me that their labor costs are less than those in China.)
• We are experiencing bottlenecks in many areas, from computer chips to shipping containers, resulting in price pressures.
• The world breaking down into separate U.S., Chinese, and perhaps European supply chains diminish efficiency and contribute to inflation.
• The goal to become carbon neutral has strained mineral resources, causing dramatic spikes in commodities, from copper to nickel. According to The Economist, the top five minerals used in green vehicle production have enjoyed a 139% price surge over the past year, despite less than 10% of the required investments having been made to date.
• Savings are at a historic high, with many economists predicting a post-pandemic purchasing binge, increasing the velocity of money.
However, it is the combination of massive monetary and fiscal stimulus that is the factor most likely to tip the scale in favor of inflation. In 2020 and H1 2021, the money supply has increased by more than 30% and U.S. Federal spending by some 50%, with trillions in additional stimulus spending likely to come this year (infrastructure, social welfare expansion, etc.)
As former U.S. Secretary of the Treasury Larry Summers recently said on a coindesk.com video: “We’re taking very substantial risks on the inflation side. The sense of [...] complacency being projected by the economic policymakers that this is all something that can easily be managed is misplaced.”
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com) and a past president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of June 18, 2021.
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