Who is to blame for inflation?

          Who is to blame for inflation?  And, what are the risks of a recession?

 Jim Staudt, PhD, CFA

  copyright 2022, all rights reserved

Who is to blame?  Republicans wanted to blame Joe Biden and profligate federal spending, but they ignore the fact that Dwight Eisenhower was the last fiscally-responsible Republican to sit in the White House (see my book, Grand Collusion).  Democrats want to blame the pandemic and the war in Ukraine.  The truth is something that most economists want to ignore.  The Fed is mainly to blame, with some blame put to forces (like the pandemic and the war in Ukraine) that have temporarily disrupted supply.  But, the Fed is the biggest culprit.

The Fed is always late to act against inflation - always.  This is because it is easy and popular to maintain accommodative money policy, as Bernanke and Yellen did in the aftermath of the 2008 financial crisis well after unemployment went below targeted levels and financial markets stabilized.  Greenspan, with Bernanke's support, did the same thing prior to the 2008 financial crisis - which is what contributed to the crisis.   Keeping interest rates low, well after the financial system has stabilized from a crisis and employment achieved targeted levels, is popular because mortgage rates drop and the prices of various assets increase.  Issue of credit grows, as credit is cheap, which benefits the banks and anyone who wants to borrow.  Many economists, especially those who work in the banking system or in government positions that are close to banking, have a cognitive bias against scrutinizing policies that benefit them personally.  Even many academic economists are drawn into this bias because most of their research is funded by the Fed, the Treasury, or banks.  Besides, few are willing to argue that the Fed should pull away the punch bowl and stop the party.  It's no way to make or keep friends in the banking sector.

Will inflation continue for a while?  I think so.  Inflation has been more sticky than economic prognosticators had hoped, and this is the historical norm.  Many economists were hoping that once the supply disruptions of the pandemic situation improved, inflation would improve.

My thoughts are that we are in for a situation similar to what happened in the 1970s and 1980s, perhaps much worse (and I'll address that later).  This is because we have inflation resulting from monetary policy induced inflation, plus some other effects that I will discuss that make the situation worse.

How monetary policy induced inflation works

Although the Fed funds rate gets the headlines, the Fed's market operations (purchase and sale of securities in the market) are what impact the money supply and also impact market interest rates, along with the funds rate.  So, the combination of the funds rate and market operations are the tools the Fed uses to regulate monetary policy.

I will caveat this discussion by saying that many academic, government or banking economists do not buy into this description of how monetary policy induced inflation works.  They tend to ignore the historical record that there is a delay between monetary stimulus and inflation in goods and services.  However, economists who are practitioners (especially, Ray Dalio, who has published on this) are more likely to see inflation working this way.  Folks like Dalio, who make their living by anticipating how markets will behave, need a much better functional understanding of the economy than academics tend to appreciate.

Monetary policy induced inflation is inherently delayed.  This is because of how accommodative monetary policy functionally puts money into the economy - more on this below.  As a historical example, the abandonment of sound money policies started in practice in the 1960s (when quarters were no longer made from silver) and officially in 1971 (when Nixon officially abandoned the gold standard).  These enabled the Fed to print as much money as they wanted and make federal deficits (and other debts) painless.  Yet, official inflation numbers did not peak until 1980 at nearly 14%.  Why was there a delay of about a decade?

Inflation is measured in terms of the cost of goods and services relative to a prior period of time.  Loose monetary policy does not immediately translate into increases in the prices of goods and services because the money initially goes from the Fed to banks, that sell their debt to the Fed when the Fed buys debt instruments from banks.  This is how the money supply is regulated.  The debt issued by banks is used by borrowers to buy assets, such as real estate, stocks/bonds, and other assets.  The money introduced in this manner does not yet go to goods or services that are the components of inflation, but assets.  These assets all rise in value, which is good for those who own these assets.

So, loose monetary policy will result in an immediate increase in the prices of assets and an increase in wealth for the wealthy.  But, the rise in price of these assets don't immediately translate into inflation because inflation (as it is measured) does not incorporate the price of these assets in determining the value of inflation.  So, in the short term, loose monetary policy makes the wealthy wealthier, and makes it easier for everyone to borrow money.  This is why loose monetary policy is popular.

But, over time these increases in asset prices do eventually trickle into the prices of goods and services as home buyers find themselves needing more money to buy homes or rent a home.  Eventually, wealthy people who have improved balance sheets from the asset inflation may buy more goods and services, driving up the cost of these goods and services. This is when you start to experience inflation.

Globalization has helped to delay the increase in the cost of goods and services as suppliers of goods and services have been able to search the globe for the least expensive supplier of the good or service.  This has the effect of depressing wages at home.  So, globalization has been a disinflationary effect.

Inflation (and globalization, for that matter) most harms those folks who are on the bottom of the economic scale, as they did not benefit from the rise in asset prices and their incomes do not provide much or any cushion to absorb the increased cost of goods and services.

So, in effect, the money injected into the economy by loose monetary policy initially just moves into asset prices and debt before it makes its way into goods and services.

Monetary Policy and fighting inflation

Now, just as there is a delay between loose monetary policy and the resulting inflation, there is a delay between when restrictive monetary policy starts and when inflation turns around.  When the Fed initiates tighter monetary policy, asset prices initially fall, and this is an immediate effect.  But, the prices of goods and services don't immediately drop.  That's what we are seeing right now.  Inflation that resulted from loose monetary policy becomes sort of "baked in" for a while.  It is why it took so long and such severe Fed intervention in the 1980s to get inflation under control.

Are we heading to a recession, and how bad will it be?

The arguments for a recession are:

• Of the last 13 Fed tightening cycles, 10 have led to recessions.  So, from the perspective of Fed tightening alone, one would expect a recession.
• The yield curve has inverted, which also tends for foretell recessions.
• Recessions are often preceded by very low unemployment that limits economic growth as productivity and available new labor stalls.  That is the case now.
• The benefits of the tax cuts of 2017 are over.  Most money went to corporate share buybacks, which don't lead to productivity growth.  There was an uptick in capital expenditure, but it was muted.  As a result, the tax cuts will not provide the level of productivity growth that are needed to compensate for the shortage of workers.
• At over ten years since the last recession, we are well beyond the norm between recessions

Those that argue that we are not heading to recession point to low unemployment and high consumer spending.  However, low unemployment normally precedes the beginning of a recession because of the limitations on economic growth and the increased wages that cut into corporate profits. High consumer spending is consistent with low unemployment, but this also precedes a recession.  Moreover, while the Fed does not predict a recession, they have never predicted a recession.  A recession is only recognized once it has already become apparent.

Given that the indicators suggest a recession is coming, it is worth considering what might happen.  Unfortunately, the United States and the world are deeper in debt than they were prior to the 2008 financial crisis.  It is, however, allocated differently.  Mortgages are not the problem - at least not now.  The really bad debt is mostly corporate debt, a good deal of which matures in the next two years and must be rolled over into higher yielding debt. Companies will need to pare costs in order to service the new debt or they will need to see their debt downgraded.  Right now over 50% of investment grade debt is triple B, double what it was in 2007 (the Fed bought most of the downgraded debt during the pandemic).  As a result, most investment grade bond portfolios are holding lower quality debt than they did in 2007.  As debt gets downgraded bond funds will need to sell debt that is no longer investment grade.  

As companies lay off workers (this has already started in the tech sector), this will put more pressure on the housing market.  So, the mortgage market is not where the next crisis will start, but the crisis will reach mortgages.

The dilemma we face with a recession is similar to what happened in 2007/8 due to high debt levels.  Although mortgage debt is not the main problem as before, the bigger problem is corporate debt.  Banks may be in better shape than in the previous crisis, but the biggest problems are those we don't know about yet and we only realize are there once they become large.  There is no telling what ways bank management may have become creative in circumventing reforms by hiding liabilities, as they did prior to the 2008 crisis.  Although there are new rules, bankers have shown themselves to be creating in finding the loopholes.

On the media's push back against Trump

by

James E Staudt

copyright 2018, all rights reserved

Across the United States the media is pushing back against President Trump's attacks on them as being "Fake News" and "the enemy of the people".  There is always a grain of truth to any great lie.

A free and independent press is one of the critical pillars necessary for a democracy to survive.  In this respect, the president's attacks on the media are wrong.  While the media doesn't always get it right (more on this later) it is necessary to have a free press to preserve democracy and prevent a government from becoming a tyranny.  This is why freedom of speech and freedom of the press are preserved in the first amendment to the constitution.  The colonies wanted the ten amendments in the Bill of Rights to prevent the federal government that had been established in the constitution from turning into a tyranny.  That is why so many of these ten amendments relate to prohibition of certain practices that were used by the British during colonial rule - such as housing soldiers or preventing assemblies.  So, President Trump is clearly wrong in calling many of the press outlets "enemies of the people".  

On the other hand, a loss in confidence in the media as an independent and trusted source of information is well justified.  An important theme discussed in my book Grand Collusion is that the two political parties and the media have a vested interest in keeping Americans misinformed and fighting one another.  The media is the chief benefactor of political spending and the political parties are able to use controversy as a means to motivate political donations.  This symbiotic relationship has made the commercial media too close to the two major parties.  Over time, the for-profit media outlets have become more of a mouthpiece of the government, large corporations or other influential groups that provide "information" (or, propaganda) at no charge. With this model, the media outlets don't need the expense of investigative journalism to examine information and question it..  For example, the media acted as a mouthpiece for the Bush administration in promoting the Iraq War.  It did not critically evaluate the evidence presented by the George W. Bush Administration in its argument for invading Iraq, which led to destabilization of most of the Middle East.  In fact, Judith Miller (then at the New York Times and later Fox News) was criticized for her role at the New York Times in promoting the Bush administration's arguments for the war.  In effect, Ms. Miller and the New York Times acted as a political agent for the Bush administration.  Unfortunately, she was not alone.  Many news outlets, Fox News for example, are not truly independent and act almost as an agent of a political party.

The media must be free to critically examine the information from the government, regardless of who is president.  But, they should do so thoughtfully, thoroughly and without bias.  Unfortunately, in today's media, which focuses more on entertaining rather than informing and also has close ties to political parties, there is no room for a trusted reporter such as Walter Cronkite to calmly report the news of the day without drama or injection of bias. When issues are discussed on today's news stations, they are often sensationalized in a contentious battle between talking heads with a banner across the bottom saying "Such and Such Fiasco".  This may make for entertaining television, but it does not inform.  If we are to preserve the United States as a democratic republic, the media must step up to its responsibility of informing the citizenry rather than attempting to use every opportunity to create controversy.

Be Afraid.  Be Very Afraid

by James Staudt

copyright 2018, James E Staudt, all rights reserved

With John Bolton appointed to replace H. R. McMaster as National Security Advisor to President Trump, President Trump is replacing one of the few remaining "adults" in the Trump administration with one of the most dangerous people in Washington, D.C.  General McMaster had a distinguished military career and in his book Dereliction of Duty demonstrated that he understands how the US can be drawn into unnecessary wars and then have these wars mismanaged and bungled by politicians and policy advocates who do not truly respect the military.  It is a great book worth reading that demonstrated that Vietnam, Iraq, and Afghanistan had a great deal in common.  In contrast to General McMaster, Bolton is the consummate Washington advocate.  He has cycled in and out of positions with Republican administrations and the American Enterprise Institute (AEI) - the right-wing "think tank" that promoted the Iraq War on behalf of it's defense industry benefactors under the guise of the Project for a New American Century.  Unlike McMaster, Bolton has no professional military or intelligence background to qualify for the post that he will now hold.  He has long been a policy advocate and therefore has the same cognitive bias that blinded Paul Wolfowitz (another AEI alum who guided the US into the Iraq War) as described in my book Grand Collusion.  Bolton is a staunch believer in "regime change" not only in Iran and much of the Middle East (except of course Israel, where he is close with Benjamin Netenyahu) but in North Korea.  As such, there is no chance that Bolton will advise President Trump to avoid war with either Iran or North Korea.

This might not be quite as alarming were President Trump more seasoned on foreign policy or more contemplative in nature, but he is neither.  It also might not be so alarming if congress had not surrendered its constitutional responsibility to authorize war with the horribly misguided Authorization of the Use of Military Force (AUMF), which effectively gave the president blanket authority to wage war against anyone and anywhere he chooses.  While intended in principle to be used against the perpetrators of the September 11 attacks, the AUMF has been used by presidents Bush, Obama, and now Trump to conduct military operations in the jungles of Niger, in Yemen, in Libya, and elsewhere against people who bore no responsibility for the September 11 attacks.  In effect, President Trump has already been granted the authority to go to war against Iran and North Korea should he choose to, and with John Bolton at his side, he will most certainly be advised to do so.  Congress cannot stop President Trump from going to war without repealing the AUMF, which will never occur with a Republican-controlled congress and would be very unlikely even if the Democrats controlled congress.  Moreover, it would require a veto-proof majority to repeal the AUMF because President Trump would no-doubt veto such a measure.

Bolton's appointment also demonstrates the hypocisy of President Trump.  As a candidate, then Mr. Trump repeatedly emphasized that he had been opposed to the Iraq War.  Why then would he turn around and appoint one of the architects of it to the critical role of National Security Advisor?  Candidate Trump was clearly telling us what we wanted to hear, not what he truly believed.

My fear is that President Trump will act as many embattled presidents do and go to war - hoping that the nation will rally around him as often happens to presidents when war occurs.  The Mueller investigation appears to be honing in on something that is creating more agitation for President Trump.  We don't know if Mr. Mueller will find actual collusion with Russia, but he could come across something else that is either embarrassing to President Trump or creates problems with people in his administration or members of his family.  For this reason, war with North Korea or Iran could start looking like a very attractive distraction from the investigation while also serving to rally the support of Americans.

So, be afraid.  Be very afraid.

On the DNC revelations

copyright, James Staudt, 2017, all rights reserved

The recent Donna Brazile revelations about the control that the Hillary Clinton campaign exerted over the DNC prior to even a single primary vote was cast may not seem surprising.  What it certainly proves is that neither of the two major party candidates - Trump or Clinton - was worthy to hold the office once held by Abraham Lincoln.

So, how did this happen?  The DNC under Debbie Wasserman Shultz, was financially in trouble.  In 2015 they made a deal with the Clinton campaign that the Clinton campaign would help with their debts and in return the DNC would turn over all decision-making, including staffing, to the Clinton campaign.  The Clinton campaign made numerous staff replacements, including according to Tulsi Gabbard (former vice chair of the DNC and a representative from Hawaii) replacing long-time DNC staff with Clinton-selected lobbyists.  In addition, state DNC party contributions would be funneled to the Clinton campaign through the DNC.  According to Representative Gabbard, 99% of such contributions were sent to the Clinton campaign.  So, contributors, thinking that they were helping local candidates, now realize that their contributions were being funneled to the Clinton campaign.

Supporters of Bernie Sanders, who suspected a rigged system, have been vindicated.  My democrat friends have had a very difficult time accepting the fact that the reason Donald Trump is president is not because of Russia as much as it is the fact that the democratic party offered a candidate that is at best extremely divisive or worse, untrustworthy.  This is not to excuse Donald Trump, who I have never considered an acceptable person to serve as president (and, I did not vote for Trump).  However, many of those who voted for Trump were people who knew that the Washington DC deep state is not working for them and were hoping for change from an outsider.  Most, I suspect, have been disappointed.  Nevertheless, this revelation about Clinton campaign control of the DNC will, hopefully, cause democrats to reflect on the party and demand reform.  However, I'm not going to hold my breath.

Are We Going to War?

by James Staudt

copyright 2017, all rights reserved

I hope not.  But, I fear that President Trump's speech at the UN brought back memories of the George W. Bush administration - especially the "Axis of Evil" speech where he told the world that "you are either with us or you are against us".  The stark "us versus them", "good versus evil" tone of the Trump speech is reminiscent of Bush and Cheney at their worst.  Also, President Trump is leading an administration that can't seem to get anything done domestically and is seeing key people from his presidential campaign, such as Paul Manafort, indicted.  A war tends to get the country to rally around a President, no matter how beleaguered he might otherwise be.  So, there are political reasons why President Trump, like President Bush before him, might be inclined to go to war.

Unfortunately, we cannot rely on Congress to prevent the war.  Although our Constitution (Article I, Section 8, Clause 11) gives Congress the sole authority to declare war and the President, as Commander-In-Chief, the power to conduct the war, since World War II Congress has consistently voted to grant the authority to commit troops to military action overseas ("war" by any other name) to the President, rather than make the affirmative choice themselves as was intended by the writers of our Constitution.  This works out well for both Congress and the President.  When things go wrong the President gets to do what he wants and can share the blame with Congress who allowed him to do what he wants.  Congress gets to put the blame on the President by saying that they didn't actually vote for the war but voted to give the President the choice to go to war and the choice was his.  Essentially, each gets to pass the buck to the other.  How convenient.

Make no mistake, there is no happy ending with a war against North Korea or Iran.  Iran is three times the size of Iraq in terms of land and population, and we know how well the Iraq War has gone.  A war with North Korea, while not much of a threat to US citizens at home, puts millions of our friends (and US citizens) in South Korea and Japan at risk and also risks a war with China.  China has made it clear that they will not accept US troops in North Korea, and we saw how well crossing the 38th parallel went about 70 years ago when China entered the Korean War.  President Truman deeply regretted taking General MacArthur's advice on that matter.

Even targeted strikes against North Korea would be a mistake. Kim Jong Un would hardly stand by, or he would risk losing power.  North Korea can easily bombard Seoul with its artillery and would likely do so in retaliation for a strike.  The population of the Seoul metro area is over 25 million.  My son is currently in Seoul on a semester abroad, and I am understandably worried about this.  Even if he weren't in Seoul, I would be opposed to an attack on North Korea.

The only world leader that applauded President Trump's speech was Prime Minister Benjamin Netanyahu.  Netanyahu encouraged the United States to invade Iraq.  He has encouraged a very militant posture with Iran, opposing the nuclear agreement.  In a war with Iran, Mr. Netanyahu's Likud government would be the main beneficiary.  As the United States and Europe have become more preoccupied with turmoil in the Middle East and elsewhere, there is less pressure on Israel to negotiate with the Palestinians.

I fear that we are getting ever closer to a serious war, perhaps even the use of nuclear weapons.

Trump and Dodd-Frank - No Surprise Here

by James Staudt, PhD, CFA

copyright 2017, all rights reserved

President Trump may be changing aspects of the regulations issued in response to the Dodd-Frank law.  How is that even possible?  As described in more detail in Grand Collusion, despite the 2000+ pages of Dodd-Frank, the law did not set any statutory requirements on the banks.  Much was to be determined in future executive branch rulemakings.  Therefore, it is pretty easy for President Trump, or any other president for that matter, to dismantle much of what few actual requirements were imposed on the banks.  This is not to say that there are no procedures that must be followed and that litigation might slow things down; however, because Dodd-Frank set very few statutory requirements and left so much to future executive branch rulemakings, Democrats cannot even filibuster to prevent fairly substantial changes.

This exposes what, in my view, was the fatal flaw of Dodd-Frank - it did not establish much in terms of statutory requirements.  By contrast, the Banking Act of 1933 that was under 60 pages long and gave us over 50 years of banking stability, had very clear statutory requirements - separating investment banking from commercial banking along with other requirements.  The argument that is always made is that there are too many details to be included in the 2000+ page law.  The reality is that today the laws that congress passes are mostly written by lobbyists because lawmakers and their staffs are far too busy raising money to devote much time to writing laws.  So, it was no surprise that Dodd-Frank - despite its length - set very few real requirements on the banks.  Agencies therefore set rules intended to achieve the goals set forth in the law, rules that must go through a proposal and public hearing process, rules that later get litigated, and therefore take a long time to enact and can get further watered down.

So, there is no surprise here.  The only surprise might be that candidate Trump, who railed against Wall Street, now perhaps wants to relax the rules.  However, if you've read Grand Collusion, this should be no surprise.  Wall Street owns both major political parties.  In fact, there is no reason to believe that Hillary Clinton wouldn't have taken steps to change the rules issued in response to Dodd-Frank.

This is not to say that the rules put in place after Dodd-Frank was passed cannot be improved upon in some ways.  They probably can.  However, with Goldman-Sachs executives advising President Trump, it seems likely that changes will be made that favor the banks even if they raise the risk to the taxpayer.

A complaint of the banks is that some institutions find the requirements costly and burdensome. If the current requirements are replaced with simpler capital buffer requirements that are more straightforward to follow but establish a solid bulwark against future failures, that could be an improvement.  Prior to banking deregulation, capital buffer requirements were very straightforward, making "stress testing" unnecessary.  On the other hand, if rules to prevent excessive risk taking through proprietary trading by depository institutions are relaxed (the so-called "Volker Rule"), that could pose a problem regardless of whether or not capital buffers are improved.

The truth is that right now we don't know for sure what President Trump has in mind.  So, we can only speculate at this point.  But, given the influence of Wall Street on every President for the past few decades, we should not be surprised if the already weak requirements of the rules established in response to Dodd-Frank get even weaker.

Flipping Washington The Bird

by Jim Staudt, PhD, CFA

Copyright, 2016

Donald Trump’s victory was unexpected. Some of my Democrat friends (who are in a state of shock) claim that this is a case of racism or White Nationalism. This is a mistake on their part. While I'm sure that there were some racists among the 59+ million people who voted for Mr. Trump, there were simply too many Americans who voted for Mr. Trump to blame it entirely on racism or White Nationalism.  Some polls show that college educated women, a group that Mr. Trump was expected to do poorly with, voted for Mr. Trump at a rate of 45%.  That is much higher than I expected given that his opponent was an extremely smart and accomplished woman.

My opinion is that the Democrats ignored the fact that a lot of Americans have suffered from economic policies put in place by both major parties over the past several decades that enriches Wall Street and big business at the expense of Main Street. These policies have hollowed out the American middle class and left us with wealth disparity that exceeds that of any country one might want to live in.  Hillary Clinton is viewed – rightly or wrongly (rightly, in my opinion) – as part of the political system that created those policies. Many Americans are weary of Washington and feel powerless against the forces that have controlled the two major political parties for several decades. Our government has grown increasingly detached from the people it governs, creating what many would consider a ruling elite.

Bernie Sanders would likely have defeated Mr. Trump. But, Senator Sanders, if elected president, would have upset the economic order that funds both political parties, which is why the DNC worked against him and for Hillary Clinton. After Bernie Sanders lost the Democratic nomination, voting for Donald Trump became the only viable option people had to give the middle finger to the political status quo.

The Democrats need to do a great deal of self-reflection.  They were once the party of the working class.  While the GOP has long been the party of big business, since the 1980s the Democrats have also become the party of big business.  As manufacturing jobs went overseas and private sector labor unions grew weak, the Democrats sidled up to Wall Street and big business to remain competitive. The result is that neither party represents Main Street any more, which is why there was a populist revolt in both parties.  In this case the GOP picked the populist candidate while the Democratic Party held on to the status quo, and the populist candidate won.  This is how Donald Trump made it to the White House.

Let's hope that Mr. Trump is up to the job.

Jim Staudt