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.