10 reasons inflation may stay elevated
And if it does, the world becomes a more dangerous place for investors.
The biggest single question facing the stock and bond markets this year isn’t Covid or midterm elections or China. It’s inflation. And I can think of 10 reasons it’s unlikely to ease to the Fed’s 2% target anytime soon. Far from it.
No. 1: Global CPI is 5.9%. The fact that inflation is happening not just in the U.S. but everywhere makes it much more likely to be sticky.
No. 2: There’s been a very noticeable shift in public opinion in favor of labor over management, government regulation over free markets, on-shoring over off-shoring, and protectionism over free trade. Every single one of those trends is inflationary.
No. 3: Wage increases show no signs of slowing down. Unemployment claims are at a 52-year-low, and the Conference Board says companies are planning pay raises in 2022 that are double what they’ve been in recent years. Here’s an example of what I mean: when John Deere union workers went on strike, the company offered a 23% pay raise. The union said, “no thanks” and eventually got a 40% pay raise … and a cost-of-living adjustment for future years.
No. 4: While supply chain bottlenecks eventually will get resolved, it won’t be because of a sudden surge in infrastructure development. The way the supply chain gets fixed is by raising prices enough to kill demand, which will feed inflation.
No. 5: History. I’m old enough to remember that back in the 1970s, there was massive spending to fight air and water pollution at a time when inflation already was running hot; now we’re likely to see massive spending to fight climate change at a time when inflation already is running hot.
No. 6: The economy is in great shape. Even after the Fed begins tightening, the real fed funds rate will still be negative for a long time. Rates generally don’t become restrictive for growth until the real fed funds rate is a positive 1%-2%.
No. 7: The late Milton Friedman, a Nobel-winning economist who ushered in the era of monetarism, said inflation is “too much money chasing too few goods and services.” If he’s right, we need to be on high alert because M2 (a broad measure of the money circulating in the U.S.) has surged 41% over the past two years, a record by a wide margin. And money supply is up 25% in Europe and 30% in China, so again this is a global phenomenon.
No. 8: 40% of CPI is housing, and I don’t have to tell you that home prices and rents have been going through the roof, so to speak. (And their feed into inflation tends to lag, so this effect isn’t slowing anytime soon even if home prices start to moderate.)
No. 9: This is kind of off-the-wall, but higher inflation helps in our economic war with China. Higher inflation in the long run results in a weaker dollar, and a weaker dollar could price Chinese exports out of the market and raise the price China pays for energy and food.
And finally, No. 10: Another history lesson. Back in the ’70s, everyone thought that inflation’s spike would be transitory, that it was a one-off deal caused by an OPEC oil embargo. But that’s because people were used to low inflation in the ’50s and ’60s.
Because we’re so conditioned to inflation always being low, there’s a risk we’re falling into that same mental trap today. But eventually, just as in the ’70s, investors and the public could start seeing the world differently, as a place with inflation in it. In a recent poll, people listed Covid as their second-biggest worry, behind higher prices.
Emotional changes are hard to predict and can take a while to develop, but when they do, inflation expectations tend to become embedded in business and consumer psychology. And they tend to become a self-fulfilling prophecy as everyone buys more now to fend off higher prices later. The only real fix to that is a painful recession, typically brought on by rapid and large rate increases by the Fed.
So, bottom line, I’m worried that inflation won’t settle back down to 2% anytime soon. And this could make the world a much more dangerous place for investors. Sustained, elevated inflation—and the medicine necessary to ultimately beat it back—rarely, if ever, is friendly for stocks or bonds.