I argued repeatedly last year that inflation might become stochastic in 2023 and beyond.
Much as I’d like to claim profundity and originality, the rationale wasn’t terribly groundbreaking, and I borrowed the stochastic characterization from Zoltan Pozsar (with whom I most assuredly don’t agree about the future of dollar hegemony).
The inflation case is easy to make. There’s a war going on in Europe that doesn’t look like it’s inclined to stop, there’s a prospective war brewing across the Taiwan Strait, the pandemic forced corporates to question their faith in the religion of just-in-time and, relatedly, governments were compelled both by the pandemic shock and geostrategic concerns to accelerate re-shoring plans which already had populist momentum.
All of that’s inflationary, and some of it’s conducive to higher inflation volatility. The Ukraine conflict could mean rolling food and energy price shocks (which were likely anyway due to climate change and, paradoxically, efforts to reverse it), a conflict in Taiwan would threaten more chip shortages and if China were to become a wartime belligerent of the West, it’s reasonable to suggest goods prices might increase sharply with the “world’s factory” on a war footing and in any case disinclined to produce and ship cheap products to consumers in adversarial countries.
Indeed, pretty much every facet of our post-pandemic/wartime reality is the last 30 years flipped on its head. Globalization is going into reverse. Commodities (even food) are being weaponized. Developed economies in the West are compelled — both by geopolitical developments and by a restive, blue collar populace at the end of its rope with the blowback from globalization — to bring industrial capacity back home. Nationalism and noxious xenophobia in the US continues to inhibit constructive dialogue around immigration policy, which is in turn delaying the societal integration of immigrants ready and willing to work. The accumulated ills of shareholder capitalism are finally manifesting in a realization among the populace that meritocracy is a myth and that redistribution is the only way to prevent a dystopian outcome where a dozen people control virtually all the wealth on the planet. And on and on.
According to many observers, markets are underpricing the risk of permanently high inflation — the risk that the 2020s represented a macro sea change. A Minneapolis Fed model of options-derived probabilities suggests the odds of elevated inflation outcomes have normalized after falling sharply over the past 12 months.
I haven’t conducted any sort of diligence on the model used to produce the data behind the chart above. Apparently, it uses inflation caps and floors. My knowledge is severely dated, so I could be wrong, but the problem with those instruments is that there’s no supply, and any demand for them forces dealers into a short position, which they have no way to cover, so they’re generally reluctant to engage, and there’s no proper price discovery. Given that, you’d imagine they trade very wide. Maybe the Fed uses some theoretical model-based values to benchmark the implied levels.
In any event, the results (i.e, the trends from the model) make intuitive sense, which is fine for our purposes. For example, the odds of low inflation in perpetuity briefly spiked at the onset of the pandemic (to account for the prospect of demand destruction on a massive scale) then collapsed completely as price growth took off. Peak odds of elevated inflation coincided with Russia’s invasion of Ukraine. And so on.
On Friday, Mohamed El-Erian reiterated that a 2% inflation target is no longer viable. He made the same point earlier in the week. “You need a higher stable inflation rate. Call it 3 to 4%,” he told Bloomberg TV. “I don’t think [the Fed] can get CPI to 2% without crushing the economy,” he added.
El-Erian cited most of the factors mentioned above, from supply chain frictions to geopolitics to energy to labor, but repeated that the Fed can’t change the target now — that’d be an admission of defeat.
More and more, the consensus among market observers (if not markets themselves) revolves around the idea that the Fed will coax inflation back down near target, then immediately pivot to a rethink, knowing that 2% is no longer viable on a sustained basis.
Again: The Fed won’t jettison the 2% target until they’ve managed to wrestle at least one gauge of consumer price growth down to levels they can plausibly suggest are mandate-consistent. What happens in the event that proves to be impossible is an open question. As El-Erian suggested, policymakers might have to engineer a deep recession to prove a point. Only then would they be willing to go back to the drawing board.
I suppose one counterargument to all of this is the idea that between automation in factories and warehouses (i.e., automating blue collar, manual labor), the trend towards self-serve kiosks in the services sector (e.g., touch screens for ordering fast food) and the potential for AI to replace white collar workers, robots can make up for a lot of the disinflationary impulse lost to de-globalization.
Something tells me workers wouldn’t take that sitting down, though. Low prices in the globalization era helped mitigate the lack of good jobs in developed economies, but it’s not clear how even lower prices can mitigate the lack of all jobs.
That raises another question: Will the coming robot-human war for control of the planet be bullish or bearish?
About that coming human-robot war. As a middle school kid the first seriously interesting book (actually a play) I read, along with a gob of Nero Wolfe mysteries, was R.U.R. wherein the word “robot” was first coined by the playwright Karel Capek. He saw a revolution. I just see a mess. People have to eat. We can’t make them all go away. And as many current efforts in AI show, our prowess in passing on our brains often doesn’t go well. Anyway, if robots don’t learn how to drive, how will they get to the prom?
It is more viable to replace Chinese workers with robots than with workers. The United States and Canada already have labor shortages, which are not going away anytime soon. There are more baby boomers than zoomers. Re-shoring will be expensive, and impossible without new technologies.
Or immigrants. If they still want to come…
The declining need for human workers will mean that we might be close to peak global population.
I recently read that the CCP put out a mandate requiring all local governments to use human workers wherever possible, even if machines would be more efficient. That goes for ditch difgers to office workers.
I have no idea if this is bullish or bearish for equities.
H-Man, maybe 3% or 4% is the new number on acceptable inflation. There is no rule that 2% is mandatory.
Indeed, and since 2% is the AVERAGE target, then if the Fed can get it down in the 3-4% range, they could plausibly claim success, that inflation can run “hot” for a little while since we ran cold for quite a while. And then, in time, if there’s nothing too unbearable about 3-4% inflation, it can become the new target without causing much rumpus.
Here are a few more trends that are probably on net inflationary vs. deflationary:
Climate change – insurance losses and insurance premiums are way up
Decarbonization
Increasing percentage of older age population vs. working age population – older people require more services (medical) but produce less stuff
Higher inflation implies higher nominal revenue growth in many industries. Some will have pricing power (as consumer staples demonstrated in the past year) while others will lose margin (but with supply chain bottlenecks easing, fewer than over the past year). Implies terminal growth assumptions can move up.
If the Fed acquisces to higher inflation, rather than raising rates higher, then discount rate may not need to move up.
That implies higher valuations.
But you have to believe the Fed will choose to abandon its inflation target and credibility, just to avoid a recession and higher unemployment.
Sounds familiar? We are back to the debate of mid 2022, when investors were hopefully being that the Fed would cease tightening to spare the economy. Jackson Hole Powell brought investors back to reality. I doubt anything since then has changed Powell’s priorities.