Lacy Harris Hunt is an economist and Executive Vice President of Hoisington Investment Management Company (HIMCO). He is Vice-Chairman of HIMCO’s strategic investment policy committee and also Chief Economist for the Wasatch Hoisington Treasury Bond Fund. He has authored two books, A Time to Be Rich and Dynamics of Forecasting: Financial Cycles, Theory and Techniques, and has had articles published in Barron’s, The Wall Street Journal, The New York Times, The Journal of Finance, the Financial Analysts Journal, the Journal of Portfolio Management, among other publication outlets. He received the Abramson Award from the National Association for Business Economics for “outstanding contributions in the field of business economics.”
How does one explain a world in which macro trends are deflationary (DumbWealth: The Case for Deflation) yet the basic necessities of life are increasing in price?
While it sounds contradictory, the two paradigms can coexist. Look at housing prices and healthcare costs over the past 10 or 20 years. Look at commodity prices during the 2000s.
From the late 1990s to early 2010s commodity prices across the board were going through a super-cycle, driven by rising Chinese demand. Commodity prices were booming, yet – despite some cyclical bounces along the way – the secular disinflationary trend that began around 1980 continued until present day.
Medium Term Crude Oil Prices
Makes no fucking sense, right?
There are those who argue the CPI stats don’t reflect reality. The thing is, price ‘reality’ for one person isn’t ‘reality’ for another. We all have different baskets of goods and all spend different proportions of income on those goods, so our true experiences will differ.
ShadowStats has re-calculated CPI based on its own interpretation and has consistently printed double the reported inflation rate:
So, despite the long-term deflationary pressures of debt, demographics, productivity and imports, one must still respect how quickly commodity prices have risen lately. We’ve seen this battle before.
Over the near term, we’re going to see rising prices. Perhaps the scariest part of all this is how quickly global food prices are rising. Over the past year, the FAO Food Price Index has risen almost 40%!
This doesn’t necessarily mean that you’ll witness a 40% price increase in the grocery stores or a huge impact to your food budget. However, for the poorest portions of global society this could mean the difference between paying rent and feeding their kids.
In the end, the cure for high prices is high prices. This means two things.
Much of the current increase in commodity prices is caused by supply chain issues created (exposed?) by the pandemic plus growing shortages of raw commodities. Higher prices are incentivizing production (and delivery) to quickly come back on line, which will eventually mitigate further price increases – potentially even lowering prices.
Higher prices could break demand. At some point people simply can’t afford to pay higher prices. There’s an argument that the final straw that broke the housing market’s back prior to the 2008 Global Financial Crisis was higher gas prices. People could no longer justify longer drives, eroding demand for new suburban sprawl developments. Simply put, higher prices eventually erode demand somewhere, somehow and this can have a domino effect on the economy, ultimately replacing rising prices with a deflationary shock. This is what we saw in 2008.
Final thoughts
Although the ‘peak oil’ movement seems to have disbanded with the influx of lower quality, relatively expensive American shale oil, it is quite possible the world is riding a deflationary low-tide coupled with broad resource shortages that result in inflationary waves.
My prevailing shower theory (i.e. something I came up with in the shower) is that the secular deflationary forces will remain omnipresent, but most of the world will fixate on the boom/bust cycles driven by resource demand and shortages, exacerbated by fragility in the global just-in-time supply chain.
There will be rotation from good times to bad and back, but ultimately there is no end to this inflation-deflation battle. We can’t make more easily accessible, high quality oil, copper, etc. Yet, ‘economic progress’ requires us to use more and more. However, demographics and debt will continue to act as a counterbalancing force for our destiny.
Inflation is a hot topic right now. Understandably so, as prices for a range of commodities (lumber, copper, etc.) have risen substantially over the past several months.
Chart: Google Search Trends for ‘Inflation’ in the United States
Raw materials price pressures are now showing up in consumer prices with CPI rising 4.2% year over year ending April 2021. This level of CPI has not been seen since the early days of the 2008 global financial crisis.
However, it is becoming increasingly clear that this inflationary burst is temporary. The conditions simply don’t exist to support long term inflation, like that seen during the 1970s.
There are several reasons.
1) Milton Friedman once said that “inflation is always and everywhere a monetary phenomenon”. I’d argue that he is only half right. Central banks can increase the money supply all they want, but to have an inflationary effect the velocity of money must remain stable or rise. Real world experience clearly shows that money velocity is not constant and tends to have an inverse relationship with the level of a country’s indebtedness. And as you all know, we are drowning in debt right now.
It is becoming increasingly clear that this inflationary burst is temporary. The conditions simply don’t exist to support long term inflation, like that seen during the 1970s.
The relationship between indebtedness and money velocity is clear in the following chart. As the level of indebtedness of the US economy started to significantly rise in 2008, money velocity declined. Ultimately, money velocity plummeted to new lows during the Covid-19 crisis and has yet to recover, despite an improving economy.
Effectively, what this means is that new money entering the system (generally to fund new debt) is simply tucked away, mitigating any inflationary effects of monetary expansion.
This phenomenon is also illustrated by the declining marginal economic benefit created by new debt. The economic impact of additional debt today is much lower than it was in decades past. Therefore much more money needs to enter the economic system to have the same impacts it did in the past. Of course, more new money means more debt. By now you’ve probably noticed this is a vicious cycle.
2) The current inflationary pulse was triggered by the partial paralysis of the global supply chain. Exports out of low-cost producing countries grinded to a halt, forcing Western countries to purchase from more expensive domestic suppliers or compete over dwindling supply.
As vaccines are delivered the mechanisms for global trade – offshore manufacturing + shipping – can resume. Imports into the US are already back to pre-pandemic peaks and it’s only a matter of time until renewed competition from cheaper sources pushes prices down.
3) Labour productivity tends to rise coming out of recessions. Higher productivity offsets higher wages, thus putting a cap on unit labour costs that can flow into prices. I believe this phenomenon will be even stronger as we exit the pandemic.
The nearly immediate and widespread adoption of new software and methods of working have compressed a decade’s worth of productivity gains into the present. Not only that, but companies that maintain a remote workforce can benefit from labour cost arbitrage across geographic regions. Over the long run, both of these advances will keep a lid on unit labour costs. This is disinflationary.
4) Population growth in the US continues to be very weak and will be for the foreseeable future. 20-something year olds simply can’t afford to have kids. Or they are choosing not to bring new people into the world for ethical reasons.
The point is that forward demand driven by new consumers entering their prime spending years continues to decline. When demand declines prices fall.
While nobody can predict the future, one can use data and hard evidence to create a guide. Evidence suggests that those calling for a shift in the economic regime – from disinflationary to inflationary – could be wrong. I believe, as a diversified investor, it is important to prepare for the possibility that the pundits are wrong.
While I won’t know if I’m right or wrong until some point in the future, it appears that the bond market might agree with my thesis, as the yield on the 10yr has flatlined since March 2021.
