High Inflation: A Forecast

Three months ago, I noted that “the fuse that makes hyperinflation explode is lit, and it is shorter than most people think.” In October, I explained how the current, reckless monetary expansion is destroying the risk markets in our economy while, again, inching us closer to high inflation. I also elaborated on how our monetary tsunami is destroying the price-risk signal on the stock market. Then, a month ago, I again put the spotlight on monetary expansion and hyperinflation.

Then, in the last couple of days, I warned that the new stimulus bill is throwing gasoline on the inflation fire, and that we are already seeing signs of inflation where we normally would not.

We do not yet have monetary inflation in the U.S. economy, but it is simmering. The transmission mechanisms from money to real-sector prices are open; all that is needed is more money printing, and inflation will hit us. In fact, what has happened this year, especially the past six months, is that the inflationary default setting has changed: prior to 2020, Congress – which is directly responsible for opening the inflationary transmission mechanisms – would have to actually take active measures to cause high inflation. Today, they don’t need to: inflation will come unless they take active measures to prevent it.

Today, we will take a look at some other data that reinforce my prediction of high inflation. We start with a comparison of GDP growth and CPI, the consumer price index.* Figure 1 reports those two variables, quarterly at annual rates, for almost 40 years. The start date is intentional, excluding any distortionary effects from the inflation peak in the late 1970s.

There are six points of interest in Figure 1, three of which are episodes of business-cycle related declines in the inflation rate. Those episodes are the ones that can teach us a thing or two about where we are today. These episodes are marked by blue and red arrows, with blue for GDP growth and red for inflation. All these episodes are related to recessions: the 1990-91 recession, when GDP growth declined and briefly dipped into the negative; the Millennium recession when GDP kept growing; and the Great Recession when we saw a deep but brief decline of the U.S. and world economies.

In all these episodes, the inflation rate declines with a 2-4 quarter lag behind GDP. This is significant, as we will see in a moment:

Figure 1

Sources of raw data: Bureau of Economic Analysis (GDP); Bureau of Labor Statistics (CPI)

First, though, let us take a look at the two green-arrow episodes. They both represent a decline in inflation that is unrelated to GDP. The first one, in the late 1980s, is the product of a gradual shift in monetary policy, from the Volcker era to Alan Greenspan’s monetary conservatism. Inflation pops up again right before the 1990 recession, in good part because of a spurt in economic activity on the heels of the Reagan tax cuts.

The second green-arrow episode happens in 2015. It coincides with a brief, almost anomalous spike in GDP growth. It looks strange, statistically, but there is very likely no causal connection between GDP and CPI at this point. Instead, we are probably looking at a shift in the cause of inflation: the inflation from circa 2011 to 2015 was likely driven by the monetary expansion we came to know as “quantitative easing”, while inflation after 2016 has been more a traditional, growth-driven phenomenon.

In fact, starting in 2017 there is an almost uncanny correlation in time and size between GDP growth and CPI. It is broken by the artificial economic shutdown of 2020.

Which brings us to the dark grey arrow at the end. Look at how CPI never goes negative: if this was a regular recession, we would see a dip in CPI similar to the blue-red-arrow episodes. It would have been lagged, but it would have been there. Instead, inflation stays in the positive – and the rate turns up again in the third quarter (the last data point) even though the economy is still in a decline on a year-to-year basis.

The gap between inflation and GDP growth is significant, both statistically and analytically. The gap in Q2 of 2020 is the biggest recorded in Figure 1, where inflation is higher than GDP growth. It spans more than nine percentage points.

Analytically, the gap is very worrisome: it tells us that there is a lot of money going into demand for consumer products that does not originate in productive economic activity. This is the money that Congress is pumping into households and businesses, courtesy of the Federal Reserve.

This is the gap that, if it remains, causes hyperinflation. Call it the monetized hyperinflation gap.

To get a different view of this gap, behold Figure 2. It reports the same inflation measurement, but contrasts it against inverted monetary velocity. This sounds fancier than it is: the green function really just reports an “upside down” velocity curve. The point with this is to illustrate changes in money supply relative changes in current-price GDP. If money supply increases faster than current-price GDP, then money supply outpaces transactions demand for money. This means that the excess supply of money has to go somewhere else: either it finds its way into equity prices, or it is funneled through a monetized government deficit into the pockets of consumers and businesses, as work-free cash.

Four episodes in Figure 2 help us understand how inflation and relative money supply have interacted:

Figure 2

Sources of raw data: Federal Reserve (Money); Bureau of Labor Statistics (Inflation)
  1. Supply-side inflation. It is a bit unfair to stretch this period as far back as to 1959. It really only starts in the early 1970s, with the first oil-price shock. However, there was a first hint of it in the money printing that took place at the end of the 1960s, when we formally left the gold standard (which had been effectively abandoned much earlier) and the federal government started running a structural budget deficit. But the two inflation peaks during this episode are predominantly related to oil prices. Fortunately, as the green function shows, money supply as share of GDP declined during the 1970s. This eventually helped put out the inflation fire.
  2. Monetary conservatism. With a steady hand on money supply, Alan Greenspan gradually rolled it back to match GDP growth. It was not entirely successful, but overall he did well. Long term, inflation trended downward.
  3. Small QE. Our first encounter with quantitative easing came right after the 9/11 terrorist attacks. A leadership change at the Federal Reserve unfortunately allowed this episode to drag on. Ben Bernanke was not nearly as monetarily conservative as his prior scholarly research suggested he would be.
  4. Big QE. Then came the big quantitative-easing episode. The remarkable characteristic of this episode is that money supply has continuously outpaced GDP, even prior to the 2020 artificial economic shutdown. In other words, we have over-monetized our economy already prior to this year’s mad stimulus spending. The reason why inflation did not pick up is simple: up until 2020, excess monetary expansion found its way into equity prices (sending our stock market into fantasy land). This year, though, the $3 or so trillion dollars of excess money-printing is working its way into consumer prices.

The last point is hugely important and leads us to the following predictions:

a) If CPI exceeds four percent for the fourth quarter of 2020, we can expect more than ten percent inflation in the first half of 2021;

b) If CPI falls between three and four percent in the fourth quarter of 2020, and if inflation remains higher than real GDP growth, we will see 10+ inflation in the second half of 2021;

Furthermore, if:

c) Congress keeps pumping out monetized spending as it is doing now, and

d) If inflation soars past ten percent in the second half of 2021,

e) Then we know we have high inflation (10-50 percent) in the making.

f) If inflation exceeds ten percent in the first half of next year, expect stratoinflation (50-100 percent) in 2022.

At that point, there is a more than 50 percent chance for hyperinflation, which means inflation in the hundreds, even thousands, of percent per year, or more, in the coming years. The journey there will be disrupted if Congress takes decisive action; with no decisive action but the continuation of spending as usual, we will get there.


*) I normally recommend the GDP deflator for inflation measures, but it is not available at the level of detail that we can get with the CPI.