Stagflation Watch

We are upgrading our Tuesday monetary policy updates to focus primarily on the rising threat of stagflation in the U.S. economy. This very term is not seeing much use in the public discourse – not yet – but we would like to remind our readers that there was virtually no mention of the term “inflation” in that same discourse either, until recently. We, on the other hand, began warning about inflation already at the beginning of the year. Therefore, we expect our stagflation warnings to be of the same predictive nature.

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Treasury Yields

In line with our monetary policy updates, we report the weekly developments of Treasury yields as an indication of how monetary policy interacts with fiscal policy.

Yields on Treasury debt with long maturities – 10-30 years – began rising with the start of the Biden presidency. The increase tapered off in mid-March and was replaced with a mild decline. This period now seems to have come to an end.

Meanwhile, yield on short-term bills with a maturity of 1-3 months fell to extremely low levels, below 0.05 percent. When the rise in long-term yields came to an end by mid-March, the short-term yields took another dive and have since been hovering between 0.01 and 0.03 percent, on average:

Figure 1

Source of raw data: U.S. Treasury

The mid-March shift in yield trends coincides with a significant monetary expansion: in the month of March, the Federal Reserve expanded M2 money supply by $427.3 billion over the previous month. This represents a 2.2-percent growth in money supply, the highest level since May last year and the seventh highest monthly expansion on record. It is twice as high as the average monthly expansion since June 2020. The yield trend shifts indicate that the Federal Reserve used its accelerated monetary expansion to expand its interventions in the market for Treasury debt. Yields drop when bond prices rise; bond prices rise when demand increases; demand increases when the Federal Reserve increases its purchases relative supply.

It is reasonable that the Federal Reserve would expand its interventions on the sovereign-debt market to keep yields – interest rates – from rising. The massive borrowing by the Treasury is already raising the cost of the national debt; if interest rates rise as well, the cost of the debt could rapidly become a confidence problem for private sovereign-debt investors. The gradual rise in long-term yields, combined with a drop in short-term yields, already suggests weakening confidence among debt investors: they move away from longer commitments and prefer to hold bills with high-frequency turnover.

To counter this, the Federal Reserve would intervene by expanding its own portfolio of debt, but it would have to do so in a manner sizable and comprehensive enough to shift the Treasury price trend. This appears to have happened over the short terms, as the rise in long-term yields came to a halt. However, the intervention by the Federal Reserve is only defensive: its market interventions are like chewing gum to the hole in the Titanic. When the hole gets big enough, its market measures will no longer be effective.

In addition, further expansion of the money supply at this point only fuels inflation. As inflation rises, and expectations of inflation rise with it, the yield outlook on long-term government debt becomes weaker. Investors have to resort to price speculation to make money. This steers them over to shorter-maturity instruments, where it is easier to forecast speculative gains. This, in turn puts more upward pressure on long-term rates, forcing the Federal Reserve to intervene yet again.

In short, as we have pointed out repeatedly: the Federal Reserve is running out of options. Monetary policy has de facto become ineffective – or, to put this in Keynesian terms: America has fallen into the liquidity trap. Only Congress can fix this problem.

Inflation Worries on the Rise

The Liberty Bullhorn Economic Newsletter has been warning about inflation since the first days of January. Now, four months later, inflation is becoming a mainstream topic in the public conversation. Billionaire investor Warren Buffett has now shared his worries, and over the weekend the White House finally acknowledged that inflation is a concern:

A White House official on Sunday said the administration expects to see some “transitory inflation” as the United States emerges from the COVID-19 pandemic. Speaking to Fox News, Council of Economic Advisers chair Cecilia Rouse was asked about whether the trillions of dollars in new and proposed spending will lead to inflation. “These are very serious concerns, and we know that coming out of an extremely deep recession that there are going to be bumps along the way. We expect that there is going to be supply chain disruptions. That will cause some transitory increases in prices,” Rouse responded.

The admission that we are headed for inflation is a good start, hopefully the beginning of a new direction in economic policy – both fiscal and monetary – for the rest of the Biden presidency. However, the hopes of a rapid policy change are muted by statements from influential voices such as Treasury Secretary Janet Yellen:

“I don’t believe that inflation will be an issue. But if it becomes an issue, we have tools to address it,” Yellen, the former Federal Reserve chair, said Sunday on NBC’s “Meet the Press.”

In other words, there is no inflation, but if there was inflation it would not be a problem.

It is highly unlikely that an accomplished economist such as Yellen would take the threat of inflation this lightly. More than a genuine analysis on her behalf, this is probably just a politically motivated first step of opening the inflationary can of worms to public debate. To fully and unconditionally admit that inflation is a problem is to admit that the Biden administration and Congress are inflationary culprits: their fiscal policy has forced an unprecedented expansion of money supply, which in turn, with some lag, drives inflation.

Council of Economic Advisors Chair Cecilia Rouse is more blunt in her statement on inflation. This is welcome, but her statement also comes with a significant, and misleading qualification. She is not correct regarding the cause and effect behind the inflation we currently see in the U.S. economy. The recovery from a recession does not cause inflation. A recession is by definition a state of idle economic resources, which by necessity means a downward pressure on prices. When economic activity does pick up, the inflation rates that follow as the recovery unfolds, are lower than those that preceded the recovery:

  • Before the recession in the early ’90s, inflation topped at 6.2 percent; inflation did not exceed 3.2 percent until the first quarter of 2000;
  • The top inflation rate immediately before the Millennium Recession was 3.5 percent; after the recovery began in early 2003 it took two full years before inflation again exceeded 3.5 percent;
  • Consumer price inflation peaked at 5.3 percent in Q3 of 2008, with the Great Recession beginning in the following quarter; inflation still has not reached half that rate in any single quarter.

The worrisome part of the current inflation rate is that it coincides with a high unemployment rate. The timing of changes to inflation and unemployment is the opposite to what we would want to see.

In the first quarter of this year, CPI-based inflation was 1.9 percent, higher than the 1.81 percent average for 2019. The Q1 2021 inflation rate is paired with an unemployment rate of 6.5 percent, compared to 3.65 percent for 2019 as a whole. It is important to note, however, that unemployment bottomed out at 3.3 percent in Q4 of 2019, with inflation at 2.03 percent.

As Figure 2 explains, the last time unemployment and inflation combined at levels comparable to the first quarter of this year, was in 2014. At that point, though, both variables were trending down, with inflation eventually dropping to below one percent in 2015.

Prior to that, inflation and unemployment exceeded current levels right as the economy were starting its recovery from the Great Recession. At that point, government was also monetizing its deficit – marking the height of the Federal Reserve’s Quantitative Easing under Ben Bernanke – but the monetization efforts were less pronounced and the stimulus spending considerably more confined. Therefore, the resulting spike in inflation, exceeding three percent in Q2-Q4 of 2011, also proved to be temporary:

Figure 2

Source of raw data: Census Bureau

If the inflation currently visible in the U.S. economy were of the traditional “recovery” kind, the Treasury and the Council of Economic Advisers would not see a need to express concern about it. While somewhat speculative, it is at least reasonable to assume that the president’s economists have reviewed the inflation rate with reference to the current level of economic activity. Such a comparison would show that the inflation rate is considerably higher than it should be, given the level and direction of economic activity.

The blunt problem for the White House is the pace at which inflation is returning to pre-recession levels. In Q1 2021 the economy was three quarters out of the unemployment peak for the artificial economic shutdown, and five quarters from its pre-shutdown inflation peak. At this point, inflation is 895/1000ths of its pre-shutdown level. In the Millennium recovery, inflation reached 710/1000ths of its pre-recession level – the closest it got during the recovery – and it took a full 12 quarters to get there.

In the Great Recession recovery, inflation reached 952/1000ths of its pre-recession height a whopping 17 quarters later.

In other words, inflation has rebounded rapidly in 2021. At the same time, unemployment exhibits adverse behavior compared to the Great and Millennium Recessions:

  • Today, unemployment is 197/100ths of its pre-recession low;
  • When inflation peaked after the Millennium Recession, unemployment stood at 134/100ths of its pre-recession low;
  • The same number for the Great Recession was 246/100ths.

The Millennium Recession figure is certainly high, but the recovery was slow, with the economy taking more than three times as long to reach its inflation peak as is currently the case. Measuring the inflation peak from the bottom of the recessions, the numbers are telling:

  • Today’s inflation level has been reached three quarters after the shutdown trough;
  • The Millennium recovery reached its inflation peak seven quarters after the recession bottomed out;
  • the Great Recession recovery inflation-peaked six quarters after the worst point of the recession.

In other words, today’s return to almost-pre recession inflation levels is faster and less attached to economic activity than during traditional recessions. This suggests that inflation is preceding the recovery of the labor market, contrary to what Council of Economic Advisers Chair Cecilia Rouse suggests. The Epoch Times again:

“When we get to the other side of this pandemic, I fully expect that our labor market will come back and be flourishing. That said, we do expect some transitory price increases,” Rouse said. “The Fed expects that as well. We do not see evidence at the moment that those have become what we call de-anchored so that we expect runaway inflation. That said, we know we have to be vigilant, and we are watching the data. We expect, at the most, transitory inflation. That is what we expect coming out of a big recession.”

The causality is the opposite of what she suggests: while she contends that the labor market recovery precedes inflation, facts on the ground in the economy already tell us that inflation precedes the labor market recovery.

This order of events is a sign of emerging stagflation.