The July 13th announcement that inflation climbed to 9.1% seems to have stunned many in the finance industry. As a Wall Street veteran and a Finance Professional for over 40 years, I am surprised at the level of confusion regarding the state of the economy, the dangers of inflation and the probability of recession.
The major driver of the confusion has been Mainstream Media’s politicization of the economic story; MSM is selling the Biden Administration’s story instead of honestly reporting the factors driving the U.S. economy. Then there are the Nobel Prize-winning economists (Paul Krugman for one) who mislead the public and journalists to promote their politics. This blog presents the facts and logic so that small business owners, who are struggling with inflation and horrified at the chances of a probable recession, can understand the U.S. economy and evaluate management options for their small businesses.
Note: to keep this blog at a reasonable length, I have left out the debate on the Biden Administration’s oil policy because it is not necessary to demonstrate that government policies are responsible for the dire economic scenario.
Three recent economic studies in the past 2 months directly address the key issues driving inflation and a probable recession. The first, from the Federal Reserve of San Francisco, directly links the Biden Administration’s aggressive fiscal stimulus to the current persistent inflationary trends. This ends the greedy corporation and evil Putin gaslighting.
The second study, a working paper for the National Bureau of Economic Research coauthored by Harvard University’s Lawrence Summers, concludes that the inflationary pain felt by today’s consumers is equivalent to the damage done in the late 1970s and early 1980s. This study clearly demonstrates that Federal Reserve Chair Jerome Powell and the current Fed governors will need to administer some strong economic medicine given that Fed Chair Paul Volcker used extreme interest rate hikes in 1980 and 1981 to exorcise inflation and send the economy into a deep recession.
Third, the University of Michigan released a gloomy Consumer Sentiment Index for June 2022 that shows that U.S. consumers are becoming very wary and drastically curtailing spending plans. This is bad news for the GDP equation.
Paper #1: Federal Reserve of San Francisco - “Why Is U.S. Inflation Higher than in Other Countries?”
The S.F. Fed paper, authored by Oscar Jorda, Celeste Liu, Fernanda Nechio, and Fabian Rivera-Reyes, unites basic economic theory and sound statistical techniques (from previous peer-reviewed papers) to prove that the aggressively stimulative U.S. Government fiscal policy financed by almost uncontrolled printing of money is driving today’s inflation spiral. The paper leaves no doubt that inflation is going to be persistent and difficult to correct with only monetary policy.
https://www.frbsf.org/wp-content/uploads/sites/4/el2022-07.pdf
To set the stage for the SF Fed’s paper, the graph on the next page illustrates the inflation talking points that most economists and journalists use for their analysis. The key is the grey line showing U.S. Gross Domestic Product (GDP). This graph clearly shows the correlation between GDP growth, the growth in U.S. Federal Debt (top blue line), growth in the U.S money supply (orange), and the U.S. Federal Government Spending (bottom yellow line). While this graph seems to clearly illustrate the forces driving the economy, and therefore inflation, the relationships are correlation not causation. However, it does show that the dramatic increase in government spending and federal debt were financed by printing money.
Source: St. Louis Federal Reserve Fred System
Note: Money = M2 = currency, checkable deposits, traveler’s checks and savings deposits
A link to inflation needs to tie GDP growth from government stimulus to inflation. The SF Fed paper uses an innovative study to determine causality as explained in the following quote:
Though many of the pandemic distortions are common to other countries, we show that U.S. inflation has risen more quickly and increasingly diverged from inflation in other OECD (Organization for Economic Cooperation and Development) countries.
First, the authors show that inflation is clearly much higher in the U.S. than in other OECD countries. True, some OECD countries are experiencing U.S.-like inflation, however, the authors address this in the second section of the paper.
The authors then show that U.S. direct fiscal transfers were also higher than the average OECD country. (Note: I use “fiscal transfers” or “fiscal stimulus” to refer to U.S. Government spending and “monetary stimulus” to refer to Federal Reserve operations.)
Rather than trying to track and sum all the various fiscal stimulus programs adopted round the world, the authors directly measured disposable income in each country. Many journalists and politicians have made the argument that the U.S. fiscal stimulus - $1,200 per person and $500 per child plus $600 a week for unemployment – was not enough to substantially change the finances of U.S. consumers. However, the SF Fed data shows that this was not true. This was substantial fiscal stimulus not seen on average in other OECD countries. The two peaks in the U.S. data “reflect the CARES Act, signed into law on March 27, 2020, and the American Rescue Plan (ARP) Act of 2021.”
The key connection: “Did excess disposable income drive inflation?”
The authors then applied the Phillips Curve analysis to the data. Phillips Curves express inflation as a function of the unemployment rate. As the authors explain: “inflation reflects a combination of the public’s views on future inflation, inflation inertia, and how hot the economy is running. Because the array of policy measures introduced during the pandemic to counterbalance the economic effects of lockdowns, common labor market statistics, such as the unemployment gap, are not reliable.”
The authors designed an ingenious method to measure the Phillips Curve effect: they compared inflation in countries that used aggressive stimulus measures to inflation in countries that were more passive. “Using the Phillips Curve logic, we can reasonably compute the effect of pandemic support of measures on the inflation forecast. The idea is to compare the countries that, like the United States, introduced aggressive support measures, which we call the policy ‘active’ group, versus the less aggressive, or policy passive group before and after the pandemic.”
Figure 3 clearly shows that inflation would have been much lower without the aggressive stimulus. The authors use Core CPI (without food and energy), which clocked in at roughly 5% at the time of their study. They predicted that the Core Inflation rate would have been roughly 2% without the stimulus.
The green shaded area displays the uncertainty around their statistical forecast. Think of the green area as a series of bell curves with the maximum for each curve located over the green line. The shaded area grows because the forecast becomes more uncertain as it is used to predict farther ahead in time. Bottom line: the study shows that there is strong evidence that excessive fiscal stimulus drove the elevated inflation experienced in “aggressive” countries.
To address the persistence of today’s inflation, allow me to sneak one more SF Fed paper into the mix. This paper, titled “Untangling Persistent versus Transitory Shocks to Inflation,” measured the persistence of inflation relative to the transitory factors.
Quote:
At the end of the data sample in March 2022, the shock volatility ratio is around 2, which means that persistent shocks to inflation are about twice as volatile as transitory shocks. This result implies that persistent shocks are the more important driver of recent inflation movements. The higher shock volatility ratio in recent data also implies that the optimal forecast should place more weight on recent elevated inflation readings, reflecting an increased likelihood that longer-run inflation has drifted up. But it is important to note that the FOMC’s decision in March 2022 to begin an “appropriate firming in the stance of monetary policy” would be expected to influence the future behavior of inflation.
In other words, inflation is driven mainly by government spending, and it is persistent – not transitory.
Paper #2: “Comparing Past and Present Inflation,” Marijin A. Bolhuis, Judd N. L. Cramer, and Lawrence Summers.
https://www.nber.org/system/files/working_papers/w30116/w30116.pdf
The significance of this paper cannot be overstated. First, Lawrence Summers is the Charles Elliot University Professor at Harvard. Second, he is not a right-wing Fox News or Breitbart shill. Summers is a true-blue Democrat. He was the Secretary of Treasury under Bill Clinton and the Director of the National Economic Council for Barak Obama. If Summers is warning about inflation, we should listen.
The paper’s introduction states:
As concerns about US inflation have grown, the Consumer Price Index (CPI) has come under closer scrutiny. The CPI grew 8.3 percent in the twelve months ending in April, down slightly from the previous month but still well above any other period since 1981. While a worrying figure, this remains far below the official March 1980 peak of 14.8 percent. That the headline number had already fallen to 2.5 percent by July 1983, following the policy decisions of Federal Reserve Board Chairman Paul Volcker, has served as the exemplum of the power of hawkish monetary policy (Goodfriend and King 2005). Since much less of a decline is needed to return to trend today, some commenters have suggested that policymakers might be able to decrease inflation towards desired levels without large macroeconomic consequences (DeLong 2022; Krugman 2022). Yet, methodological changes in the CPI over time make drawing conclusions from these types of intertemporal comparisons fraught.
The author’s findings state:
Our estimates suggest that the current inflation rate is closer to the peak of other cycles than the official CPI data suggest. … We draw two sets of conclusions. First, our observations imply that the current inflation regime is closer to that of the late 1970s than it may at first appear. In particular, the rate of CPI disinflation engineered in the Volcker-era is significantly less when measured using today’s treatment of housing. In order to return to 2 percent core CPI today, we need nearly the same 5 percentage points of disinflation that Volcker achieved.
Note that even Larry Summers is calling out Krugman for gaslighting the American public in an NBER paper! However, let’s focus on these frightening findings and put this work in perspective with a historic graph of interest rates and inflation.
To make sure the reader understands the importance of Summers, et. al., they are reporting that the consumer pain felt in 1980 and 1981 (when inflation was at 14%) is EQUAL to the consumer pain felt now because the 1981 inflation data needs to be adjusted for the basket of goods and services in 2022 and computational changes in measuring housing. Once this is done, the authors conclude that the current inflation is about the same as in 1980.
As we can see from the graph above, the Fed Funds Rate, the main Federal Reserve tool for controlling economic activity, peaked at 19.1% in July 1981; inflation had peaked over a year earlier in March 1980 at 14.8%. Basically, Volcker and the Fed needed to increase interest rates ABOVE the inflation rate for an extended period to control inflation.
The reason? Before the Fed took control, investors could borrow at interest rates below inflation – that means that they were being paid to borrow since they were paying back with dollars that had devalued more than the interest rate they paid – in other words, they were paid to borrow. Then investors used funds from the loans to invest in fixed assets that appreciated at the inflation rate. This is the arbitrage that wealthy families used in Germany in the 1920s hyperinflation to become incredibly wealthy. Savvy investors are doing the same today, that is one reason that the real estate market continues with strong positive performance.
Look at the current relationship between inflation and the Fed Funds Rate – the Consumer Price Index clocked in at 8.3% in May 2022 and updated Fed Funds are sitting at 1.5% to 1.75% (this paper was being released just as the Department of Labor released the 9.1% number for June). As Summers and crew explain, the Fed will need to inflict some strict monetary tightening and nasty economic medicine to control the current economy. However, the economy is not expecting the Fed to increase interest rates above 4.0%. If 1981 serves as a guide, the Fed will need to push rates to 8% or 9%.
The risk to my 9% Fed Funds forecast is the possibility that the Fed does not need to raise interest rates above inflation because of “quantitative easing” tools. In previous economic downturns, the Fed relied on the overnight rate to steer the economy. However, during the Great Recession of 2008, the Fed started practicing “quantitative easing”; they bought market securities with longer maturities to inject liquidity into the economy. This tool was especially effective in 2008 and 2020 when short-term interest rates dropped to almost zero. Similarly, the Fed could tighten liquidity by selling these longer maturity securities. However, that would still remove liquidity from the economy, slow economic growth, and risk a recession.
Bottom line, there is no doubt that the U.S. Federal Reserve will need to administer more monetary tightening than the market is expecting.
Paper #3: Michigan Index of Consumer Sentiment Drop Ties the Lowest Levels Ever Measured
To understand the importance of the Michigan Index of Consumer Sentiment – a graph that you are about to see - you need to understand this Gross Domestic Product (GDP) equation.
GDP = Consumption + Business Investment + Government Spending + Net Exports
Terms: Contribution to GDP
C = Consumer Spending 70%
I = Business Investment 18%
G = Government Spending 17%
E = Export minus M = Import -5%
Note that Consumer Spending contributes a whopping 70% to the GDP. When you see the Consumer Sentiment Index drop dramatically as seen in the chart below, then you know that that our economy faces some difficult times since it has nearly 4 times the weight of the next most important component of GDP.
Source: University of Michigan Survey of Consumer Confidence
This is the statement from the University of Michigan:
The final June reading confirmed the early-June decline in consumer sentiment, settling 0.2 Index points below the preliminary reading and 14.4% below May for the lowest reading on record. Consumers across income, age, education, geographic region, political affiliation, stockholding and homeownership status all posted large declines.”
Inflation continued to be of paramount concern to consumers: 47% of consumers blamed inflation for eroding their living standards, just one point shy of the all-time high reached during the Great Recession.
Many economists and journalists react to these numbers with the hope that consumers will reach into their savings accounts and spend down savings. Oh yeah, I haven’t posted the trend for the Personal Savings Rate, have I?
This is probably why consumers are so scared; they have already drawn down their savings. This Personal Savings Rate graph is what led Jamie Dimon, CEO of J.P. Morgan, to predict a severe recession (an economic hurricane). We can see the two income spikes that were in the SF Fed study; the Personal Savings rate reached an unheard-of level of 33.8% in April 2020 and spiked again to roughly 26.6% in March 2021. J.P. Morgan reported that the average personal checking account held $1,500 at the end of 2019 and that had risen to $7,500 in 2021. Now personal savings have plunged to 5.4% in May 2022. The low was 2.1% in July 2005, so consumers have some room to go, but not much.
Now, when we consider the rest of the GDP equation, Business Investment is the only variable that has been contributing to positive economic growth. This could change with the increases in interest rates – we have seen the fallout in the Cryptocurrency market from Crypto firms that were dependent on zero interest rate policies. Hopefully, Crypto problems will not spread to other business sectors.
Government spending is also falling, as can be seen in the first chart. The government is spending less as the spending for employment supplements and other COVID stimulus packages expires.
Additionally, Net Exports are also likely to be a drag on GDP growth as the Fed pushes up interest rates, the dollar has strengthened and will continue to strengthen (it just traded at par with the Euro). This makes exports more expensive and imports cheaper, which leads to a growing trade gap and reduces GDP. All in all, it looks like a perfect storm for the economy. Did we mention the war in Ukraine?
Inverting Yield Curve
This is a bonus section (since it has been in the headlines recently) because an inverted yield curve is a very reliable predictor of inflation. Investors subtract the 2 Year Treasury Yield from the 10 Year Treasury Yield to calculate the slope of the yield curve. As of Thursday, July 14, 2022, the 2 Year was yielding 3.12% while the 10 Year yielded 2.94% for a negative 18 basis point curve inversion. While this is not a good sign, an inversion of more than 15 basis points has a 100% accuracy record in prediction recessions. (Recessions are the gray bars and the curve is inverted when it dips below the black horizontal line.)
Conclusions and Implications for Small Businesses
Inflation will continue at elevated levels into the foreseeable future and imperil U.S. economic growth. This is not transitory; inflation will persist even if the inflation-adjusted economy stops growing - stagflation. Inflation alone is enough to threaten economic growth as consumers curb spending because they need to spend more of their fixed budget on necessities. However, the Fed’s economic medicine will most likely be more damaging since the Fed has already lost control of the economy. The Fed will need to become much more aggressive and we are not talking about exact science with precise doses of economic medicine that will allow the Fed to safely land this economy at 2% inflation.
Conclusion 1:
Inflation is the result of financing aggressive government stimulus with growth in the money supply – printing money. This inflation was expected, is not transitory, is not the result of the war in Ukraine, and will persist for the foreseeable future. The US printed money to finance this spending and the easy monetary policy financed the nearly uncontrolled spending – now we are paying the piper. While monetary growth has fallen from the 12% year-over-year gains seen in 2021, it is still above average for the U.S. economy.
Implication 1 for Small Businesses:
1. Accept inflation as the new normal for now. Become aggressive in learning to deal with inflation.
2. Understand the importance of pricing and expense control.
3. With respect to pricing, ignore the profits reported in GAAP accounting. Prices need to be adjusted now to reflect future price increases for inventory, not when you buy inventory or equipment in the future.
Conclusion 2:
The level of inflation is as economically painful as it has ever been in modern financial history. Those who lived through the late 1970 and early 1980s can tell you that it was a very difficult period. We are currently going through the same pain and the economic medicine needed to bring inflation down to the 2% long-term target will taste nasty.
Implication 2 for Small Business:
For the second time - get moving if you are postponing action to address inflation! Most of the probability distribution around future inflation is on the upside, as can be seen in Figure 3 from the Federal Reserve of San Francisco paper. This means that the inflationary trend will most likely continue and there is little chance that inflation will drop dramatically in the short term.
1. Look at your pricing options; where can you safely increase prices?
2. Maintain good relationships with your clients, especially your biggest clients.
3. Use social media to communicate with your clients and potential clients.
Conclusion 3:
There will most likely be a recession and it could be one of the deeper recessions. While the Fed correctly points out that jobs are still strong and the economy is still pressing ahead, administering the monetary medicine needed to bring inflation to 2% will be difficult and the financial markets are underestimating the doses needed to slow economic growth.
Implications for Small Business:
1. Go for price increases now where possible. Don’t wait for the economy to collapse.
2. Understand your cash flow – profits don’t pay bills. Cash pays bills. The first thing that finance and investment professionals do is tear apart the profit and loss statement to understand the future cash flow picture.
3. Talk to your bank about a line of credit or other financings now when you don’t need it. If you can SAFELY (meaning that the amount represents a risk-adjusted small portion of your business) borrow money at a 1- or 2-year rate now to purchase inventory or other assets - buy now before prices increase further and pay the money back with dollars that are worth 5% to 10% less than today.
4. Look at expenses to bring them in line with revenues.
5. Eliminate unprofitable or low-margin product lines and introduce new products that diversify your income stream.
Check out the Neural Profit Engines website for more papers regarding the dangers of combining GAAP accounting and inflation. Contact us for more insights into positioning your company to thrive in today’s chaotic business environment.
Vernon Hamilton Budinger, CFA and CAIA
Neural Profit Engines
Position Your Company to Survive through Grow
vernon@neuralprofitengines.com