I’ve written a number of times about the Fed and inflation, both with regard to asset prices and in the general price of goods. While the concern over inflation is arguably now consensus, and thus worth questioning if it has been overplayed, I actually think it is just the opposite.

It has been two generations since this country has experienced inflation. Most people talking about it don’t truly understand it. It’s a bit similar to people 15 years ago talking about inflated house prices. Yes, everyone was aware of the risk. However, few people truly understood it until it became reality. So today, I am going to do an overdue deep dive on inflation risk to the economy and our living standards.

The punchline is inflation is an insidious tax on productivity. It’s not as benign as simply “raising menu prices”. It creates artificial constraints on supply and increases uncertainty. We are seeing increasing anecdotes of this recently. We will see more in the years to come.

The idea that inflation is “transitory” is nonsense. That is not how inflation works. Inflation is driven by inflation EXPECTATIONS! Even if, in a vacuum, the Fed would be right, they will be wrong in the real world because people will change their behavior based on the inflation they see.

To put it in investing terms, inflation expectations are the momentum of inflation. Once people get in in their head that the trend has changed, they keep following that trend.

This could really be the whole post, but I will offer some supporting arguments below rather than ask you to take my word for it.

An Abundance of Shortages

It doesn’t seem you can pick up the paper anymore (yes, I still actually do that) without reading about another shortage of goods. Everything from semiconductors to lumber to strawberries to used cars to chlorine to chicken to ketchup packets, you name it, we don’t have enough.

I don’t have the tally handy, but an astonishing number of companies mentioned inflation on their recent earnings calls. For those more digitally inclined, go to Google Trends and see how much search activity has picked up for some of these affected products.

Restaurants can’t find workers. They are offering meaningful signing bonuses, sometimes just to interview! Guess what? Almost all the shortages mentioned above (with the exception of semis) are not due to lack of raw material. They’re due to lack of workers.

The sawmills don’t have enough workers. The meat processing plants…not enough workers. Trucking companies…not enough drivers to deliver other people’s goods. The hotels…not enough cleaners. Here’s Google Trends result for “worker shortages“.

We have a shortage of labor. Nearly half of small businesses can’t fill jobs. Think of it as a supply shock. The supply of labor is constrained. That means prices for labor will go up to compete for the remaining workers. That is what we call inflation (it’s actually what we call stagflation, but more on that later).

But Isn’t It Temporary?

That’s what Jerome Powell would like you to believe. He is trying to “speak it into existence”. And, sure, you can make a case that these shortages are all Covid related and, once everyone has their vaccine and we drop the extra unemployment benefits, these pressures will disappear. Except that is wishful thinking.

I mean, plenty of people are now vaccinated and plenty of others, from what I see out in the world, have resumed normal activities. Covid isn’t stopping people from doing things. Most people who had jobs before Covid presumably could get a similar job today.

Yet, we just had the biggest disappointment in new jobs relative to expectations since, well, ever!!! OK, maybe a bit dramatic, but for as long as people have been forecasting payrolls. Similarly, job openings hit an all time recorded high. And, by all accounts, the reason is lots of people don’t want jobs.

Let’s pause and think about that for a moment. Unemployment is elevated and the government fears that without aggressive support it would be even higher…yet, job openings are the highest in decades! How can that be? Typically, job openings are at their lowest when unemployment is high.

Some Quick Math

The number of unemployed is about 10M which equates to a 6% unemployment rate. The job openings is about 4M above normal. If we filled those 4M jobs, the unemployment rate would drop to about 3.5%. In other words, it would be back to the historic lows we had pre-Covid!

The economy is running at full capacity! Yet, we are adding WWII level stimulus to it!!! This is a dangerous path to follow.

If you want to make the transitory argument, your case largely relies on the extended unemployment benefits and that, once those expire, people return to work, shortages disappear, and workers gladly go back to their old wages.

Oh, and that the tooth fairy will go back to paying quarters a tooth and not $10. Look, the cat is out of the bag. Potential workers sitting at home collecting their extra $300/week know they can get raises over their old pay and still aren’t coming back. To get them off the bench, wages will have to go higher yet.

The idea that if you wait until October to look for a job (if the government even lets the benefits expire in September) people will recognize there is now a glut of job seekers and lower their wage expectations is fantasy. They hear what their friends are getting and think they deserve that too.

Maybe the employment market is suffering from its own bubble where people are overestimating their odds to claim one of the openings before everyone else acts and many will end up sorely disappointed in the end?

Path Dependency

Or maybe something else is going on, like people’s life circumstances have changed and they don’t plan to go back at all. Why might that be? We know it is hard to change habits (which is why most New Year’s Resolutions fail), but once they change, they tend to stick.

People have gotten used to new ways of doing things and don’t want to disrupt them. There have been plenty of stories about moms re-evaluating willingness to work and people who don’t want to return the office.

We know there are people who think they make more money trading bitcoin than holding a real job. There’s been a giant spike in small business startups, with the emphasis on small (single proprietor selling stuff on Etsy or Amazon).

The point is Covid acted like creative destruction. It forced people out of their comfort zone and a lot of people have moved on. That sure sounds like a structural change in “animal spirits that will take some time to reverse. Good luck, JPow!

This isn’t your typical supply shock. It’s a shock that will change how people react going forward. This is the whole animal spirits thing.

Once people are used to getting raises, what do they expect a year from now? Another raise. Once companies realize they can raise prices, what do they do next year? They raise prices again. Consumers get used to prices going up. They ask for another raise to keep up with rising prices for things they buy.

This used to be the accepted theory of how inflation works. Today, there is not a single policy maker who believes this can still happen!

The Return of the Uncertainty Tax

But there is more. Not only have employers taught customers for 30 years not to expect rising wages, they have also taught themselves to not raise the price of their product. To accomplish this, they rely on tools like just in time inventory to reduce carrying costs.

The problem with JIT is it assumes nothing ever goes wrong. It is like writing home insurance in Florida and assuming there are never hurricanes. We have seen over the last year that relying too much on JIT leads to shortages when something goes wrong, whether it be toilet paper, lumber, chicken, or whatever.

If you’re a producer who has been hurt by shortages in the last year, do you think your response will be to treat it as a one off and return to normal? Or to plan for it possibly happening again and carry more inventory? We know people tend to respond to the last war. Inventories will head up.

Actually, they’re going to head way up. Why? Demand has become harder to forecast. We have seen wild swings in demand for all sorts of items, especially as the economy reopens. Not all shortages are supply based.

If you run a company that is less certain about the volatility of demand, what will you do? Hold more inventory to address the variability. So we have inventory going up in response to supply disruptions and demand volatility.

What does higher inventory mean for the economy? Less productivity. You sell the same amount, but margins are lower due to the capital tied up in inventory. What would be a natural response by a company to higher inventory costs? Raise prices to make the customer pay for part of the uncertainty they created. This all becomes self reinforcing.

Policy Mistakes

So, let’s return to stagflation. The one big problem with supply shortages is, if you remember your supply and demand curves, they lower output and raise prices. That’s a pretty rough combo.

What’s particularly difficult about it is the Fed has limited tools to address it. The Fed addresses demand, not supply. It’s current efforts to increase demand will neutralize the negative output from supply shortages, but further increase the inflationary pressure.

Government spending also targets demand and the increased Federal spending will have the same effects…higher GDP at the cost of higher inflation.

The trouble with the current spending though is there are elements of it that further restrict worker supply. Higher minimum wages are, by definition, stagflationary (inflation for those who keep their jobs, stagnation for those who lose them). Proposals to have government paid family leave reduce the supply of hours worked. I’m not taking a position on whether they’re the right long term policies, but it’s a poor time to implement them.

The main tool the government has to impact supply is tax policy. Unfortunately, raising taxes acts similarly to a supply shortage. It exacerbates the problem, rather than correct it. It is also politically unpopular.

The sneaky truth is the “best” way for a government to pay for more spending…is inflation. It is less politically divisive than raising taxes. So, if you’re a politician trying to figure out how to keep voters happy without letting the debt get out of control, more inflation (if…BIG IF…you can keep it from getting out of control) is one of your more palatable options.

Behind the Curve

Let’s wrap this up by talking briefly about the Fed. The Fed’s current policy is to not address inflation until after they see it. This contradicts all historical Fed policy.

It would be like an insurer saying “we see signs loss trends are getting worse, but we’re going to wait until we have to pay the claims to add to reserves”. I mean, some insurers actually do that, but they typically end up in runoff soon after.

The risk is that, by the time the Fed decides they have a problem, it will be too late to do much about it. If the market loses confidence in the Fed, they will begin to ignore their rhetoric and take rates where they think they belong. In other words, much higher.

Once a Fed loses credibility, it is hard to get it back. Nobody wants to live through what Volcker had to do last time to set things straight. What Powell appears to have lost sight of is inflation expectations matter more than the level of inflation.

If he waits for 4% inflation to adjust policy, but the market believes it is going to be 6% in a year, then he needs to tighten a whole lot more than if the market thought it would stay at 4%. This is a rookie mistake, but Powell is focused on the wrong metric.

I should also mention quickly that there are two types of inflation, asset inflation and goods inflation. We have tolerated periodic asset inflation for the last 20 years to avoid goods inflation. It would be a whole nother post or two to debate which is more harmful, so I’ll punt on that for now.

What is important for now is that fighting goods inflation, whenever that day comes, means tightening monetary policy which is pretty terrible for asset prices.