Reflections on Late-Stage Inflation

A few days ago I noted that “inflation expectations” were the same or nearly the same for every period from seven years through thirty.

Actually, the thirty-year expectation was slightly less than the 10-year expectation. For discussion, please see Traders Expect Less Inflation Over a 30-Year Period than a 10-Year Period.

I do not think much of inflation expectations but the Fed strongly believes in them, and so do some others.

Pater Tenebrarum at the Acting Man blog commented “I agree . It is typical for the late stage of the business cycle, you get price inflation going, but it cannot last long. Note though that at some point (depending on central bank actions in response to the next bust and contingent circumstances) there could be a tipping point toward another stagflation period.”

Tenebrarum emailed two links where he discussed the setup.

• Business Cycles and Inflation, Part 1
• Business Cycles and Inflation, Part 2

Part 1 Snips

Ben Hunt, author of Epsilon Theory and chief risk officer of Salient Partners, mentioned a specific narrative that has accompanied quantitative easing for almost a decade now (even longer, if we take Japan into account). At first glance it appeared reasonable enough: central bankers argued that QE would help increase “inflation”. This is of course unequivocally true in terms of monetary inflation, but they referred to consumer price inflation. Alas, both CPI and inflation expectations obviously failed to respond appreciably to their ministrations. Ben posits that this narrative may be set to falter in a rather unexpected manner, by continuing to defy widespread expectations.

In short, the idea is that the end of QE, or rather its upcoming unwinding (“quantitative tightening”), may be accompanied by an unexpected increase in consumer price inflation. One cannot help but be sympathetic to this idea simply based on how contrarian it is. Meaningful consumer price inflation is pretty much the last thing anyone expects.

At the moment we are still inclined to believe that a sizable future decline in asset prices is likely to create another deflation scare and will at least initially exert further downward pressure on inflation expectations.

Part 2 Snips

When it comes to prices, one has to be especially careful when trying to predict future developments. One reason for this is that prices are determined by four different factors which exert their influence concurrently: the demand for and supply of goods, and the demand for and supply of money (incidentally, this is also why attempting to measure and calculate a “general level of prices” actually makes no sense – there is no constant that can be used for such a measurement).

The idea that consumer price inflation could actually rise despite the Fed beginning to take back QE cannot be dismissed out of hand. It not only remains an interesting, highly contrarian bet, it can also not be ruled out on theoretical grounds. Moreover, there is significant potential for contingent circumstances to change in a such a way that radically changes the public’s perceptions of the future purchasing power of the dollar.

Readers old enough to remember the late 1970s only need to think back to the “narrative” that prevailed at the time. Just as almost no-one can imagine a return of significant levels of consumer price inflation today, back then almost no-one would have believed it possible that CPI and treasury bond yields would decline almost relentlessly over the coming three and a half decades. And yet, that is precisely what happened.

Nonetheless, Tenebrarum pinged me his take, essentially the same as mine “you [can] get price inflation going, but it cannot last long.“

Invisible Threat

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Tenebrarum offered a caveat to the idea “inflation cannot get going for long“.

I paraphrase his alternate idea as as follows: One does not know what idiotic thing the Fed may do in the next downturn.

Different This Time?

Will it be different this time? Here is a pertinent Tweet from Rosenberg.

Fed hiking rates. Bond yields popping. Oil prices soaring. Think 1973-75. Think 1979-80. Think 1989-90. Think 1999-2000. And think 2006-07. And tell me a recession isn’t coming our way.

— David Rosenberg (@EconguyRosie) May 18, 2018

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Given that asset bubble burstings are inherently deflationary, it’s easy to stick with my position that we are in the midst of an inflation scare, the Fed is responding to that scare, and another deflationary bust is just around the corner.

For further discussion of inflationary and deflationary forces at hand, please see Fed Tightening Cycles Coincide With Bursting of Asset Bubbles: How to Play It.

Mike “Mish” Shedlock