Inflation, Deflation And Stagflation

Summary

  • The Fed must simultaneously fight inflation, guard against another wave of energy inflation and keep the economy out of a recession that could bring on stagflation.
  • Inflation has been coming down in key parts of the economy, but wage inflation is sticky and energy inflation remains a risk.
  • The dollar corrected from its recent highs, but a “data dependent” Fed could push the dollar up one more time to protect from energy inflation, and hitting asset prices.
  • The Fed continues to have a lot of cover to raise interest rates another time or two, as well as, keep rates higher for longer with unemployment being low.
  • The Fed has a secret weapon in its lending programs for banks which are a form of stealth QE, that should keep any recession short and shallow, plus, support stocks.

I often warn people to avoid putting faith into trader’s narratives or narratives driven by backwards looking economics or just wrong economic theory.

One place that the narratives have consistently been wrong for two generations now is on inflation. I have been hearing the chants from peddlers of newsletters, certain demagogues and the less economically educated, that the United States would soon become the next Weimar Republic, since I was in college. They have never been right and probably will never be.

While inflation has been a near term problem for the first time in four decades, the biggest problem over the next generation will be a continuation of the deflationary pressure we’ve seen since the Great Recession.

What the Fed must do over the next few quarters, is try to keep the inflation spark from turning into a runaway blaze, that colludes with a recession, to create a stagflationary shock that triggers another financial crisis.

They’ll probably win that war, though there could be some battle wounds.

Deflation Is The Real Bogeyman

My “slow growth forever” thesis has proven right framework for viewing inflation for over a decade now since I proposed the idea on MarketWatch.

In short, “slow growth forever” suggests that deflation, not inflation is the persistent bogeyman to look under the economic bed for. It is based on the twin ideas that deflationary aging demographics and technology driven disinflation will last well into the middle of this century. 

I reviewed that idea in these three pieces:

Long-Term Deflation Vs. Inflationary Policy (May 2021)

Macro Dashes – Inflation Is Transitory, Most Prices Are Permanent (Nov 2021)

Macro Dashes – The Fed Could Cause Stagflation Next (Sept 2022)

If you read those pieces, you will see that the ideas have been spot on. 

The Federal Reserve had to fight deflation, most of the way, from the Great Recession into the Repo market crisis of late 2019. Then, as the economy finally started to normalize, Covid hit. 

Inflation Was Covid Made

While many blame the Fed and government bailouts of Covid for current inflation in a very Milton Friedman “Inflation is always and everywhere a monetary phenomenon…” I think there is a lot more to it.

Covid caused two major disruptions to the economy that apply to the second part of Friedman’s quote that nobody every cites: “… Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” 

Output is the major problem here with inflation.

When the economy had its heart attack, that is flat lined, the Federal Reserve, other central banks and governments were obliged to pull out the paddles and try to jump start the economy. 

It was an unprecedented situation. And, by all measures, the amount of money transfusions pumped into the economic body was in fact a little too much. But, it wasn’t a lot too much though. 

So, why did inflation take off? There were two reasons. 

Covid in general disrupted production, but China’s Covid Zero policy really mucked up global supply chains, which in turn, held back economic output even more. Remember these: 

China Supply Chains Breakdown
China Supply Chains Breakdown (Foreign Policy November 2021)
2021 Supply Chains Break On Covid
2021 Supply Chains Break On Covid (Council On Foreign Relations Dec 2021)
China Zero Covid Policy
China Zero Covid Policy (CNBC January 2022)
Supply Chain Disruptions II
Supply Chain Disruptions II (Statista)

There were thousands more headlines and articles if you want to do a few searches. 

Next for pushing on inflation was another wave of U.S. oil bankruptcies. The first wave having been after OPEC flooded the market with cheap oil from late 2014 to 2016 in a transparent attack on U.S. oil production, which was the vast majority of new oil supply on the markets. 

Oil & Gas E&P Bankruptcies
Oil & Gas E&P Bankruptcies (Haynes Boone)

As U.S. production fell, OPEC limited their production of oil to around $80 per barrel. Then, Russia invaded Ukraine to tight oil markets to over $100 per barrel.

Oil Price History
Oil Price History (Trading Economics)

The Energy Linked Inflation Risk

Clearly, OPEC, Russia and China have had outsize roles in inflation since Covid hit. I won’t dwell on that here, but I think it’s an important observation from the geopolitical viewpoint.

With U.S. oil production peaking because the best shale wells have been tapped, a product of high grading, the risk of a surge in the price of oil during the U.S. “driving season” summer, seems high. 

The growth in U.S. production is trending towards zero new barrels per year in the next year or two. 

U.S. Oil Production Growth Falling
U.S. Oil Production Growth Falling (Bloomberg & EIA)

Even the Permian, well productivity has not only flattened out, but has started to turn over. That’s where essentially all U.S. oil production growth has been since 2019. 

Permian Oil Production
Permian Oil Well Productivity Flattens (Rystad)

If this drilling chart were a stock chart, what would you think?

Drilling Cycles
Drilling Cycles (Baker Hughes)

A lot of the U.S. oil production weakness is on the back of one factor, and it’s not political. “High grading” is the selective drilling of the best wells. In short, the U.S. has gotten to most of the easiest to get to oil. 

I think that is in large part why Conoco (COP) was allowed to start a major drilling project in Alaska. It is needed and it might be the last one ever done, or at least done for a long time. 

Meanwhile, on the other side of the world, OPEC is continuing to control their oil output in order to keep the price of oil around $80 per barrel.

OPEC Cuts Again
OPEC Cuts Again (Washington Post)

With OPEC doing what they can to keep oil supply tight to oil demand, there is a major risk of a surge in energy inflation.

What happens if there is a disruption to oil supply somewhere or demand surges on from some or all of China, U.S. or India?

The recipe is for firm to higher oil prices for the next several months at least, which is why we own Occidental Petroleum (OXY) with its CO2 operations in addition to oil and gas, as well as, Permian Resources (PR) which has extremely cheap rock. 

What can the Fed do to help prevent energy inflation? Simple, prop up the dollar at least through summer.  

Wage Inflation Is Sticky – Good

Today, most inflation indicators are turning over or at least decelerating. Indeed, inflation peaked in summer of 2022 and has been trickling down since.

One exception has been wage inflation which is up a whopping 6%. 

Wage Growth Tracker
Wage Growth Tracker (Atlanta Fed)

Then again, that’s after a massive drop in real wages after the Global Financial Crisis and a minimal rebound. Which was itself after real wages stagnated since the early 1980s.

To me, at least for now, wage inflation is good. I’m sure you wouldn’t be happy to help fix inflation by taking a lower income. The Fed might be threatening just that though. 

Let’s be very clear here, if Chairman Powell is too tight for too long, he will kill wage growth and drag inflation back down to under 3%, but he’ll take the economy, stock market and real estate prices down too. 

The risk he runs by continuing to tighten is putting the U.S. in a position for a recession that is also vulnerable to the higher oil prices.

What does the economy look like in a recession with energy inflation? Stagflation!

Stagflation is the worst of all economic and financial worlds. A slow economy with high unemployment and inflation to boot. Ask anyone who was trying to raise a family around 1980 about it. Stagflation should scare you. 

Will we go down that road? I don’t think so, but, Powell if takes us there, then people will rightly for once, be able to say the Fed made a mistake.

What The Battle Plan Should Be

I think there is no doubt that the Federal Reserve raises interest rates a quarter point this week. And, I do not think it will come with “dovish” rhetoric from Chairman Powell unless he forgets what he was told to say (he’s not an economist, he’s a lawyer who tries relay a message). 

A dovish tone only sets the stage for an unneeded rally in stock and real estate prices that have finally started to normalize to almost normal interest rates. If that occurs, then the next correction would likely be worse than needed to finish fixing valuations. 

Remember, interest rates are NOT high. They are higher than they were recently, but historically, 5% is about normal for 10-year treasuries. 

If the Fed is going to do things right, then they are going to maintain their “data dependent” stance and not talk about disinflation much. 

And, if the Fed does that, then the S&P 500 should fall from a 2nd standard deviation valuation down to the normal range. And that’s fine.

Standard Deviation Average
Valuation Indicators (AdvisorPerspectives.com dShort)

With so much money in cash instruments, such as money markets, and almost cash like in very short term bills and notes, that would likely be a pause that refreshes for stocks. Real estate will take a bit longer to play out, but stocks could bottom, then rally all within a few quarters. 

What will the battle plan turn out to be? We’ll know soon. 

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