Can you expect continued inflation — or a trend toward disinflation and possibly even deflation?
That’s probably the most important question in economics today.
This is more than a matter of competing narratives. The question goes to the heart of modern economics (the so-called Neo-Keynesian consensus) and the models used in economic forecasting.
In truth, it goes to the heart of economics generally and helps to explain why so many forecasts are so badly wrong.
The inflation narrative is straightforward. Inflation was gaining momentum from mid-2021 until it peaked at 40-year highs in June 2022. That peak was 9.1% inflation, a rate not seen since the early 1980s. At the same time unemployment was at lows of about 3.4%, a rate not seen since the late 1960s.
This combination of high inflation and low unemployment seemed to confirm the validity of the Phillips curve, which posits an inverse correlation between inflation and unemployment. When unemployment is low, inflation is high and vice versa.
The Case for Deflation
The deflation narrative, which includes disinflation, is also straightforward. By late 2021, the Federal Reserve became increasingly concerned about inflation and decided to act. The Fed began tightening monetary policy in early 2022, reducing the base money supply by not rolling over maturing mortgages and U.S. Treasury securities.
They tightened further with a policy of 10 straight interest rate hikes beginning last March and continuing until this May. (The Fed skipped a rate hike in June 2023 but is keeping the option to hike further on the table for now.) This took the Fed’s policy rate to 5.25%, one of the fastest increases of that magnitude in Fed history.
The Fed’s monetary tightening seemed to work. Inflation has dropped from 9.1% last June to 4.0% this May. That’s still well above the Fed’s target inflation rate of 2%, but it does represent significant progress toward that goal.
It seems all the Fed has to do is raise rates one more time, perhaps this month, and wait patiently and inflation will soon fall to the Fed’s target rate. If a mild recession and higher unemployment are the price of this success, then that’s a price Fed Chair Jay Powell is prepared to pay.
If this two-year inflation-deflation narrative seems too neat and tidy, it is.
The standard economic models and simple explanations break down in a number of places. In fact, the breakdown is so extensive it calls in question whether the Fed and mainstream economists have any idea what they’re doing.
The best evidence is that they don’t.
The Phillips Curve Is Junk Science
To begin, the Phillips curve says the falling inflation should have been accompanied by higher unemployment. That hasn’t happened. The unemployment rate rose in May to 3.7% from 3.4% the month before, but the current rate is still at levels not seen since the 1960s.
The March unemployment rate was 3.5% and February’s was 3.6%. The fact is the unemployment rate has not risen much at all even after 16 months of monetary tightening.
The 1930s were a period of high unemployment and low inflation. The 1960s were a period of low unemployment and low inflation. The late 1970s were a period of high unemployment and high inflation.
History and data show that there is no correlation between unemployment and inflation.
We have to look elsewhere for explanatory factors that have real predictive value. Likewise, recession has not turned up in the data despite Fed tightening. It has been 38 months since the end of the last recession. Average annual growth during that period has been 5.88%.
Growth for the first quarter of 2023 was 1.3%. Projected growth for the second quarter of 2023 is 2.1% according to the Federal Reserve Bank of Atlanta’s GDPNow forecast. These recent growth figures are weak, but they are not recessionary.
There are ample warning signs of recession including inverted yield curves and I expect a recession soon. But it’s not here yet.
If unemployment remains low, the economy continues to grow and stock indexes are in a bubble despite the Fed’s historic monetary tightening, this calls into question the Fed’s models as well as the mainstream Neo-Keynesian consensus.
What’s going on?
The first flaw in the model-based forecasts is the failure of analysts to distinguish between inflation that emerges from the supply side and that which emerges from the demand side. The difference is crucial from a forecasting perspective.
The Psychology of Consumer Behavior
The inflation of 2021–2023 was real but it was caused by supply chain bottlenecks and shortages of critical goods and industrial inputs. The supply chain disruptions were exacerbated by unprecedented economic and financial sanctions because of the war in Ukraine.
This kind of supply-side inflation tends to be self-negating. The high prices cause reduced demand, which in turn tends to lower prices. We’re seeing this every day starting at the gas pump where the record high prices of the summer of 2022 have come down significantly (although still higher than 2021).
We see further evidence in OPEC’s decision to cut oil output as a way to prop up prices. In short, the inflation was real, but it’s already fading for reasons that have nothing to do with the Fed.
The second flaw in the models is the failure to understand the process by which inflation can shift from the supply side to the demand side if inflation persists long enough. This is a change in the psychology of consumers and plays out in behavioral responses. Neither the psychology nor the behavior is accounted for by standard models.
If inflationary psychology takes hold in the general public, it can feed on itself despite recession and declining real wages. The models don’t show this but history does. This is exactly what happened in the 1970s.
Inflation Can Be a Stubborn Thing
The inflation then began from the supply side with the Arab oil embargo of 1973 after the Yom Kippur War. The U.S. suffered a severe recession from 1973–1975 with peak unemployment of 9.0%. The U.S. had another recession in 1980, and a third in 1981–1982 in which unemployment hit 10.8%. That last recession was the most severe at the time since the Great Depression.
Despite three recessions in nine years, double-digit unemployment and two stock market crashes, the mid-to-late 1970s and early 1980s witnessed the highest inflation since the end of World War II. By 1981, inflation had reached 15% and interest rates were raised to 20% to combat the inflation.
The term for this combination of low growth and high inflation was “stagflation.” The inflation that began on the supply side in 1973 had moved to the demand side by 1977 and was out of control. Recessions couldn’t stop it.
Even in periods of economic stress, consumers respond to inflation in ways that make sense. They accelerate purchases because they expect prices to rise further. They use leverage to buy hard assets and stocks because they see these as safe havens against inflation.
Retailers raise prices to meet higher wage costs and to maintain margins. The entire process feeds on itself. And this self-help can continue even in recessionary conditions as it did in 1975 and 1981.
Stagflation has already emerged in the U.K. CPI inflation in the U.K. is 8.7%. At the same time, the U.K. is bordering on a recession with growth of 0.1% in Q4 22 and Q1 23, and forecast growth turns negative after that. Stagflation is not just an historical outlier. It’s a present-day reality.
Are we at that point? Are we in a world where human nature dictates inflationary defense tactics that feed on themselves despite possible recession and monetary tightening?
We’re seeing some evidence of this, including a new five-year contract for unionized teachers in New York City that offers back pay and signing bonuses and raises wages by 20%.
There’s no need to debate whether teachers deserve this raise. The plain fact is they got it. And there are many similar examples. How long before the pay raises to teachers and others get pushed into more consumer demand and higher retail prices that inflate away the wage gains.
The economy could party like it’s 1979.
Use the Barbell Strategy to Combat the Inflation/Deflation Tug-of-War
The odds of a recession and stock market decline are high. Still, the odds of persistent inflation and high interest rates are also high. Those two phenomena are not inconsistent despite what the standard models say.
We’ve seen them go together before in the late 1970s and in prior episodes.
We could be witnessing a case of inflation and interest rates higher for longer than Wall Street and the Fed expected. (By the way, if you’re interested in a much more in-depth analysis of this inflation-deflation conundrum, please see Chapters 4 and 5 of my most recent book Sold Out.
Given the uncertainties of the inflation/deflation struggle, the best approach for investors is a diversified barbell strategy that protects against both.
A model portfolio could have gold, natural resources and energy stocks as inflation hedges, with Treasury notes as deflation hedges, and a healthy allocation to cash between the two ends of the barbell to provide liquidity and optionality as conditions become more clear.
I’ll continue to follow these developments and keep readers informed. Stay tuned.
