US Inflation Spikes

The latest data on US inflation illustrates the points I made recently on the effects on prices resulting from the lockdown of economies by governments, and the additional costs that have been imposed on production. US inflation rose by the most in thirty years. That contradicts all of the predictions of those that think that a reduction in economic activity must translate into lower prices rather than stagflation, as occurred in the 1970's, and early 1980's. As I also pointed out recently an analysis published by the IFS, showed that UK inflation in terms of what people actually spend their money on, had shown that it had risen in one month by as much as it would normally have risen in a whole year! 

The US data also understates the real situation for that same reason. The headline rate understates the real situation, whilst the core rate gives a more accurate picture, but even this is an understatement. The core rate strips out more volatile items, but in current conditions, even this is distorted. Its obvious that if people cannot spend money on certain items, the prices of those items may fall, but in terms of the effect on people's spending this is irrelevant, precisely because they cannot buy those items. Meanwhile, the proportion of their income spent on other items will increase, and it is those items whose prices have risen more sharply. This article by Shuli Ren of Bloomberg, explains why inflation is much higher than official data is showing. 

For example, the official US basket of goods used for calculating inflation comprises 8% groceries and 15% transport, but with the effects of government imposed lockdowns and lockouts the amount of travel has been reduced significantly. As Alberto Cavallo of Harvard Business School says, the actual proportions should be more like 11% groceries and 6% travel. But, anecdotal data also shows that many of the services that have not been available for several months are now starting to be provided once more, but with much higher prices. That is before all of the mass of money tokens printed by central banks starts to circulate and inflate the prices of all of these commodities as they begin to get bought and sold once more. 

The month on month, and year year data is also be misleading. The US CPI data shows the level of prices rising in July to 258.72, as against a base level of 100. This level is slightly below the highest level it reached of 259.05 in February, prior to the start of lockdowns, which reflects the points set out above.

But, core CPI, which strips out the volatile elements rose in July to 267.715, which is the highest it has reached, even prior to the lockdowns. For the reasons set out above, even that is a significant understatement of the real increase in inflation. The rise in the core rate, which is the biggest since 1991, shows inflation rising by 0.6% month on month over the figure for June. As a Year on Year figure, its up by 1.6%.

The month on month figure rose by 3 times the estimate. But, even these figures understate the situation looking forward. If the 0.6% month on month figure were to continue for the next year, then the annualised figure would represent a rise in inflation of around 7.5%. Its one thing for Fed officials to say they would tolerate inflation slightly above their 2% target for a while, its unlikely that either they, or, more significantly, the bond markets would tolerate an inflation rate of 7.5%, whilst the official interest rate was near zero, and bond yields on US Treasuries are negative in real terms already. 

But, economies are only just starting to reopen, so its likely that, as they reopen further, and all of the liquidity pumped into the system starts to pump up prices and accommodate all of the rising costs, not to mention the fact that, as incomes fall for many who see their jobs in retailing etc. disappear, there will be shortages of labour in other expanding, higher value areas, where wages will be increased, encouraging firms to try to recover these higher costs in higher prices, rather than suffer falls in their profits, again facilitated by large amounts of liquidity sloshing around the system. 

So, its no wonder that there is also increasing volatility in credit markets. One day earlier this week, the UK 2 Year Bond saw its yield rise by 300%. That was still only to a yield of 0.01%, but precisely illustrates the point that at these artificially low, and unsustainable levels, even the smallest of changes in absolute terms translates into huge relative movements, and these large relative movements in yields are reflected in large relative movements in asset prices which are the inverse of the yield. The US Ten Year Treasury, also rose to its highest level in 8 months, this week. Yet, the real sales of bonds by states to cover the astronomical levels of borrowing they have undertaken have not yet even started. When all of this debt issuance hits the market, it is bound to send bond prices crashing, and interest rates surging. Then comes all of the additional government borrowing to cover its spending on welfare benefits, as unemployment spikes, when furlough and other schemes are ended, and businesses begin to lay off millions of workers. On top of that is the borrowing by governments to cover the loss of tax revenues, as business profits have disappeared, VAT receipts have been crushed, and workers have lost wages. Thereafter comes the trillions of Dollars that will have to be borrowed by governments to bail out the large core industries that have been bankrupted by the imposition of lockdowns. 

So far, businesses have largely relied on using cash on their balance sheets, where they have it, or else on drawing down on billions of dollars of credit lines with their banks. But, in the months ahead, they will also need to be issuing bonds, and shares in large volumes, which will depress the prices of those assets, and, with speculators demanding much higher rates of interest to buy up these assets, both because the demand for money-capital will rise sharply as against the supply, and because the prospect of rapidly rising inflation means that lenders will seek higher nominal rates to cover the potential for falling real rates. Already, business bankruptcies and defaults are increasing sharply. With millions of workers going on the dole, the number of household bankruptcies and defaults will spike higher too, and that impacts the balance sheets of banks who see all of this bad debt impacting their own balance sheets. They will be hit with a double whammy, as they get hit by all of these defaults, at the same time as their balance sheets get hammered by crashing asset prices, which, over the years since 2010, is all that has given the banks and financial institutions the semblance of even solvency.