Thoughts on inflation, the recent rally in equities, and its political and diplomatic significance (longer read)

*Given the recent quietude in markets, I'm taking this month's blog post as an opportunity for a longer read. We've seen a lot of vigorous debate over the past few months about inflation vs deflation, bull market vs bear market, and the political implications of the Covid-Era. This is meant to be an addition to that debate.*

     This expository is meant to be a refinement of the previous discourse on the structure of the macroeconomy. Careful attention will be given to our ideas about inflation, where they might be flawed, and how those flaws are leading to our misunderstandings in legislation. It will then give a possible explanation for recent moves in equity markets in light of employment numbers near Depression levels.

     I am writing this with the motivation to disprove the Friedmannian idea that, “inflation is always and everywhere a monetary phenomenon.” This is not the case, as there is a distinction that must be made between the real and financial economy, which makes this claim not nuanced enough to explain our current situation. In the financial economy, as in the real economy, there are the factors of demand-pull, cost-push, and built-in pressures. In the financial economy the cost-push pressures come from the cost of money, as in the interest rate. The demand-pull comes from the demand for money across the world. The built-in pressure comes from the adaptive expectations that arise from the changing of these two dynamics. Continuing with this line of reasoning, the demand-pull pressures for dollars are especially high as it is the world’s reserve currency. This is what makes dollar demand seemingly inexhaustible as other countries continue to increase their productivity, therefore growing their credit flows and credit infrastructure, and as a result issue more debts in dollars. There is also the fact that commodities, especially crude oil, are denominated in dollars that creates systematically higher demand for dollars. This is what leads to the built-in pressure that given its relative stability through systematic demand, savings from across the world are therefore held in dollars. Currently, we see a huge glut of savings in China, of which a significant amount is held in dollars via Treasuries as a store of value, and is also invested in booming American businesses. These factors create high demand-pressure for dollars and lead to the phenomenon of “exorbitant privilege” that the United States gets to enjoy.

     This leads to an analysis of cost-push pressures. By and large, the cost of money is related to the supply of money relative to demand. The supply, in particular, of dollars comes from the Federal Reserve. The worry that we have had, particularly over the past few months, is that through QE infinity the supply of dollars now in the market far outstrips the demand for it. This is what is thought to bring about monetary inflation, which leads to the idea of inflation being a monetary phenomenon. Though there is a kernel of truth in this statement, it is in my opinion a misguided way of understanding inflation. This is because, through the reserve management system, a minority of the dollars that are printed through the Federal Reserve’s QE program find their way into the market to create monetary inflation. This is because as the Federal Reserve prints money to buy US Government Treasury Securities, those monies flow to the Federal Government. From here, it is important to understand where exactly those monies flow - and most importantly they do not flow to the real economy. This is due to several factors: the belief in trickle-down economic theory that overly prefers capital to labor, the improvident use of monies in foreign policy and the waging of wars, and the financing of the social security program.

     An analysis of the Congressional Budget Office’s planned expenditures would show you that the consistently largest line-items are financing social security, and the upkeep of the military as part of the United States’ foreign policy initiatives. This isn’t brought up to make a political statement, but rather to show where most of the monies flow. In both of these programs, we don’t find a solution to increasing inflation. This is because the recipients of social security by and large are not big consumers that help to increase the supply of money in the real economy - except for in healthcare which is one of the biggest systemic drivers of inflation. Nor are the wages of those employed by the military enough either. Perhaps the only area in this spending that has potential towards that aim is the payments to defense companies, though it actually turns out that that’s not the case - more on that later. In the aggregate, this means that for all of the printing of money that happens by the Federal Reserve, a smaller portion of it actually finds its way to the real economy through programs such as unemployment insurance and food stamps. This might mean that the Federal Reserve has much more room to print than most market participants are currently imagining - or willing to admit.

     The pushback one might offer here is that over the past few months, the printing operation has been directed more so towards the PPP and SBA loans, checks to employees of $1200, as well as the numerous credit facilities set up by the Federal Reserve. While it is undoubtedly the case that the first three are likely to get inflation up, it is also the case that they don’t go far enough to bring about that outcome. Starting with the one-time checks to employees, $1200 is not nearly enough to get inflation up as a still-significant portion of Americans live on monthly wages higher than that. Along with the fact that unemployment numbers and employment uncertainty are near their highs, this is likely to keep employees in cash conservation mode which would limit the ability to get inflation up. For some Americans, the addition of PPP might put them in a position to create a cash buffer as well as spend. The important point about these two programs is that they are only temporary programs that, once the crisis is over, are likely to be pulled back leading to a return to business as usual. Therefore, what can be said about the current state of the economy is that it is operating in a low growth environment with low wages, where this printing is not likely to create the monetary inflation described above.

     This leads to the factors driving inflation in the real economy, which are longer term drivers of inflation. Referring back to demand-pull, cost-push, and built-in pressures, the real economy has its own variants. Demand-pull in the real economy comes from the fact that residents of the country are demanding more goods, which leads to increases in prices for consumer goods. For most residents of a country, the fluctuation in demand is largely driven by wages growth. The United States is an interesting exception as increasingly, the demand-pull effect is also determined by the strength of the American stock market due to overwhelming flows into passive investments. Therefore in the United States, it is possible that we might see an increasingly strong correlation between stock market returns and inflation statistics, along with wages growth. Linking back to the previous longer-form discourse, wages growth are in large part a function of productivity and subsequent credit growth. Importantly, productivity growth is the domain of the legislature whose goal is, or in any case should be, to put in place legislation that is accommodative to gains in productivity. As was also discussed in the previous discourse, the longer term factors of productivity growth are currently not as strong as they used to be (declining immigration and as a result aging population, lower life expectancies, lower fertility rate, higher obesity rates, decline in the quality of American education, decreased social mobility, among several others). These are longer term trends that can be tracked to the beginning of the 80s, which is around the same time that wages stagnated and inflation started tracking down from its peak, and has trended down ever since. This is especially noticeable after 08’ in that wages took the longest they have ever taken to recover from a recession. We also see that since then, commodities prices have been trending down for most of the past decade which can be attributed to declines in demand-pull pressure. At the same time, until recently, we have also had softening cost-push pressure via globalized trade that has brought prices and American wages down through competitive production costs in China and Southeast Asia. These two factors have acted to create a downward spiral in inflation expectations that has led the overnight rate down from its early 80s peak.

     But here we are confronted with the dilemma that today’s market participants are faced with: that if it is the case that unemployment is near depression levels, that wages growth is nonexistent, that a large portion of Americans currently live on meager government aid, then how can it be the case that stocks are once again nearing all time highs? The subtextual reasoning here might be that if there is no inflation to feed into corporate earnings and lead to earnings yields for shareholders, then what exactly is the economic logic of investing in stocks? A valid point, but one that I think highlights the possible shift in the economic regime that we might be in. The first point that might derail this argument is an understanding of credit markets today. What might be the case right now is that before the crisis, many of the country’s largest companies were in very strong financial positions, having strong balance sheets that could weather many if not all storms. This could be due to the fact that companies are saving because they are not finding many projects to invest in in the United States. This might be a tie back to the decline in the longer run factors of productivity. Given the fact that rates are at their zero lower bound, it has made it extremely economical for the biggest companies to draw down their ample credit lines. Along with the fact that the Federal Reserve is practically guaranteeing these credits makes it much less risky for companies to take on credit that they may or may not be able to afford in the future. This extreme safety has led to a situation where many industries, notably the energy industry, has resorted to drawing down credits to maintain their dividends - thereby safeguarding the economic logic in investing in them. Thus, there is a dichotomy here between the real and financial economy. What we are seeing is that in the financial economy large aid programs have allowed for companies to operate in a semi-normal state while avoiding many of the challenges of this downturn. This is leading to safety in investing in, and eventually profits for shareholders. The disconnect is happening in that there is no transmission of credits from corporations to employees. Because of this, wages and inflation are not increasing at the same time that stock prices are.

     The other reasoning here is that companies, and nowhere more so than American companies, are in today’s day not tied to their country’s fortunes. This is because they are large multinational entities that can profit from wages and consumption growth anywhere in the world - especially in China. We see this distinct pattern in American, European, and Japanese equity indices. It is that after the announcement of central bank aid, indices started to rally. This effect has been most pronounced in the United States, as it has the most powerful multinational corporations. Subsequently, we have seen European and Japanese indices taper off after the initial rally. This leads to a very pernicious outcome which, if left unchecked, could hasten the rise of China as the global hegemon. It is that if the legislature does nothing to improve the conditions of American labor, eventually American consumption will tail off from its historic highs. While this will be a tragedy for employees and corporations alike, it will be much more tragic for employees. This is because American corporations would still be able to profit off of the prosperity and consumption growth in China. The effect of this would be one that is very similar to what we see in Australia today: that its economy by and large lives and dies with the Chinese economy. It is also worth noting that the Australian economy hadn’t seen a recession in the past 34 years, as its economy has for most of that time been tied to the strength of the Chinese economy. This could lead to a change in the structure of the global political order as China has established a strong intention to become the world power. Thus, what we see here is that the neglect of the American worker by the Federal Government, and allowing for economic inequality to widen, could hasten the separation into two Americas. One controlled by the scions of capitalism and corporate power that extends its influence over the world, and one of squalor and a diminished, even retarded, quality of life. Though it doesn’t seem to be a problem now, as American corporations are still on top, it would eventually become the entire country’s problem and is something legislators should take due notice of. Though the programs that have been rolled out during this crisis are a very good start, and indicative of a shift in political sentiment, more must be done to continue accruing the returns from productivity to labor rather than capital.

     Looking out to the next few weeks and months, there might be some opportunities here. Having established that currently US stock prices will be more a function of credit availability and Chinese consumption, with a US recovery being a secondary factor, it is conceivable that this rally might continue. It is possible that there might be some dip in spoos back to 2600 if the reopening fails and social distancing measures are re-tightened. Or if we break through 3000 before this possible failure, the support might be at 3000 instead. Therefore as long as the Chinese economy and the Federal Reserve’s programs continue as they are, this rally might have room to run and possibly make all time highs. The caveat here is that though we have seen a vicious rally over the past few months the pace may slow down a lot, possibly more so than the pace before the virus crisis to a snail’s pace. This is because for the time being the United States is still the biggest consumer though that lead is narrowing, and it being offline will certainly leave a dent in corporate profits. The difference maker these days is that that alone isn’t enough to crash the world economy anymore.