In The Flow Of Inflation we talked about how inflation moves from monetary policy through the system. The core tenet is that reductions in the purchasing power of the currency are first visible in securities prices, especially stocks and bonds, and only later show up in consumer prices and wages. Securities are traded in real time, tick by tick markets and respond virtually instantaneously to currency value declines. Consumer prices do neither. Moreover, in contrast to currencies, bonds and stocks are used almost exclusively to store purchasing power for later use, and so act as storage tanks for inflation. Once their prices inflate, they either must come down again, or consumer prices rise to meet them.
It’s widely thought that the longer term record of stock prices rising is feature of how they provide returns to investors. But as we saw in Making Stock Market History, it’s just inflation, pricing them in a depreciating currency, the same thing that’s made the prices of bread and rent go up long term. While individual stocks can rise and fall in real value, in the aggregate real returns of stocks overwhelmingly come from dividends.
Now let’s think about what this insight might tell us about the financial outlook. The first problem we run into is that we don’t have any specific time frame for how long inflation is stored before it spills over into consumer prices. People use stocks and bonds to accumulate and store purchasing power for months, years and even decades. The chain has multiple overlapping lags.
For example securities prices rose all through the 1980s-1990s. Consumer prices rose too, but at a falling rate. Fed Chair Alan Greenspan was hailed as the “Maestro” for his supposed ability to fine tune the system to generate a windfall to investors while moderating “inflation”.
Shortly after the calendar turned over to 2000, though, stock prices turned down. The Greenspan Fed attempted to reflate the system with renewed monetary ease. But this time, securities price increases were soon joined by increases in prices of real goods and services, the most visible being houses and oil. The US CPI had finally begun to rise at a rate high enough to prompt the Fed to begin to tighten monetary policy. By 2006 residential real estate was in a full fledged bubble and by 2008 oil prices were well into triple digits.
Looked at from the point of view of our Inflation Flow model, by 2000, the storage tank had become full … it was no longer possible to inflate securities prices without goods and services prices following suit. To the contrary, because of the prior inflation that had been stored up it was necessary for securities prices to deflate in order to slow the increases in consumer prices. The difficulty faced by the Fed was, however, despite its gradualism in tightening policy (remember the famous Greenspan intonation “at a pace that is likely to be measured”), no progress was made at all … until, in the second half of 2008 it all came at once. The Fed had naively failed to realize its “transparency” (a euphemism for predictability) was in fact a form of ease itself, and had encouraged a historic buildup of speculation and leverage that unleashed a deflationary crash. Consumer inflation did not gradually and smoothly abate, but went from too high to negative in only a few months. Oil prices that had reached $147 a barrel in the middle of that year were in the $20s before year end.
This set the stage for a new cycle. From its March 2009 low of 666.73, the S&P 500 soared to nearly 3400 by early 2020. You can be sure the volume of goods and services did not rise fivefold, yet consumer price inflation was still moderate by historical standards. The Yellen Fed used that as justification to maintain the “emergency” accommodation put in place after the 2008 debacle for years after the emergency was over, inflating a new bubble in both stocks and bonds. It was only a matter of time before that inflation, like that of the Greenspan era, spilled over into consumer prices.
The straw that broke the camel’s back came in 2020. The emergence of the coronavirus spurred a deflationary crash in securities prices as the world rushed to dollars. The Powell Fed responded with an explosion of liquidity to counter the deflation. But as the Yellen Fed had done the prior decade, it maintained the emergency ease long after the emergency was over. Securities prices rocketed higher. The inflation was so extreme that this time it only took around a year before consumer prices began to follow suit.
After a period of denial (the inflation was “transitory”), the Powell Fed finally began to respond with rate hikes in 2022. The bond market was already on the case, though, and stock prices had begun to decline. From its highs in late 2020 until its lows in late 2022, the bond market absorbed a decline of a size not seen in decades. Over the first three quarters of the year, the US dollar appreciated against not only foreign currencies but most every other security as well. By late that year, this deflationary impulse had begun to filter into consumer prices, not with outright consumer deflation, but at the second derivative level, with a declining rate of increase.
The securities markets have celebrated this apparent victory however, with a renewed inflationary impulse. This is even more remarkable in light of the fact that the Fed itself has now publicly recognized the connection between securities price inflation and consumer price inflation, albeit indirectly, through a doctrine that “financial conditions” are a “transmission channel” for monetary policy to the “real economy”. It doesn’t quite get it yet (that it’s just dollar depreciation affecting different prices at different times), but the effect is almost the same. It consciously put a “Fed call” on the stock market, while moving the strike price on the much older “Fed put” much lower.
This brings us to today.
We still don’t have a definite time delay to pencil in for the lag from inflation affecting securities prices to affecting consumer prices. But after deflating those first three quarters of 2022, securities prices have begun to see renewed inflation while the dollar is clearly also depreciating against foreign currencies, copper and gold. In other words, the reverse of what we saw for most of last year, the dollar appreciation and declining securities prices that had begun to be reflected in moderating consumer inflation.
Comparing with earlier cycles makes it difficult to frame the initial progress as a reset sufficient to permit another period of years of securities price inflation before consumer price inflation becomes a problem. The bond market has mostly corrected but stocks are still far from cheap. Consumer price inflation is still far above not only zero but the Fed’s own stated comfort zone, and many more Americans are struggling to pay higher consumer prices than are suffering from hardship due to low stock returns.
The inflation “storage tanks” are still pretty full. We’ve just tested their capacity and found their limit.
So far the disinflationary wave has been roughly sufficient to reverse the 2020-2021 inflation, but the 2009-2020 inflation remains. It therefore seems likely that stocks will have to soon turn lower, or the earlier progress on reducing consumer price inflation will stall. If stock price inflation continues, the declining rate of consumer price inflation will not only stall but begin to turn upwards again. This then should in turn again bring securities prices under pressure, much as it did in early 2022 when the last disinflationary cycle started.
Regardless, the Fed’s “financial conditions” paradigm is accurate for working purposes and this “easing of financial conditions” represents upward pressure on consumer prices in the coming months. Gold, copper and foreign currencies further confirm the resumption of dollar depreciation.
So in one scenario stocks shortly turn lower, and in the other there is a delay while this resurgent inflation works its way in and gums up the gears of the consumer price disinflation machine, producing a downturn later.
Can we think of other scenarios? They’re smaller probability but can’t be ruled out. One is that the Fed gives up and decides to accommodate the inflation. It’s under immense pressure from Wall Street to keep its lucrative product line (stocks) lucrative. Those six and seven figure bonuses have been cut this year and Wall Street wants them back. Silicon Valley millionaires and billionaires have been having to tighten their belts too.
But would the bond market play along? Failure to get inflation under control would mean higher long term rates (see 2021-2022), something that would not be welcome either on Wall Street or K Street. It would come at great cost to the Fed’s credibility, and the signaling value alone could mean no going back to low rates ever. Another doubt is Jerome Powell’s concern for his own legacy. Just a subjective opinion, but my read of Powell is that how he goes down in history figures prominently in his thinking. He doesn’t want to be poster child for a 2008 type debacle, but even less to be remembered as Fed Chair who unleashed a decade of inflationary misery on his watch.