INFLATION
The Real Problem with the 2022 Global Inflation
Why the current inflation may only go away after a devastating global recession
To understand what is really going on with the current global inflation, we must focus on 2 key elements:
- Food & Energy
- Supply & Demand
CPI vs. PCE — Are we focusing on the right inflation indicator?
CPI — Consumer Price Index — is a widely used measure of inflation.
However, the Fed is known to prefer another key indicator of inflation called PCE — Personal Consumption Expenditures.
The reason the Fed prefers PCE price index over CPI is that PCE “has a broader scope and better reflects how consumers change what they buy to account for rising prices.” (Iacurci, Greg. “The Fed uses one inflation gauge as its North Star. Here’s why.” CNBC, Jan 28, 2022, https://www.cnbc.com/2022/01/28/the-fed-uses-one-inflation-gauge-as-its-north-star-heres-why.html. Jun 10, 2022).
Likewise, economists and policy makers often prefer the Core CPI to the overall CPI because they would like to see the effects of food & energy excluded, because these two categories are considered “volatile”.
But the real problem with the current global inflation is the skyrocketing prices of these two crucial categories — food & energy — that the average consumers simply cannot do without.
In this unprecendented time of impending food & energy crisis, the price of non-essential products — especially things like services — should not matter as much.
Think about it.
We all need to eat. We all need shelter. We all need transportation. For the people to survive, these essentials of life must be maintained, no matter how high the prices may be. Instead, what can be done in response to the skyrocketing prices for these essentials — food & energy — is to cut back on anything else that are unnecessary for survival, e.g. Netflix subscription.
Can you see what is going on here? Because of skyrocketing food & energy prices, consumption of non-essentials must be reduced. However, the demand for food and energy cannot be reduced so abruptly because, well, they are needed for human survival. While the amount consumed can be unwillingly limited by your budget, food and energy consumption cannot be cut off entirely.
Cutting on other non-essentials that we have all been enjoying during the pandemic boom will likely bring the broader economy to a recession. However, even if our account balances shrink, we still must eat.
The Supply & Demand
By the laws of supply and demand, it could be really difficult for the price of food and groceries to come down any time soon, given the resilient demand for food as a human necessity while the prospects for the supply of agricultural commodities like wheat are continuing to worsen.
With Russia weaponizing essential commodities, bad weather conditions around the globe exacerbating supply shortage stress, and nations around the world increasingly restricting export of key agri products for domestic protection, it seems the supply side for food could have a very hard time improving any time soon.
Thus, we could soon face a serious recession from spending cuts on most non-essential products and services, which will likely lead to a big slowdown in broad consumption → big reduction in corporate profits → widespread paycuts and layoffs → global recession. In the meantime, however, the price of the essentials — especially food — may keep going up as long as global production and shipments of wheat and other commodities don’t improve.
The highest inflation in at least 40 years follows an unprecedented period of economic boom
Such an environment is unfolding while the global consumers of the world have been enjoying such an unprecedented period of economic boom and wealth made possible by the “absurd” cash injections by governments and central banks.
During the past 2 years or so following the great Covid shock of 2020, the price of almost everything went up and up and up. Most notably, the price of global stocks and cryptocurrencies have been so strong that for many newcomers to investing, investing must have come across as so easy.
Take the tens of thousands of dollars received from the government for free, borrow more money at the lowest-ever interest rates, pour these free-earned-money into stocks and coins and you would have become so rich, at least compared to your own economic well-being prior to the pandemic. No wonder why so many people have not been seeking work while companies are in dire need for workers. Simply, everyone got rich so quickly and easily.
Was the pandemic really an economic shock? I don’t think so. As recently as early 2022, before the global stocks began its serious correction, I couldn’t believe how so many people could feel so rich and spend so much. Even with the recent stock and crypto corrections, I can still feel many people not much deterred in their ability and will to spend.
Why is that?
Massive household cash from government relief funds
U.S. personal savings — the amount of money deposited in people’s bank accounts have increased tremendously in 2020.
Many market participants point to this data to support their view that the U.S economy is stronger than ever. However, it is important to understand the reason for this massive increase in personal savings in 2020. It didn’t happen because Americans suddenly felt the urge to save more for the future. The increase in savings is exactly what the government sent out to everyone as “free-money” as pandemic relief funds.
Looking back though, the quick development of effective vaccines has essentially nullified the economic shock from the pandemic while the unprecedented amount of cash injections has boosted the economy like never before.
But with other parts of the world still delayed in fully recovering from the pandemic and Russia invading Ukraine, global supplies of almost everything have been deteriorating, causing the mismatch in the supply side and the demand side to expand beyond imagination.
Think about it.
Supply shortages are still on-going, but consumers have suddenly become so rich with the government’s massive free-money send-outs.
Supply shortage + massive cash & spending spree (Demand surplus) = high inflation.
Say, you initially had nothing in your bank account, but one day, the government just deposited $10,000 into your account for free. All of a sudden, you feel rich because you now have free $10,000 that you didn’t have before. What is more, there is so much money in the world and the interest rate so low that you can easily borrow more money at very little cost. Let’s say you borrow $10,000 more at 2% interest. Now you have $20,000 in your bank account for an annual cost of just $200. You buy $10,000 worth Nasdaq Composite Index and $10,000 worth Bitcoin during 2020.
Let’s say your average cost was 11,000 for Nasdaq Composite and 10,000 for Bitcoin in 2020. By the end of 2021, Nasdaq Composite shot up to 16,000 and Bitcoin to 60,000.
By the end of 2021, your bank account balance would be worth over $70,000. That’s from $0 to over $70,000 in just a single year.
Now, what do you do with such massive free cash in your bank account?
Spending spree, of course.
Massive spending spree
Such massive spending spree is shown by the enormous rate of decline in the U.S. personal saving rate since 2020. As of April 2022, saving rate fell below 5%, below the stable range of roughly 6 ~ 8% before the pandemic and well below the 34% peak reached with the massive government cash injection in the spring of 2020.
We must be clear on the reason for the jumps in household savings. It’s not because people were being discrete in their spending. It’s simply because the government sent out massive amount of free money to everyone. As soon as people got the free-money, they began the spending spree, which is why the saving rate has been delining so quickly ever since.
So, going back to the previous hypothecial example, because you suddenly have over $70,000 in your bank account, you feel rich and go on a spending spree, buying a nice car, laptop, smartphone, TV, furnitures, etc. Now, your bank account shows a balance of $10,000. This is still $10,000 you didn’t have before, still remaining after all those nice spending. But you feel less rich now because your balance is shrinking. You feel like you have to be more discrete in your spending now, although you still have some room for more.
I believe this is roughly where we are right now, as of June 2022.
The massive global pandemic cash has been used for crazy spending spree while supplies are in continuous shortage, creating a seriously high inflation across the globe. Many people bumped up consumption thanks to the explosion of wealth effect created by massive free-money and skyrocketing asset prices.
Now, after massive spending and rising inflation, people’s cash base is shrinking, but still not completely depleted.
But soon, they will be depleted with the on-going high inflation. Then, consumption of many products and services will likely slump abruptly as people’s wealth effect disappears.
However, people still must eat, still need shelter. Prices of food and energy will likely be the last things to slow down. But with the essential elements like food and energy becoming less and less affordable, the degree of consequences for the global society is hard to fathom.
Conclusion
So here is my view: inflation is not going away soon, and the rise in food and energy prices, especially, can have serious consequences to the global economy in the near future. Hopes for soft-landing seems like naiive wishful thinking. Expecting such a massive cash injection and free money to not have any negative consequences just seems absurd to me.
As Charlie Munger mentioned several months ago regarding massive money printing: “We are closer to terrible trouble than we’ve been in the past.”
With May CPI rising to 8.6% even after 25bp + 50bp hikes by the Fed and the on-going forward guidance of much more to come, I think the current market situation is really really serious. Simply put, the Fed’s current tightening plans are just not working. If inflation is not solved soon, then the real problem can shift from inflation to inflation expectations. If inflation expectations start becoming uncontrollable, it will be 1970s once again, and only the Volcker-style massive rate hikes and a serious recession may solve it.
