New inflation and the old descriptions

 

"Cost push inflation"

"Demand pull inflation"

When was the last time you heard those phrases? You may have to get into the way-back machine from decades ago. These inflation phrases are still taught in introductory macroeconomic costs, but little time was spent dwelling on the specifics especially given the sub 2% period post-GFC. Inflation was often discussed as a necessary evil to allow for policy flexibility.

We are certainly in a different inflation world than the 70's. Oil price shocks and union wage demands do not have the same potential impact for creating cost-push pressures. Globalization and output slack also does not allow for the demand pull reaction seen in the past. Yet, it may be time to brush up on inflation dynamics and their potential impact on the economy. 

Investors have to focus on two issues. 

1. What is the threat of pass-through from increases in input prices? If commodity prices increase, will there be an increase in end user prices? If there are increases in wages, will this translate into higher check-out prices? If supply chains are stressed, will prices increase? Given earnings have been high, profits can be squeezed without the failure of firms. Firms can choose to hold prices steady. Will they follow this strategy now?

2. What is the threat of price increases from excess demand? If incomes are higher, there can be stresses from higher demand that was not anticipated. We have already seen this  in the lumber market. Many lumber yards cut inventory in the spring of 2020 under the anticipation of falling demand. They were wrong and the cost has been demand-driven shortages. Again, firms have to determine whether to increases prices in the face of higher demand. Or, consumers have to determine whether they will pay higher prices to ensure delivery and reduce waiting times. 

The pricing game is simple - can firms adjust prices and get away with consumers accepting less at the same or higher price? If firms perceive that consumers will accept price increases, they will do it. We are seeing this with airfares. Prices are moving higher, and planes are being filled although load factor data are still not available for the current month. The increases are sticking, so demand pull price changes are happening. If this occurs across many industries, we have inflation.

"All inflation is transitory until after the fact."

Simple monetary arithmetic - P-star suggests higher inflation

Few money managers are monetarists. Many lost money and in some cases their jobs for believing that the expansive QE of the post-GFC period would lead to higher inflation. Follow money at your own risk, but some analysts say this time is different given the magnitude of money growth and the large decline in money velocity. See, for example, Lars Christensen "The Market Monetarist" blog and his simple use of the P-star model. 

P-star is a simple toy model. Take the classic quantity theory of money equation, MV=PT and include money growth, long-term trend in velocity, and long-term NGDP growth to solve for inflation potential. P-star = M(V*)/NGDP*. 

P-star is the price inflation that would exist given current money growth and if velocity and GDP were at their long-term trend. It is then easy to compute the gap between P-star and P. This gap would be the expected inflation given trend velocity and GDP versus actual inflation. This inflation gap can be closed a number of ways; however, if money growth stays high and velocity and growth normalize to trend, the only solution is an increase in actual inflation.  

There will be a delay effect between a money shock and economic trend, but the logic is straightforward. If excess money balances are drawn down, velocity which has been excessive low will increase and move back to long-term trend velocity. GDP may rise above trend, but if it reaches potential GDP, prices will have to rise. If GDP growth is constrained by its potential, then higher money will need to be held as higher balances which will lower velocity or prices will have to rise to equilibrate our classic equation. 

There are a number of simplifying assumptions with this toy model, but it provides a point of departure for discussion using a simple monetary framework. If growth is below potential, there is less likelihood that prices will rise. If money balances are high (velocity is low), there is less inflation, but if balances are reduced and spent, prices will rise especially if GDP is constrained. Output gaps which are closed will also close inflation gaps. 

Of course, this does not account for leakages into the financial system which have been high and have served as an alternative to purchases of goods and services. Money balances may decline not to buy good but to purchase financial assets. The financial leakages have driven financial prices not real assets. It is assumed that as the economy normalizes, financial leakages will switch to real purchases.   

Working with this simple equation leads to the uncomfortable conclusion that inflation may rise significantly in the next year as economic growth returns to potential and velocity normalizes. This inflation will only be transitory to the extent that money growth slows going forward. This is not a prediction but a point of departure with the classic monetary identity. 

Investors forming bets around transitory inflation arguments

There is heightened discussions on inflation especially with the higher than expected April CPI print, but the real focus is on the issue of transitory inflation. The Fed has fostered this discussion with their argument that there is no need for any preemptive early action even if there is an inflation spike because it will not last. Any inflation fears today should be tempered. This is consistent with market consensus inflation forecasts and inflation breakeven term structures. Overall inflation expectations are higher, but the inflation term structure is inverted. In a year to eighteen months inflation should decline albeit be slightly above 2 percent. 

We have listed a set of arguments for transitory inflation in the table below. Many of the transitory inflation arguments make sense and have good foundations. For example, supply chain bottlenecks can lead to higher prices now which should be offset over time. Some labor shortages will be eliminated as pandemic rules are further relaxed. Base effects and inflation dispersion will be moderated over time as we return to pre-pandemic economic behavior. 

However, a focus on short-term transitory inflation is a smokescreen versus the core issue of whether current monetary and fiscal policy provides a foundation for a higher inflationary environment. Recent history suggests that any link between money and inflation is weak, and any Phillips curve trade-offs is illusionary, yet these are the questions which have to be addressed for higher long-term inflation. A bet on higher inflation and a monetary policy mistake is against the consensus yet betting on or hedging against extremes is a time honored approach to higher performance. The cost of following the consensus may be very high in this case. 

 

SPACs and changing optimism - A possible sign of changing sentiment

IPO and SPAC issuance provides a measure of market optimism and potential speculative excess. An increase in issuance tells us something about demand, but price performance against benchmarks provides a measure of market optimism in the face of uncertainty. IPOs provide a measure of optimism on potential growth of small new firms that are driven by new ideas and technology. Investors look at the filings and recent past performance and extrapolate this growth into future to form a valuation. 

SPACs have the process backwards. Rather than bet on the known past, investors buy into a management team that will find a future opportunity within a fixed time period. The SPAC investor forgoes known behavior for an unknown future. You are buying pure optimism on unknown opportunities. 

There are ways to track the SPAC market, the CNBC SPAC 50 index and the SPAK ETF. Both show strong optimism in early 2021 only to see a quick reversal. The SPAC ETF can be compared with an IPO ETF (IPO). Both show the same behavior with a slight upward bias toward the IPO portfolio. These moves may represent an early change in overall market sentiment.