Where Are We Going?
We suffered the great exasperation of hearing parts of Fed Chair Powell’s Humphrey-Hawkins testimony in front of the Senate on Wednesday. Fortunately, we managed to miss some of it, but rather than a session to better understand our current economic problems, it became a series of political advertisements, each charging the other with malfeasance in one form or another. That accomplished exactly nothing. The message that came through loud and clear is that Congress is either a bunch of economic knuckleheads or cares substantially more about their personal political careers than the lives of their constituents. After hearing this session, we fear that both are accurate.
We were not especially impressed with Chair Powell either. Rather than speak frankly as one of the key economic minds in the country, he continually punted on questions of what remedies Congress might employ. Thanks for nothing. After a day of testimony and many questions, we still have no answers and apparently no idea where we are going.
Grasping the Multi-Faceted Inflation Problem
As we have said previously, in simple terms, inflation is caused by too much money chasing too few goods. Correcting inflation can be achieved by increasing supply, reducing demand, or a combination of both, until supply and demand are in balance. But all inflation is not the same. To better understand the situation we face today, we want to break down inflation into three main categories: energy, food, and ‘everything else’.
The chart below shows the year over year change in CPI for these three categories. Working backwards on our list, everything else, the pink line, is by far the steadiest. Here’s why: Consumers address inflation for everything else by avoiding those goods as much as possible. Purchases can be delayed or cheaper substitute products can be found. Maybe I don’t really need that $1000 iPhone when that $200 Android phone works nearly as well. The idea is that higher prices can to some degree be avoided and this limits the extent to which inflation plays a role in prices for everything else.
Food inflation is the dark blue line. Note that it varies up and down a good bit more than everything else. In other words, the trend is more volatile. This makes intuitive sense as the options for consumers to deal with food inflation are more limited. We all have to eat. Nevertheless, there are still options. Those store brand corn flakes might not be our favorite, but they are a way to at least partially circumvent price increases. The consequences are obvious in the chart: Food prices tend to vary more than other goods over time.
The green line is energy inflation and it is by far the most volatile of the three. This volatility reflects on the difficulty in avoiding energy use. With few options, consumers are energy price takers and prices are very erratic. The one thing we would note on the chart is that they generally do not stay high for very long! The place where that is least true is the first decade of the 2000’s, which is the period of China’s massive economic expansion, which created structurally high and growing global energy demand, and kept prices high.
Other than structural issues, energy inflation is generally rather short lived and typically associated with recessions (the gray bars). This means that the answer to energy inflation is typically the painful process of demand destruction. When manufacturing slows down, energy demand declines. When people drive less, energy demand declines. When people lose their jobs, energy demand declines. The problem we face now appears to be more structural than cyclical. The pandemic impact is more cyclical than structural, but the impact from Ukraine invasion will require structural changes to global energy supply chains and that will be a serious challenge. The only good news is that once corrected, the country has been able to get back to work rather quickly, but it still appears we need to have a recession first.
Don’t Believe Powell…
…when he says the Fed can’t do much about energy inflation. The Fed affects demand and therefore they can do something about energy inflation, it just isn’t a pleasant process. Despite the denial, they do appear ready to address the energy inflation demon and we suspect they will push us into a recession, if they have not already. Effectively, every time energy prices have risen this much, we have invariably had a recession shortly thereafter. The caveat is that markets need to continue to function. If the Bond market locks up as it has done in the past, we expect the Fed to step in once again and ‘save the day’, at least until next time.
We Need a Coherent Energy Policy…
…but we have been lacking that since the first oil embargo in 1973. Note in the chart below that our response to the embargo was generally lower U.S. production from the early 1970’s to the mid 2000’s. U.S. production is not quite back to pre-pandemic levels yet, but it is rising once again.
Our current failure to recognize the need for a realistic transition to green energy is coming back to haunt the us and the rest of the Western World. We have allowed politics to dictate policy, rather than have a policy dictated by market realities. You can’t change the world’s energy infrastructure overnight. It will take a generation to accomplish that. Policy should dictate an achievable pathway. Trying to change too quickly can kill us as fast as doing nothing about global warming.
The energy problem we face today has roots in the cyclical pandemic event, but has migrated to more structural causes as the Russian invasion of Ukraine has fundamentally, and probably permanently, altered global flows of energy. Until a new equilibrium trade status can be achieved, inefficiencies and shortages are unlikely to disappear. You can blame whichever political party you choose, but it does not change the economic reality of the situation. We are in a bind and there are no painless solutions available.
What We’re Reading
Central Banks are facing a great awakening on inflation (4 min. video)
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