Inflation

FAN YU is an expert in finance and economics and has contributed analyses on China’s economy since 2015. Fan Yu

Inflation Is King

The financial markets today seem solely driven by inflation expectations

Inflation is now the single most important indicator for the financial markets.

Fundamentals? They’re meaningless. Earnings? Important but not indicative of the future. Momentum? Well, that also depends on inflation.

The financial markets now seem to be singularly driven by the anticipated trajectory of inflation. In other words, readings of inflation would provide an indication of whether the U.S. Federal Reserve has done enough to combat inflation by raising interest rates. So it’s a prediction of how much and how long the Fed would continue boosting benchmark interest rates.

Investment strategists who typically have interesting things to say have suddenly thrown out their playbooks and now look toward the Fed (and the other central banks). If investors believe that inflation is peaking and the Fed can slow down or reverse its interest rate hikes in the near future, they would turn bullish on stocks. If investors believe inflation still has a way to go, they would sell and stay away from the market.

In other words, one’s views on the market have become rather binary and dependent on one’s views on inflation expectations.

The latest CPI report released on Oct. 13 was another reminder that elevated inflation is nowhere near cooling off. September prices rose 8.2 percent year-over-year and 0.4 percent monthover-month, with both readings above analyst expectations. That has caused analysts at Bank of America to declare in a note that inflation could remain high for years to come, as historically, once it breaches 5 percent, it typically takes 10 years for inflation to go back down to the 2 percent range (what the Fed is targeting) for developed economies.

David Einhorn, the founder of hedge fund Greenlight Capital, sees this problem as self-made.

“When was the last time we put a cement factory in this country, and when was the last time we created an oil refinery?” he wondered during an Oct. 11 interview with Bloomberg TV. For the past two decades, our country (and its investor base) has been obsessed with building technology companies with borrowed money.

A key question is whether the Fed is on the right path to fix the problem. Einhorn believes the Fed may be barking up the wrong tree.

“Half of the inflation problem is caused by fiscal measures. And there’s no discussion at all about making fiscal measures to either increase supply, which actually would be a nice thing to do because as you increase supply you increase wealth,” he added. “Instead what we’re trying to do is to decrease demand, which means lower everybody’s standard of living to try to fight the inflation.”

At its core, inflation is caused by a supply-demand imbalance. Simply put, when demand exceeds supply prices tend to go up. And to cure the imbalance, either supply needs to be increased or demand needs to be reduced.

Whether you believe current inflation is caused by poor policy (loose credit, underinvestment in certain sectors) or poor luck (COVID-related supply chain issues, the Russia–Ukraine war), it’s ultimately inflation driven by too little supply, argues economist Nouriel Roubini, professor emeritus of economics at New York University and chairman of Roubini Macro Associates.

“This matters because supply-driven inflation is stagflationary and thus increases the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened,” he wrote in a Time magazine op-ed.

Roubini’s thesis is that an economic hard landing is inevitable and, given the amount of debt in the financial system coupled with high-interest rates, growth will be low for the foreseeable future. “Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises—that is, a stagflationary debt crisis.”

To battle inflation by demand destruction—forcing unemployment and cratering household wealth— could set the country up for low growth for years to come.

Roubini is aptly nicknamed “Dr. Doom” as he’s been sounding the alarm on inflation for years even when deflation was the mainstream worry. But today, his thesis has come much closer to reality.

Roubini’s thesis is that an economic hard landing is inevitable and given the amount of debt in the financial system coupled with high interest rates, growth will be low for the foreseeable future.