Fix the CPI or Bust

FAKE FINANCIAL NEWS

A new century dawned a long time ago. When will the Consumer Price Index catch up to the way we actually live?

By Vonetta Logan

Ihave a framed print that I found at a local art fair. (No, it’s not Live, Laugh, Love. I’m not a psychopath.) It’s a picture of a Chihuahua with the caption, “I work hard so my Chihuahua can have a good life.” I don’t often think about inflation and the Consumer Price Index (CPI), but I do think a lot about what it’s going to take to keep my Chihuahua in the lifestyle to which she’s accustomed. I’m sure the same thought runs through the heads of sugar daddies as they log onto seekingsugarbaby.com: What’s it going to take to keep Kandiss in the lifestyle to which she is accustomed?

In terms of plum writing assignments, “ramifications on consumer discretionary spending during sustained periods of inflationary pressure” ranks just above “first-person account of a root canal.” But we’re going to make it work. The U.S. Bureau of Labor Statis-

$1.48 $4.99

In an age when everyone knows everything about you because your data is in the cloud, the U.S. economy is still using a rotary phone.

tics (BLS) produces the CPI, the most widely used measure of inflation in the United States, and by some accounts, it’s the highest it’s been in 30 years. But if you Google “What’s wrong with CPI?” a litany of issues arises. Man, who knew economists could be so ornery? Their calculations vary wildly, and they don’t agree on whether the CPI is overstating or understating inflation.

When it was created, the CPI simply compared the cost of a fixed basket of goods between two time periods. OK, if my little basket of groceries last month cost $100 and then this month cost $125, that’s inflation, baby! But that doesn’t tell the whole story, so now CPI has evolved into a cost of living index. This method “takes into account changes in the quality of goods and substitution. Substitution [is] the change in purchases by consumers in response to price changes,” writes Investopedia.

There’s a lot of nuance to consumer spending. The price of one good may not go up by a measurable amount because people stop buying the most expensive item and instead buy a cheaper one, thus substituting it. Or, consumers might spend a lot of money on a product or service at the onset, but that product or service is of much higher quality than was previously available so they don’t need to buy it as often.

In his book The Inflation Myth, Mark Mobius writes that “it’s hard to define

It’s hard to calculate the cost of living because manufacturers introduce new and improved products almost daily.

exactly what is meant by the cost of living when new goods are introduced on a daily basis. One example of that would be the automobile. ‘Today’s automobiles are ... much improved than in the past ... offering all kinds of conveniences that did not exist before.” Last year, I bought a new hybrid SUV. So, some pencil-pushing economist would put the price of my car into a spreadsheet, but other factors, like the 50% monthly reduction in what I pay for gas and the 30% reduction in my insurance premium (it has a lot of safety features) wouldn’t be counted. The result is a CPI that doesn’t actually account for what’s happening. It’s not just that CPI measures only what’s happening in brickand-mortar stores. Investopedia notes that it fails to consider “the spending habits of those living in rural areas, including farm families.” It also neglects members of the armed forces and leaves out nearly everyone in prisons or mental hospitals. Yes, the CPI covers approximately 93% of the population, but those groups seem too important to ignore.

According to Investopedia, the CPI’s basket of goods is filled with basic food and beverages such as cereal, milk and coffee. “It also includes housing costs, bedroom furniture, apparel, transportation expenses, medical care costs, recreational expenses, toys and the cost of admissions to museums,” the site said. “Education and communication expenses are included in the basket’s contents, and the government also takes note of other, seemingly random items such as tobacco, haircuts and funerals.” But a lot gets left out.

We need a new measure of inflation for a

new era of consumers, CONSUMER PRICE INDEX (CPI) COMPONENTS so I’m pleased to present my own updated version of CPI which I am calling Housing 42.4% Baseline Observation Of Buying Sprees, or BOOBS. That’s right, check out my Transportation BOOBS.

15.7%

Food & Beverages 15.2% Step 1: Get modern. It’s almost 2022, and you’re telling me that key Medical Care measures of economic 8.9% data are based on calling some lady in Peoria on her Education & landline and asking what Communications she spent on Raisin Bran? 6.8% Hedge funds are flying Recreation 5.8% drones over Apple store parking lots and aggregating the data on Google Other Goods & Services Maps to see how many 3.1% people are in line for the Apparel 2.7% latest phone. My banking app magically knows how much I spend each month Source: U.S. Bureau of on a wide array of goods Labor Statistics and services. Why can’t we anonymize the data but pull real-time spending info from people’s actual bank accounts? Instagram’s algorithm took two days to figure out I had a thing for bearded dudes wearing flannel before it filled my timeline with hot lumberjacks. Why can’t we do the same with real-time consumer data? Step 2: Expand your BOOBS. CPI has so many biases and blind spots it just got its own cable news show. Include rural families. Include online shopping because that’s all most of us are capable of. Normalize the data to account for the higher cost of living for single people. I guess economists get laid way more than I do because I couldn’t find anything that states that CPI is adjusted based on marital status. Spoiler alert: Single people spend more money because they can’t spread out the costs. Those boxes of wine, pallets of cat food and sleeves of D batteries aren’t free, Milton.

Step 3: Account for fake BOOBS. Investopedia notes that BLS freely admits that the CPI does not factor in the effects of substitution. When certain goods become significantly more expensive, many consumers find less expensive alternatives. For instance, they might buy the store brand instead of the name brand, or replace premium gasoline with regular. In the words of George Costanza, “cheapness is a sense.” American consumers are super savvy about sniffing out deals. Sleep in a tent to get $50 off a TV? OK! Hoard 15 pallets of paper towels in my garage and be forced to park on the street because I had an awesome coupon? Done! Get thrifty! Get schwifty!

Here are a few categories I would expand as a metric of BOOBS: • Plants — they’re the new pets • Pets — they’re the new kids • Sin — booze, weed, frisky time (how is this not included in our GDP?) • Online shopping • Inclusion of rural, military and incar cerated populations—and, oh yeah, single people (that’s a lot of ramen going unaccounted for) • The coupon conundrum — Americans rock at sniffing out deals

In an age when everyone knows everything about you because your data is in the cloud, the U.S. economy is still using a rotary phone. The treasury secretary says inflation is nothing to worry about, but my banking app makes the saddest sound when I open it. There’s a disconnect between Wall Street and Main Street, and the way we’re currently measuring inflation isn’t working. Can my BOOBS save the economy? Maybe. But new metrics are real, and they’re spectacular.

Vonetta Logan, a writer and comedian, appears daily on the tastytrade network and hosts the Connect the Dots podcast. @vonettalogan

RISING PRICES, DECLINING CONFIDENCE

Illustration by JASON SCHNEIDER

12 JUST TRANSITORY?

14 RAINBOW’S END

18 STAGFLATION, NO

20 STAGFLATION, YES

24 PRICE APPRECIATION 26 GIMME SHELTER

28 EMBRACING DEFLATION

34 MEASURING MISERY

36 PERFECT HEDGE?

38 CHINA UPDATE

Rising Prices, Declining Confidence

UNCERTAINTY PREVAILS AS INFLATION UNNERVES CONSUMERS AND PERTURBS ECONOMISTS By ED MCKINLEY

Prices are soaring and necessities are scarce as annual inflation of 6.2% grips the nation. While economists differ on how much of the blame to assign to monetary policy, labor shortages, supply-chain disruptions, working from home or the spread of the Delta variant, a consensus is emerging among the experts that this round of inflation doesn’t seem transitory.

“It’s the classic inflationary scenario of having too much money chasing too few goods,” said Alan Cole, former senior economist for Congress’s Joint Economic Committee and author of the Full Stack Economics newsletter.

That nearly unprecedented shift in spending increases demand for goods and puts pressure on supply, causing prices to rise, noted James P. Sweeney, chief economist for Credit Suisse.

“About two-thirds of consumption and half of GDP is services spending by households,” Sweeney said. “It almost never contracts. In fact, it’s only contracted two or three times in 75 years. And this time, it absolutely plunged.”

The resulting inflation has prompted legions of economists to abandon their laissez-faire attitude toward controlling prices, observed Carol Corrado, former chief of industrial output at the Federal Reserve Board and now research director in economics at The Conference Board.

Meanwhile, some economists argue that inflation is merely masking the deflationary forces at work in the economy. Technological advances like robotics and artificial intelligence will continue to force prices and reduce the need for human labor, said entrepreneur and author Jeff Booth. (For more on deflation, see pp. 28 and 49.)

Whatever position economists take on inflation and deflation, they tend to agree that demand for merchandise has remained strong during the pandemic, at least partly because the federal government has kept income at or even above pre-pandemic levels despite staggering levels of joblessness.

The first wave of federal relief came with the Coronavirus Aid, Relief and Economic Security Act, better known as the CARES Act, which pumped $2.2 trillion into the economy as direct payments, augmented unemployment benefits and forgivable business loans. President Trump signed the bill into law in March 2020, after the Senate passed it unanimously and the House passed it on a voice vote.

It was the biggest stimulus package ever but only marked the beginning of the effort to keep America whole despite the ravages of the pandemic. A year later, President Biden signed the American Rescue Plan Act, pushing another $1.9 trillion into the economy. That measure passed the Senate 50-49 and the House 220-211.

But economic stimuli could do nothing to prevent changes in spending habits wrought by the virus. People could no longer congregate in bars, restaurants, theaters or music venues because of quarantines, lockdowns, layoffs and social distancing. They became shut-ins, working from home and entertaining themselves with electronics.

As a direct result, they cut their spending on services, leaving them with the funds to increase the amount they spent on merchandise. Meanwhile, the supply of goods was shrinking because the pandemic was preventing workers from going to their jobs and making things.

A shortage of workers was also creating bottlenecks in supply chains, making goods more difficult to obtain. Container ships from China waited outside U.S. ports because not enough longshoremen were available to unload them. Trucks sat idle across North America, waiting for drivers.

As if to prolong the problem, workers furloughed by the pandemic have been slow to return to low-wage jobs, and many with higher incomes are choosing early retirement. Before COVID, America employed nearly 153 million workers, but by October the number had climbed back up to just 148 million. Viewed another way,

By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

JOHN MAYNARD KEYNES, 20th-century economist

$40t

The amount of money in circulation in the world, including all of the physical money and the money deposited in savings and checking accounts

81% of prime-age workers were employed before the virus struck, and now 61% have returned to the workplace.

If employers are forced to raise wages to attract workers, inflation would naturally result. And as employers take on inexperienced new workers in the face of labor scarcity, the inefficiency of those new hires also raises the prices of the goods they produce.

Even after the pandemic, the labor market could remain tight and continue to fuel inflation for another 10 years, some economists believe. Wages may continue to rise because they have been depressed because of the decline of unions, automation that eliminated jobs and increases in employment overseas.

But there’s reason for cautious optimism. After the initial shock, supply-side issues tend not to get worse and thus prices won’t increase again after the initial adjustment. Sometimes the unfavorable situation improves, and prices can fall. For example, a new worker tends to gain efficiency and thus become less of a force for inflation.

On the other hand, some types of inflation have already occurred and have not been taken into account. The U.S. Bureau of Labor Statistics (BLS) bases measurement of rents on leases, some of them signed before COVID raised prices.

So how will this all sort itself out?

The world seems unlikely to return to anything resembling the runaway inflation of the 1970s, according to Cole, the newsletter author and former Congressional staffer. The world’s aging population is saving for retirement, he said, which leaves less money to bounce around and drive up prices.

But even if inflation doesn’t reach record highs, Americans would do well to prepare for a wild ride that might last through 2022, a growing number of economists agree.

AUTO CORRECT

A breathtaking bout of inflation is roiling the market for new and used cars as increased demand meets pandemic-induced supply issues. No one’s ever seen anything like it.

“Prices are at their highest ever,” reported Jonathan Smoke, chief economist for Cox Automotive, which owns Kelley Blue Book, autotrader.com and Manheim Inc., reputedly the world’s biggest wholesale auto auction.

Pre-COVID, new car buyers paid an average of 94% of the manufacturer’s suggested retail price for cars, but now they’re shelling out a jaw-dropping 101%— more than the sticker price on the window, according to Smoke.

In September, the average price paid for a new car surpassed the $45,000 barrier for the first time, and that was when the average sticker price was $44,400, he said.

But that’s nothing compared with what’s happening with used vehicles. In October, used car prices were up 37% year over year, and that followed a year when they increased 14%, according to Smoke’s stats.

In normal times used cars lose about 10% of their value every year because of wear and tear, Smoke noted. But shortages of used cars remain so acute that some two-year-old vehicles are selling for more than they cost when they were new, he said.

Today’s $15,000 used car has typically clocked 40,000 more miles on the odometer than a car that sold for that amount pre-COVID, Smoke noted.

It’s happening because some urban workers are choosing to drive private vehicles to the job instead of risking COVID on public transit. Meanwhile, working remotely is enabling some employees to move farther from city centers and thus increase their commitment to private modes of transportation.

Before the pandemic, the number of vehicles in the United States typically grew by about 5 million annually. Last year, the nation experienced the first contraction in its stock of vehicles since the Great Recession, Smoke said. In other words, automotive manufacturers have yet to catch up from COVID-related shutdowns and semiconductor shortages.

When will it end? Used car prices should begin falling next spring after the rush to buy them with income tax refunds subsides, he predicted.

“The new vehicle market may see abnormal price increases for longer than that—as long as supply continues to be relatively constrained,” Smoke warned, “through at least next year and into 2023.”

I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”

FRIEDRICH AUGUST VON HAYEK, economist

THE TECHNICIAN A VETERAN TRADER TACKLES TECHNICALS

The End of the Rainbow?

PROSPECTS FOR CONTINUED INFLATION MAY INTERFERE WITH FINDING A POT OF GOLD

By TIM KNIGHT

The word “inflation” may not mean much to anyone who wasn’t around in the 1970s and early ‘80s. Ever since Paul Volcker successfully broke inflation’s metaphorical back during the first Reagan administration, the cost of goods and services has generally inched up only a couple of percentage points each year.

Sure, a few lurches—both up and down—have occurred along the way, particularly with news-sensitive commodities, such as oil. But for about 40 years, citizens of the United States really haven’t suffered the kind of angst about inflation that roiled the populace in the 10 years preceding Volcker.

That may be changing, however, with trillions of dollars in COVID relief reshaping the American economy. Some prices are surging, and when they’re not, the products themselves are simply getting smaller. Some call it “shrinkflation.”

One of the best sources for long-term data on the corrosive effect of price inflation on purchasing power is, ironically, the Federal Reserve, and the charts accompanying this article provide insight into trends stretching back to the creation of the Fed in 1913.

COMMODITIES IN A SAUCER

The government doesn’t provide a single, straightforward inflation number. Instead, it juggles all manner of historical data, with different granularities (monthly, quarterly, yearly), different calculations and different exclusions.

For example, the most frequently cited government report on inflation omits food and energy because their price changes are so volatile. It might seem important to convey such data, volatile or not, but most members of the public don’t dig any deeper than the headline number.

One important flavor of inflation data— the producer price index for commodities— draws upon data going back nearly three full decades to 1994. The chart’s price action from 2015 to the present looks awfully similar to what was happening between about 1996 and 2004, when prices began a powerful ascent.

Still, a single instance of a certain pattern yielding a certain result is far from conclusive evidence that the same thing will happen. What’s more, the powerful move in commodities from 2004 to 2008 occurred almost entirely because of extraordinary demand from the BRIC nations, a situation unlikely to repeat itself.

Yet this analog is worth keeping in mind as long as it remains intact—in other words, as long as prices don’t slip below the saucer formation already completed.

A TRIMMED CALCULATION

The U.S. government tracks a wide variety of inflation measures, and one of the most useful bears the clumsy name of 16% Trimmed-Mean Consumer Price Index.

This calculation, a creation of the Federal Reserve Bank of Cleveland, starts with a basket of products and “trims” the top 8% and bottom 8%, thus eliminating the outliers and retaining the other 84% to produce the trimmed CPI.

This seems more balanced than the more popular calculations that blithely ignore the

In 2001, economists began grouping the BRIC nations—Brazil, Russia, India and China— because they had achieved a somewhat similar state of development.

rising costs of such outlandish luxuries as food and energy.

The first chart of the trimmed CPI shows monthly change. It may look wildly volatile, but it ranges from 0.0% to only about 0.5%. Those numbers might seem small, but they add up. In fact, a 0.5% monthly change implies a yearly change of 6%, which is quite high.

For the past decade, month after month, the figure came in between 0.05% and 0.25%, and usually around 0.1%, which is a remarkably tame CPI. Recent data, however, clearly shows the economy has left the shaded area behind, as the CPI has lurched out of this decade-long box into some of the highest levels of this time series.

Month-to-month data rolls up into long, sweeping trends, which is what the next graph represents. This is the same 16% trimmed CPI except on a rolling annual basis.

Just before the financial crisis, the trimmed CPI was at about 3%. From 2007 through 2010, however, that figure plunged to nearly 0%, and the Fed became terrified of the “D” word: Deflation.

Throwing open the financial spigots to combat COVID, the Fed succeeded in reigniting inflation. Its oft-cited goal of 2% has already been reached, and it’s using other measuring sticks to show inflation has not quite achieved its target.

GDP AND INFLATION

Combining two data sets lends perspective to a view of the long-term economy. Let’s divide the nation’s gross domestic product (GDP) by the inflation accumulated over the years, as measured by the Consumer Price Index. The resulting eye-opening chart breaks down into three time periods.

⊲ 1947-1968: The graph pushed steadily higher because GDP was growing powerfully enough to render inflation moot. It reflected genuine, not just nominal, prosperity and productivity.

⊲ 1969-1982: The chart went into free fall as surging inflation handily beat GDP. Although not shown here, the stock market Continued on page 17

The dreaded saucer

The pattern that preceded 2004’s spike in inflation has just recurred. Will it prove the precursor for another round of alarmingly higher prices? Time will tell.

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Some prices are surging, and when they’re not, the products themselves are simply getting smaller.

All the trimmings

The Fed lops off the commodities with the biggest changes in price to create a trimmed index. It’s supposedly more instructive to view inflation without the outliers.

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A CENTURY OF RAINBOWS

Does it seem like everything costs twice as much as it should? Well, prices have actually climbed a lot more than that in the last 100 years. In fact, they’ve risen an average of 3.12% annually since 1913 for a total increase of 2,670.8%.

Charting that price explosion yields rainbow patterns. That imagery may seem fanciful, but it reflects the smooth curves of long spans of time and emphasizes the particularly strong or weak extremes within those curves of broad overall movement.

Readers can view the long chart included here as representing six distinct eras of inflation.

⊲ 1913-1918: The consumer price index went nearly vertical in 1913 when the Federal Reserve Bank was established and U.S. spending on World War I kicked into high gear. Before then, no one gave a thought to inflation. Generally speaking, prices in 1910 were about the same as in 1870—or 1830. But with the creation of the Federal Reserve, the money supply ballooned and buying power plummeted.

⊲ 1919-1932: Relatively undamaged by the ravages of World War I, the United States became an industrial powerhouse and the breadbasket of the world. Technology brought efficiency and productivity, helping America produce cars, radios and agricultural products at a dizzying pace. That sent prices lower for everyday purchases, particularly food. As pleasant as that sounds, it was devastating for American farmers, who felt the pain of the Great Depression long before it registered with the general public.

Chasing rainbows

A graph of the last century reveals six bouts of worrisome inflation.

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⊲ 1933-1945: One of Franklin Delano Roosevelt’s first acts as president was to ban gold and untie its value to the dollar. That released the inflationary genie from the bottle. Without gold as a balance, there was no theoretical cap on how many dollars the Fed could print. It made as much sense as walking out to the driveway in the morning to see if the car was 10% larger. Coupled with substantial government stimulus and the industrial juggernaut of World War II, inflation pushed higher.

⊲ 1946-1968: This was the most prosperous and profitable era in American history. The economy grew persistently, thanks to efficiency and innovation. Although inflation was a yearly reality, it was always a little behind the everexpanding prosperity of the general public. ⊲ 1968-1982: Inflation’s steady pace hit an inflection point late in the 1960s, and by the mid1970s it was often the top story on the evening news. President Richard Nixon took radical steps, such as federally mandated wage and price controls, but they were as ineffective as President Gerald Ford’s “WIN” buttons, which stood for Whip Inflation Now. Inflation ran rampant until the Fed finally halted it by ratcheting interest rates up to a heart-stopping 20%.

⊲ 1983-present: Once red-hot inflation has been snuffed out, the growth of the U.S. Consumer Price Index returned to a pace that would have been familiar to consumers of the 1950s and 1960s—steady but not devastating to household budgets. This era may already have ended, but it will be years before that’s entirely clear.

Continued from page 15 performed poorly for most of those years, and by the early 1980s investors were becoming uninterested in trading stocks. But they were making money as prices soared for assets like gold and agricultural commodities.

⊲ 1982-present: It’s sobering that the graph has been meandering up and down in a relatively tight range for a full 40 years. In spite of a stock market that’s literally thousands of percentage points higher than the early 1980s, the nation’s productivity has remained terribly flat when inflationary forces are taken into account. Surging asset valuations have masked the reality that America’s explosive industrial growth ended before most of today’s traders were born.

WHERE THE FUNDS FLOW

The real question isn’t about inflation in the 19th century or how GDP compares to the CPI. Americans simply want to know if prices are going to keep going up.

It’s impossible to know for sure because of a wealth of uncertainties. One of the biggest is where those extra trillions in COVID cash are going to wind up. A tremendous stockpile of undeployed cash is sitting around in digital bank vaults, immaterial to the day-to-day economy.

The Fed maintains that recent inflation will prove “transitory.” Others suggest the trillions of dollars in relief and stimulus will continue to inflate not just asset prices but also the cost of meat, gasoline, sugar, clothes and the countless other goods and services that ordinary people use in their everyday lives.

Tim Knight has been using technical analysis to trade the markets for 30 years. He’s the host of Trading the Close on the tastytrade network and offers free access to his charting platform at slopecharts.com. @slopeofhope

20%

The interest rate that finally curbed 1970s inflation Lurching higher

Opening the financial spigots to combat the economic effects of COVID helped reignite inflation.

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America’s explosive industrial growth ended before most of today’s traders were born.

Feeble growth

The stock market has climbed thousands of percentage points higher since the early 1980s, masking the nation’s disappointingly flat productivity.

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To me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.”

JANET YELLEN, U.S. Secretary of the Treasury

No, It’s Not Stagflation

YES, PRICES ARE UP AND GDP IS DOWN COMPARED WITH EARLIER THIS YEAR, BUT THE ECONOMY ISN’T ENTERING A ’70S-STYLE MALAISE

By CHRISTOPHER VECCHIO

The economic woes of the 1970s, a decade marked by runaway inflation and painfully slow growth of gross domestic product, came to be known as stagflation. Could a similar fate befall America in the near future? In this article, a currency expert says he doesn’t foresee a return to those conditions—at least not yet. A story that begins on p. 20 presents a different view.

The U.S. economy seems to have fallen into a bit of a quagmire. Inflation, as measured by the consumer price index (CPI) or the Fed’s preferred gauge of inflation, the personal consumption expenditure index (PCE), is running at its highest level in 30 years. Meanwhile, growth rates appear to be sagging.

The Q3 report on U.S. gross domestic product (GDP) showed a +2% annualized real growth rate. The sharp slowdown comes after two strong quarters to start the year, with Q1 and Q2 U.S. real GDP coming in at +6.5% and +6.3% annualized, respectively.

Some commentators and market

This year’s U.S. GDP growth

+6.5 (Q1) +6.3 (Q2) +2.0 (Q3)

observers are suggesting the slowdown in the third quarter marks the onset of stagflation, defined as “persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.”

The state of the economy, so they say, could be creating a policy dilemma that would push the Federal Reserve into a corner as it prepares to taper asset purchases and ultimately raise interest rates. And with President Joe Biden’s fiscal stimulus plans mired in Congress, thanks to divisions between progressives in the House and centrists in the Senate, the threat of a fiscal cliff—a sudden drop in government spending—looms large as a potential albatross around growth’s neck in 2022.

However, ample evidence suggests this isn’t your father’s stagflation. In fact, it may not be stagflation at all. Indeed, price pressures are high, the highest seen in decades. But the other conditions of stagflation haven’t been met. In fact, quite the opposite is true.

Consider the labor market. The unemployment rate (U3) is back below 5%, and while job gains have been inconsistent in recent months, the pre-pandemic labor force is returning more quickly than after other downturns in the post-World War II era.

About 18 months after the start of the pandemic, the economy is still approxi-

mately 3.5% below its peak employment in 2020. After the global financial crisis of 2007 and 2008, it took approximately 50 months before the economy was only 3.5% below its pre-recession peak employment. It ultimately required 78 months to recover all of the lost jobs. The labor market is recovering jobs at a breakneck pace, considering the pandemic provoked the largest drop in employment in economic history. So, the labor market isn’t suffering from stagflation.

The case for calling the current situation stagflation becomes even weaker when one considers the demand side of the equation. Personal consumption expenditures are at their highest level ever and, according to data from the St. Louis Federal Reserve’s economic database, consumption is actually above its pre-crisis trend.

The inflation Americans are experiencing comes from strong demand amid a supply shock to supply chains left in disarray by the pandemic. Plus, the economy has history on its side. Typically, inflation caused by supply shocks fades over a few quarters.

Sure, the economy is experiencing slower real GDP growth now than earlier in the year. But the labor market is proving resilient, if not strong, and consumers—many with the assistance of government financial support during the pandemic—are spending more money than ever.

Will backlogged ports create more problems in the short term for businesses and consumers? Most likely. But the economy isn’t facing stagflation. It’s an economic boom limited by supply constraints that should fade in 2022 and beyond.

Christopher Vecchio, a senior currency strategist for DailyFX, forecasts economic trends in a number of countries. @cvecchiofx

Spending rebounds

Consumer spending has returned to its pre-pandemic upward trend

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CPI-U

Typically, inflation caused by supply shocks fades over a few quarters.

*An estimate for 2021 is based on the change in the CPI from second quarter 2020 to second quarter 2021.

Year Annual Average

Annual Percent Change

(rate of inflation) 1981 90.9 10.30% 1991 136.2 4.20% 2001 177.1 2.80% 2011 224.9 3.20% 2021* 271.4 4.80%

Source: Federal Reserve Bank of Minneapolis

The economy isn’t facing stagflation. It’s an economic boom limited by supply constraints that should fade in 2022.

Yes, This is Stagflation

BUT IT STILL MIGHT BE TRANSITORY

By JAMES STANLEY

Something new happened in the 1970s and it’s apparently coming back to haunt the nation again. It goes by the name “stagflation.”

The word, a portmanteau of “stagnant” and “inflation,” stands for slow growth (stagnation) combined with high prices (inflation).

It creates a host of problems for central banks: Do they hike rates to stem inflation and risk even slower growth? Or do they cut rates to spur the economy and risk fueling inflation?

There’s no right answer. What’s more, stagflation hasn’t happened very often, so there’s no playbook to go by. But the decisions central bankers make about stagflation produce market winners and losers.

THE “ME DECADE”

Some remember the 1970s as the “Me Decade”—a time when Americans cast aside the social movements of the ‘60s and refocused their attention on their own personal well-being. Some prefer to forget the ‘70s altogether because of the decade’s economic tribulations.

Inflation was already high when the decade began, running 6% for 1970 and 4% for 1971. To stem those price increases, President Richard Nixon instituted wage and price controls and suspended the gold standard in August 1971.

But inflation climbed higher when OAPEC—the Organization of Arab Petroleum Exporting Countries—embargoed shipments of petroleum and thus created the 1973 oil crisis. The price of gasoline skyrocketed and motorists lined up to fill their tanks. Stations posted signs when they ran out of gas.

Stock prices plunged, losing nearly 50% of their value in 20

THE 1970S BY THE NUMBERS

20%

Interest Rates

50%

Drop in Stock Prices

months. Interest rates rose to nearly 20%. Listlessness prevailed.

ENTER, PAUL VOLCKER

President Jimmy Carter appointed Paul Volcker chairman of the Federal Reserve Bank in the summer of 1979. Home mortgages were carrying doubledigit interest rates as inflation grew by about 1% per month. The dollar was considered nearly worthless.

The prevailing wisdom was that paper assets—currency, stocks and bonds—were terrible stores of value. Instead, many viewed commodities as optimal investments because they wouldn’t be as badly debased by a weakening currency.

Stocks underperformed, largely because they were denominated in dollars, a currency that didn’t inspire confidence among investors at the time. Metals and commodities did well because inflation didn’t erode their value.

Before Volcker, the Fed was run by Arthur Burns, whom Nixon appointed in 1969 with one directive: No recession. Nixon even made a remark to Burns about “the myth of the autonomous Fed.” So the central bank kept interest rates low, and that helped Nixon win re-election in 1972.

Burns followed Nixon’s directive and ran expansionary monetary policy for much of the decade despite lackluster results. After he left office, Burns said it was “illusory” to expect central banks to curb inflation, implying that the political pressure behind low rates and expansionary policy was too much for a central banker to resist.

Six days after Burns cast doubt on the idea of the Fed’s independence, Paul Inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people’s savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments.”

AYN RAND,

developer of the philosophical system Objectivism

Volcker made a radical announcement: The bank would target the volume of bank reserves in the system, as opposed to interest rates, allowing rates to go as high as needed to reduce reserves. The move was designed to shield Volcker from political pressure because he was instituting a formula to fix the problem of stagflation instead of making a subjective decision on how to adjust interest rates.

Volcker expected interest rates to spike because the system was awash in excess credit. The Fed Funds rate jumped from 11% in 1979 to 19% in 1981, causing a recession. Volcker knew what had to be done and devised a way to gain enough political cover to do it. Along the way, Jimmy Carter lost his bid for re-election to Ronald Reagan in 1980.

By 1983, inflation had moved back below 4%. In 1986, it fell to 1.9%. Volcker’s plan had worked. It induced a mild recession to temper the excess credit, which enabled Americans to focus on consuming rather than hoarding or guarding their investments against runaway inflation.

STAGFLATION TODAY

The greatest similarity between today’s economy and that of the ‘70s is artificially low interest rates. The Fed holds rates down to prevent recession and drive economic growth. That isn’t really the Fed’s job, as the bank has two mandates: price stability and employment.

Congress should be responsible for economic growth, but after the global financial collapse of 2008, the Fed had to step in with multiple rounds of quantitative easing (QE)—the policy of buying longer-term securities on the open market to increase the money supply and encourage lending and investing. That put the responsibility on the central bank, and it’s stayed there.

Some feared QE could bring the return of runaway inflation because the bank was looking to flood the system with excess credit. When that didn’t happen, the Fed continued to indulge in QE, covering for politicians who were unable or unwilling to risk assuming responsibility for the economy.

When COVID-19 struck, the Fed went

Snapshot of a decade

The S&P 500 monthly price chart for the ‘70s documents the tribulations of an era of stagflation.

Nixon imposes wage controls, removes the gold standard Oil shock S&P drops by 49.93% less than two years

01 Jan ’70

1971 1973 1975

S&P 500 Gains 77% in remainder of decade

1977 1979

01 Jan ’80

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Correlation

The rate on the 10-year Treasury, shown in blue, moved roughly in tandem along with the inflation rate (as calculated by the CPI), shown in red.

14.000

12.000

10.000

8.000

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4.000

01 Jan ’70 1972 1974 1976 1978 01 Jan ’80

Good as gold

In the ‘70s, the price of the precious yellow metal began the decade at $35 per ounce and ended at $533.60 for a return of 1,426.75%. Then it continued to climb, reaching $900 in January 1980.

01 Jan ’70 Stagflation helped to bring a major move to gold prices in the 70s, growing by 1,426.75% from Jan. 1, 1970 to Dec. 31, 1979.

1972 1974 1976 1978 600.00

500.00

400.00

300.00

200.00

01 Jan ’80

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35.20

Should the Fed hike rates to stem inflation and risk even slower growth? Or cut rates to spur the economy and risk fueling inflation?

Silver explosion

Silver outpaced gold in the ’70s, increasing in value by 1,446.96%, versus gold’s 1,426.75%.

Silver ramped up during stagflation, increasing by 1,446.96% during the decade.

36.000

0.382(34.025)

32.000

0.5(29.142)

28.000

0.618(24.25924.000

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0.764(18.218

16.000

0.886(13.170

12.000

1(8.453) 8.000

01 Jan ’70 1972 1974 1976 1978 01 Jan ’80 4.000 1.910 0.000 back to the emergency playbook to institute carte blanche lending that, like in the ‘70s, left the financial system awash with excess credit. As in the ’70s—but unlike the period after the global financial collapse—inflation has started to pick up.

With inflation rates moving over 6% throughout 2021, the inflationary aspect of stagflation is already in place. While growth for 2021 has been relatively strong, the question remains: How much of that growth is pandemic-related bounce-back and how much is legitimate and organic?

Real rates have been negative for more than a year, and the Fed wouldn’t dream of hiking them anytime soon. The Fed has warned that it may raise rates one time in 2022, but if history is any guide, it will back down unless the economic backdrop is absolutely perfect for a “lift-off” in the second half of next year.

So, yes, the nation has a form of stagflation today, although it may last for only a few years.

THE STAGFLATION INVESTOR

The S&P 500 produced a return of 19.85% in the ‘70s, with investors valuing precious metals and commodities much more than paper assets. Much of the pain in stocks was relegated to the bear market that ran from 1973-1974 and accounted for a 50% loss to the index. But that’s when the oil shocks were happening as OAPEC constrained supply—clearly an extenuating factor.

The rest of the decade was more stable, with the S&P 500 returning 77% from the 1974 low into the end of the 1980 open. Inflation ran rampant, so there’s not a strong correlation between weak stock prices and strong inflation, although precious metals did easily outperform stocks.

Stocks aren’t necessarily a no-fly zone during stagflation, but sector and style of equity become important considerations given the macroeconomic backdrop.

BONDS IN THE ‘70S

Interest rates were elevated and continued to climb as the Federal Open Market Committee led by Burns failed to temper

rising prices. But, real rates were negative much of the time, so holding a bond to clip the coupons was a losing proposition.

With the prospect of higher rates, bondholders faced deeper depreciation of principal (rates and prices move inversely)—a confounding scenario for anyone looking for returns through Treasuries or other fixed-income investments.

PRECIOUS METALS IN THE ‘70S

The prevailing economic wisdom during the stagflation of the 1970s was that investors should avoid paper assets and seek commodities, and it was a very good decade to be long gold. After starting January 1970 at approximately $35 per ounce, gold prices pushed up to $533.60 by the end of the ’70s. That amounts to a return of 1,426.75%.

A wild January 1980 saw prices top out at just under $900 per ounce before reversing and falling by 66.29% into the summer of 1982. It was no coincidence that the gold trend reversed as Volcker started to hike rates. This pivot may offer lessons for market participants now.

Silver outpaced gold in the ’70s, albeit by a minimal margin with silver putting up 1,446.96%, versus gold’s 1,426.75%. Like gold, silver spiked and burned shortly after the 1980 open as Volcker kicked rates higher.

BITCOIN’S RAMPAGE

The creation of bitcoin was still far in the future when the ’70s ended, but given its impact in markets today, the original cryptocurrency bears mention. Many speculate that bitcoin is the world’s new inflation hedge. Given the near-term performance of gold and silver, with both largely underperforming over the past 12 months, that

PRICE FOR AN OUNCE OF GOLD

$35

in 1970

$900

in 1980 Phenomenal growth

Bitcoin is increasing in value rapidly and seems to be replacing gold as the best hedge against inflation, some economists believe.

2017 2018 2019 2020 2021 2022 60000.00

50000.00

40000.00

31776.65

20000.00

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5343.64

0.00

880%

Bitcoin’s one-year price increase

idea seems to be gaining traction.

Cryptocurrencies in general are interesting, but let’s focus on bitcoin because the limited supply of 21 million coins can have a monumental impact as an inflation hedge. Bitcoin can never surpass that number. As inflation erodes purchasing power, the value of one bitcoin will always be one bitcoin, and a depreciating dollar can make that an even stronger equation for holders of the cryptocurrency.

Notably, gold prices have remained relatively weak since topping out last August when bitcoin was trading below $12,000. As inflation has ramped up recently, gold has continued to show weakness while bitcoin has jumped by 80% from the June low and a whopping 880% from last year’s low. Perhaps there is a new inflation hedge in the equation.

TODAY’S TAKEAWAYS

Would Volcker be able to pull off his strategy today? That’s worth pondering as a social media-connected world with financial markets on watch 24 hours a day is unlikely to let someone like Volcker implement a strategy that would cause a recession. The public scrutiny would be too much, and as with the relationship between Fed chair Jerome Powell and former President Donald Trump, politicians continue to influence central bankers who are supposed to operate with independence.

Volcker’s strategy saved the Fed’s independence, and he probably saved the dollar, too. But the cavalcade of central bankers that have come in his wake has seemed prone to honoring public sentiment and carrying out the directives of elected officials. That makes the prospect of another Volcker-like central banker doing what needs to be done a distant prospect.

So, position accordingly.

James Stanley, a senior strategist for DailyFX, helps direct educational content and produces articles and web seminars. @jstanleyfx

It is a way to take people’s wealth from them without having to openly raise taxes. Inflation is the most universal tax of all.”

THOMAS SOWELL, senior fellow at the Hoover Institution, Stanford University

Price Appreciation

INFLATION FROM 2000 TO 2020 Cumulative price change: 50.30% Average annual inflation rate: 2.06%

Is someone manipulating government inflation numbers for political gain? That’s what a lot of Americans say about the most common yardstick, the consumer price index (CPI), which tracks the cost of a basket of household goods and services and often makes headlines. If they’re paying close attention, they may say the same about the more obscure personal consumption expenditure measurement (PCE), a model based on CPI that the Federal Reserve uses to target inflation. But honorable public servants compile that data, according to former Congressional staff economist Alan Cole. “The U.S. Bureau of Labor Statistics indices for inflation are trustworthy in the sense that these people are serious, they are unbiased, they’re not trying to push an agenda,” Cole said. “Their personal honor, their integrity, is solid.” But that doesn’t mean their jobs are easy. “The very act of defining, much less measuring, inflation is actually much, much more of a judgment call than a lot of people realize,” he noted. In any case, government tallies show cumulative prices rose a little over 50% in the past two decades—as the accompanying graphics illustrate.

MISERY INDEX

7.4%

2000

9.4%

2020

10.2%

now

MEDICAL CARE

AVERAGE COST FOR MEDICAL CARE SERVICES

$40

30

20

10

2000 2020 Now

DOW JONES U.S. HEALTH CARE INDEX

360.2 1258.2 1477.9

2000

2020

Now

HOUSING

MEDIAN PRICE OF A SINGLE FAMILY HOME $363,800

for 2,261 sq ft

$225,000

for 2,333 square feet $119,600

for 2,266 sq ft

$400k

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200k

100k

2000 2020 Now

MUSICAL CHAIRS

FED CHAIRPERSON

Alan Greenspan 2000

Jerome Powell 2020, now

ANNUAL PER CAPITA PERSONAL CONSUMPTION EXPENDITURES (PCE) $23,983 (2000) $42,635 (2020)

$10,750 to $17,630

2000

TRANSPORTATION

1 GALLON OF REGULAR GASOLINE

$1.48 $2.17 $3.42

2000 2020 Now

HONDA CIVIC

$20,000 to $36,995

2020

$21,250 to $43,995

Now

EDUCATION

AVERAGE STUDENT LOAN DEBT FOR GRADUATING STUDENTS

$17,297 $30,030 $30,600

2000 2020 Now

$60k

50

40

30

20

10k

Harvard College Tuition & Fees

University of Virginia out-of-state Tuition & Fees University of Virginia in-state Tuition & Fees

2000 2020 Now

FOOD & BEVERAGE

$6

$5

$4

$3

$2

$1 2000 2020

2% milk

(1 gal)

Fresh eggs

(1 doz)

Ground beef

(1 lb)

Inflation is taxation without legislation.”

MILTON FRIEDMAN, economist

Higher Housing Prices Ahead

EVEN IF FOOD AND ENERGY COSTS DECLINE, RISING RENTS COULD SUSTAIN INFLATION

By DANIEL DUBROVSKY

Is 6.2% a lot? That was the year-overyear inflation rate in the United States in October, as measured by the Consumer Price Index (CPI), the most popular price gauge.

That means average prices rose at their fastest pace since 2008. The Federal Reserve, which manages the production and distribution of money, seems mostly unperturbed, but trends brewing in the housing market could keep policymakers on alert.

The central bank has a dual mandate to maintain price stability and pursue maximum sustainable employment. The former means the Fed is trying to target inflation that averages 2% over time.

In the interim, policymakers have been arguing that recent inflationary trends are transitory and that price growth should return to levels closer to the target by next year as post-pandemic effects fade. Still, some economists have noted upside risks of inflation.

18%

Home price appreciation year-over-year

9%

Rent increase in the same period

Prices for energy, food and shelter have been soaring. Recent housing market trends could hint at upward pressures on the CPI and core Personal Consumption Price Index (PCE), the Fed’s preferred gauge of inflation.

The central bank is expected to complete asset purchase tapering by the middle of 2022. If price pressures persist, then subsequent rate hikes may follow more quickly. This risks bringing volatility back into the Dow Jones, S&P 500 and Nasdaq Composite.

HOME PRICES

To get a better idea of why U.S. housing may keep CPI and core PCE above the Fed’s target, let’s look at data from Zillow, an online real estate marketplace. It reports that home values appreciated more than 18% year-over-year in September.

However, CPI and core PCE rely on rent to gauge housing market trends, so it makes sense to look at similar data. In the same month, Zillow reported rents up 9.16% year-over-year, well above pre-pandemic rates of inflation. Now, let’s take a look at how that compares with traditional government data.

Shelter accounts for about 33% of the CPI gauge and includes renters and owners’ equivalent rent of residences. That makes it the largest component of the index. In the PCE gauge, housing has a smaller weight, about 22.6%, according to the U.S. Bureau of Labor Statistics.

Zillow data indicates the rent slowdown bottomed in October 2020. Meanwhile, CPI shelter bottomed in February 2021 and PCE housing did the same in March. The lag between the timely Zillow figures and traditional gauges seems to be about four to five months.

Moreover, the shelter components of CPI and PCE remain below pre-pandemic trends. The lag in traditional gauges makes sense. Rising rents can take time to make their way into consumer prices for reasons that include the length of leases and the delay in raising rents as property values increase. Moreover, CPI also samples rent about once every six months. Given that Zillow rents are still increasing

year-over-year as of September, the housing components of CPI may have some catching up to do.

THE UPSIDE RISK TO HOUSING

A closer look at the data reveals that not only are traditional housing inflation gauges lagging behind Zillow data, but momentum is also underperforming. After seven months from the bottom, the Zillow rent index climbed about 5.32%. In other words, average rental prices increased 5.32% in the seven months after October 2020. That’s as the urban consumers’ shelter component of CPI climbed just 2.5% from February through September 2021.

This is not comparing apples to apples, but this data might indicate a greater chance of upside surprises in the shelter components of traditional inflation gauges in the coming months. Put another way, if energy and food prices subside, rising rents may still keep CPI and PCE above the Fed’s target. This stickier inflation may open the door to a Fed that is more eager to raise rates once asset purchase tapering is potentially completed by the middle of next year. This is something that Wall Street may not take too well because it will bring volatility into the stock market.

Daniel Dubrovsky is a strategist for DailyFX, the research and analysis arm of retail trading platform IG. @ddubrovskyFX

The central bank is expected to complete asset purchase tapering by the middle of 2022. If price pressures persist, then subsequent rate hikes may follow more quickly.

Slower rise

Zillow rents are increasing dramatically but not as quickly as house prices. The Zillow rent index bottomed in October 2020.

Zillow U.S. Home Values Index YoY Zillow U.S. Observed Rent Index YoY

Rent slowdown bottoms in October 2020

20%

15

10

5

Jan19 Mar19 May19 Jul19 Sep19 Nov19 Jan20 Mar20 May20 Jul20 Sep20 Nov20 Jan21 Mar21 May21 Jul21 Sep21

Source: Zillow

Differing views

Zillow compares its observed rent index to its home value index, with the data changed to a year-over-year basis from January 2019.

Shelter CPI component bottoms in February 2021, 4 months after Zillow rent data

U,S. PCE Index Housing YoY U.S. CPI Urban Consumers Shelter YoY 3.5%

3.0

2.5

2.0

1.5

Jan19 Mar19 May19 Jul19 Sep19 Nov19 Jan20 Mar20 May20 Jul20 Sep20 Nov20 Jan21 Mar21 May21 Jul21 Sep21

Source: Bloomberg

Indexing the indexes

This chart places Zillow, CPI and PCE data at the same starting point of 100, where the 100 represents when the three gauges individually bottomed in the preceding charts. Each point along the time period represents the change in rent and shelter since Month 0.

Zillow US Observed Rent Index (100 = 2020 Bottom) U.S. CPI Urban Consumers Shelter (100 = 2021 Bottom) U.S. PCE Index Housing (100 = 2021 Bottom)

After seven months, U.S. CPI urban consumer shelter is increasingly underperforming Zillow rent data

109.00

106.25

103.50

100.75

0 1 2 3 4 5 6 7 8 9 10 11

Source: Zillow, Bloomberg

How I Learned to Stop Worrying

and Love Deflation

BY GARRETT BALDWIN

WHY DO MAINSTREAM ECONOMISTS FEAR LOWER PRICES?

INVESTORS CAN EMBRACE DEFLATION BY BUYING TECH STOCKS AND BITCOIN.

Unemployment recently dipped to 4.6% as the economy added 531,000 jobs, according to the monthly jobs report issued in November by the United States Department of Labor. Those top-line numbers always make headlines, but a truly startling statistic is buried deep in the report.

For 14 straight months, more than 100 million able-bodied Americans have been out of the workforce. That means only 61.4% of the labor pool is on the job. That percentage has declined steadily for two decades, and it’s continuing to decrease even now with 10.9 million jobs open.

To be fair, the 100-million figure includes retirees, students, family caregivers and discouraged job seekers no longer looking for employment. But most of the jobless don’t fit those categories.

Armchair economists and political pundits have been trading barbs and assigning blame for the trend since at least 2001, when 66.7% of potential workers had jobs. They trace the decline in participation to everything from low wages to an understandable reluctance to uproot a family and move to where jobs are available. They blame Amazon’s domination of retailing. They blame Biden. They blame Trump. And now they blame COVID-19.

But what about the march of technology and the U.S. monetary system’s commitment to debt-based growth? Don’t they deserve some of the blame?

JEFF BOOTH ON DEFLATION

In January 2020, just as the pandemic was beginning to ravage the global economy, Canadian entrepreneur Jeff Booth released his book The Price of Tomorrow— Why Deflation is Key to an Abundant Future.

Booth serves as chairman of CubicFarm Systems, which develops equipment for year-round indoor vertical agriculture. He has started companies that specialize in agribusiness, real estate and technology. Through it all, he has promoted the principle of “more for less.”

He offers a simple thesis for understanding a debtbased financial system like the one in the United States: A government that creates debt to counteract the deflationary influence of technology could eventually wreck its economy.

While the U.S. may not have reached that extreme, recent trends suggest an unwillingness to embrace deflation that will aggravate chronic structural problems.

The pursuit of inflation causes many of the challenges facing the U.S. and other nations, Booth maintains. The policy centralizes wealth and power while abetting inequality, polarization and the rise of opportunistic fringe candidates.

Pursuing inflation reinforces a system that leaves many citizens feeling impoverished even though technology is raising their standard of living.

In his book, Booth asks a fundamental question: “What if, instead of trying to stop deflation at all costs, we embrace it? As technology spreads, deflation happens at the rate it should. Deflation becomes something celebrated because it means that we are getting more for less. We allow ourselves to accept abundance.”

1930’s-STYLE FEAR OF DEFLATION

Why are mainstream economists so fearful of deflation?

Keynesian-influenced professors taught them never to question inflationary policy. The argument goes that when prices fall, consumers will wait for

MORE TECH FOR LESS

$2,500

PowerBook G3 (2000)

$1,299

MacBook Pro (2020)

PRICE COMPARISONS OF 14-INCH APPLE LAPTOPS prices to fall further, thus precipitating a collapse in demand.

Booth argues that artificially induced inflation ends up increasing the cost of essentials, such as food, rent and transportation. Deflation, however, tends to link to things that don’t matter.

Technological progress has spawned deflation everywhere. Cell phones used to cost $2,000, but now they’re 10 times as powerful for a quarter of the price. The price tag for a television set has declined 98.7% in inflation-adjusted dollars since 1977.

“Does technology reduce price? Yes. That is undeniable,” Booth says. “Do we all benefit from the fact that technology gives us more freedom? Yes, that’s why we use it.”

Booth declares that as rational beings, consumers want more for less. That’s why technology companies win.

“It’s why we use Google and Amazon,” he writes. “They give us more value, we get more choice, we get cheaper products versus the status quo. Technology does that faster at an ever-increasing and exponential rate.”

Smartphones create value and provide benefits by eliminating the need for other products, including cameras, scanners, entertainment systems, banks, email networks, calendars, board games, and printed books, magazines and newspapers. Those displaced products have effectively become free.

Consumers benefit from free or reduced-priced goods, but the economic system is built on credit and would collapse with deflation, Booth asserts.

Case in point: Since 2000, governments around the world have created $185 billion in new debt. But the return on that debt hasn’t generated significant economic growth. So despite all that stimulus, the increase in the money supply produced only $46 trillion in global growth over those two decades.

History shows that every single new dollar of debt has created less economic growth than the dollar that preceded it. But even with diminishing returns from newly created money, America remains committed to what amounts to fiscal madness.

Today, every new dollar of debt creates an uptick in GDP of fewer than 35 cents, according to the Federal Reserve Board and Hoisington Investment Management. That’s well below the 70-year average of $0.61 and continuing to decline. So, a question arises: Can we still enjoy abundance when prices and wages deflate? If they fall in unison, it shouldn’t be an issue.

How does this truism go ignored, and why do Americans fear deflation?

Well, many economists blind themselves to reality by persistently looking back upon the 1950s, when

returns from debt were substantially higher. Meanwhile, many of today’s economic policies harken back to the 1930s and 1970s while failing to adjust to the structural impact of technology over the last 40 years.

Even when they’re wrong, central bankers tend to stick around a while. Then they move on to jobs in banks where they profit from the prevailing system or retire to universities to teach another generation of economists to seek inflation. Their memoirs chronicle their bravery in confronting the problems they helped to create.

OTHER DEFLATIONARY VOICES

Robert Shiller has written extensively on the deflationary influence of technology. In a 2003 Wall Street Journal column, he suggested that technology linked to deflation can cause “revenge effects” in an economy.

Shiller worried that economies faced “a cascade of consequences from recent advances of information technology like the World Wide Web, which became available to the public in 1994.”

That was 18 years ago, long before Google emerged as a public company.

But the debate about technology and deflation has been on display over the years between academics and technology-focused entrepreneurs.

In 2015, for example, venture capitalist Marc Andreessen suggested that technology creates higher living standards and lower prices but isn’t measured effectively in the nation’s economic statistics.

“While I am a bull on technological progress,” Andreessen wrote, “it also seems that much of that progress is price deflationary in nature, so even extremely rapid tech progress may not show up in GDP or productivity stats, even as it equals higher real standards of living.”

Former Treasury Secretary Larry Summers challenged Andreessen. “It is...not clear how one would distinguish deflationary and inflationary progress,” Summers replied. “The price level reflects the value of goods in terms of money, so it is hard to analyze without thinking about monetary and financial conditions.”

Summers speaks to how price levels are measured: In nominal currencies. But what’s the real issue at hand? Is deflation so bad that government should confront it with policy that reinforces Thanks to the spread of electricity and other such wonders in the final quarter of the 19th century, prices dwindled year by year at a rate of 1.5% to 2% per year. People didn’t call it deflation— they called it progress.”

JIM GRANT,

Grant’s Interest Rate Observer

We’re getting more for less ... accept abundance.

structural problems?

In a 2017 essay called “The Illusions Driving Up U.S. Asset Prices,” Shiller tackles the origins of monetary policy that result in the consequences Booth described. Shiller notes that the Fed, like other central banks, has been debasing its currency.

A Google search by Shiller indicated the term “inflation-targeting” started appearing more often in the 1990s. He says the pursuit of positive inflation— or price stability—began after the 1991 recession. He also cited Summers, who said Americans would display “irrational” resistance to falling nominal wages if the Fed targeted a “zero-inflation regime.”

Technology had a significant deflationary impact while the Fed’s 2% target rate, which Shiller called “feel-good policy,” took hold. The Economist noted in 2019 that the U.S. had experienced only a small increase in consumer-goods prices, except for food and energy, since 2000.

Booth maintains that inflationary policies not only fail to stop tech-driven deflation but also concentrate power and wealth.

Academics and economists—the people driving 20th-century monetary policy—don’t seem to comprehend the exponential impact of deflationary technology. In a recent example, Bank of England Chair Mark Carney compared artificial intelligence to harnessing the power of electricity.

“Electricity was never going to be smarter than humans,” Booth noted, adding AI’s path to superseding humans may take 20 to 50 years, but along the way it will drive exponential deflation.

To understand exponential growth, imagine putting a single drop of water on the 50-yard line during the first minute of an NFL game. A minute later, add two drops. Keep doubling the number of drops every minute. The stadium would fill with water in about 44 minutes—approximately the end of the third quarter.

Booth provides another alarming example in his book. To understand compounding growth, suppose that a single sheet of notebook paper can be folded seven times. How big would a piece of paper have to be to fold 50 times—the size of the Empire State Building? Nope. It would have to stretch the 93 million miles from Earth to the sun.

HOW THE SYSTEM WORKS

Booth notes that society can continue down the path of denying deflation exists and “pretend to get paid less to save jobs.”

But he argues that humankind can progress by adopting a deflationary system that would enable

technology to create and broadly distribute abundance. Otherwise, people are simply focused on the risk of a brave new vision.

“Printing more money is just concentrating that risk,” Booth says, adding that in the inflation-based economy people are actually paid less in real terms than they would be after the acceptance of deflation.

The concentration of power in various sectors, combined with the effort to chase inflation, forms a negative feedback loop that drives inequality of wealth.

Here’s how it works: Apple and its cell phones, computers and other devices wield deflationary power by displacing bank tellers, boardgame makers and manufacturers of everything from compasses to cameras.

Next, the government offers dramatic unemployment benefits to those displaced workers and provides even more significant capital to bail out investors who owned the companies facing obsolescence. Booth notes that America bails out rich corporate failures and socializes their losses. Refusing to allow unsuccessful businesses to fail compounds the structural problems.

In the next phase, new capital enters the system. This inflation reduces consumer purchasing power while driving up the cost of food, rent and energy. Finally, money flows to the investor class, including other deflationary companies engaging in the same cycle as Amazon, Tesla and Alphabet. These companies with monopoly power now invest in deflationary technology like artificial intelligence that will displace more workers, and the cycle begins again.

Now, while Congress sharply focuses on fiscal policy, observers might want to give monetary policy a second look. When there’s deflation, it means that although most markets are shrinking, and people have less to spend, the 1% that hold 99% in debt are getting all the growth in wealth and income. Deflation means that income is being transferred to the 1%, that is, to the creditors and property owners.”

MICHAEL HUDSON,

Wall Street financial analyst

INEVITABLE INFLATION VERSUS DEFLATION

Competition between inflationary and deflationary forces will drive greater instability in the future, Booth suggests.

He notes that technology has driven down the costs of products and services but that the financial system relies on the old definition of economics—“the

Inflationary policies not only fail to stop tech-driven deflation but also concentrate power and wealth.

management of scarce resources.” But that scarcity occurs because of the debt-based system.

And consumers will feel the dramatic advance of technology in the next decade in virtually every sector of the economy with the introduction of 5G, the growth of artificial intelligence and the proliferation of robotics.

Meanwhile, it remains to be seen how governments will manage three industries that have experienced incredible inflation over the last four decades thanks largely to dramatic debt-based support by the U.S. government: Education, healthcare and housing.

From 1977 to 2021, the price of new houses increased 385.4%, medical costs rose 820.8% and college tuition soared 1,421.5%.

So, how will a tech-driven, deflationary economy respond to those hikes in the cost of education and housing, two bedrock institutions?

Americans anticipate that the value of their homes will never stop appreciating in value, and politicians are aware that 25% of household “wealth” is linked to a primary residence. (It’s 75% in China, where the state firmly holds centralized power.)

However, Booth notes that housing prices could fall because of technological advances in construction and 3D printing, offsetting the increasing cost of labor in the industry. Booth also focuses on the bigger picture and the declining returns based on new government debt.

“People who think their house goes up forever don’t realize that it took $185 trillion of stimulus against $46 trillion of economic growth,” he says. “Now, if you believe that the next 20 years could have $400 trillion of credit growth, to grow economies by $40 trillion, then housing might be an excellent place to [invest].”

And what about education? In today’s tech-driven world, education is largely free with the right internet connection, but getting credit for educational achievement is not.

“Certification only comes because people believe they are going to get a higher paying job because of the certification,” says Booth. “And that’s not true today. It certainly won’t be true in five years.”

The 1999 film Good Will Hunting suggested one could receive the equivalent of a Harvard degree with just a library card and late fees. Today, YouTube and countless open-source online programs offer access to a world-class education. Post-COVID, fewer younger Americans are enrolling in universities and community colleges.

When people pay for a college degree merely to advance in the system itself, the government-university pact begins to look more like a multi-level

marketing platform than a reliable source of economic advancement. So, a shift in education appears inevitable, and the price model will likely change. That could enrage graduates with massive student loan debt.

Meanwhile, healthcare remains a heavily financed “rail” of American government. Costs should be declining in the sector because of technological innovation, but the government is incentivizing rising costs and aging baby boomers are availing themselves of more medical care. Those factors make it difficult to roll back the inflationary pressure in a healthcare system that represents 16% of the U.S. economy and is a significant source of wages.

One can debate the U.S. economy’s future as systemic forces collide. It’s free-market economics versus what feels like technological feudalism, centralization of power against decentralization, and inflation against deflation.

Not many leaders have recognized those conflicts, and some might even be using them to gain advantage in the political tribalism that lies ahead.

“Think about what technology looks like in five years,” Booth suggests. But doing so requires an ability to comprehend the exponential impact of artificial intelligence, robotics, cryptocurrencies and deflationary forces.

He’s forcing a conversation, one sorely needed as so many forces collide. The time is at hand when emerging technologies make most people as useless as horses, the only choice is to play by the established rules of employment and investing. That might be the best-case scenario. You should not be afraid of deflation. You should be afraid of policies attempting to fight it.”

MISH SHEDLOCK,

Sitka Pacific Capital Management

THE PATH FOR INVESTORS

So, what’s an investor to do in an economy where deflation drives down prices to meet the expectations of consumers and businesses?

Some experts suggest that guarding against inflation requires exposure to rising commodity prices, growing bank deposits, foreign markets and foreign currencies.

Companies like Chevron (CVX) and EOG Resources (EOG) have strong balance sheets and have appreciated, thanks to the recent surge in oil prices.

If JPMorgan Chase’s suggested supply-demand imbalance accelerates in 2022 and beyond, produc-

America bails out rich corporate failures and socializes their losses.

ers with low debt and significant amounts of reserves will benefit.

Then there’s the suggestion that combining exposure in foreign markets with gold, a historical inflation hedge, offers a defensive play. But gold remains below its all-time highs from a decade ago, and foreign currencies in resource-rich nations face macroeconomic challenges.

Meanwhile, most of the challenges to supply-demand balance stem from supply chain bottlenecks that could disappear in the second half of 2022.

Then there are the regional and community banks. While mergers and acquisitions continued at a pace of 3% to 5% annually before the pandemic, banking loan books have been anemic over the last 18 months. Since Booth penned his book, the SPDR S&P Regional Banking ETF (KRE) has risen from $56 to $75 (33.9%).

But the Nasdaq 100, led by companies that have fueled tech-driven deflation, has surged from $222 to $390 (or 75.6%).

This suggests a relatively simple alternative strategy. The deflationary approach is to own stock in companies that have been replacing workers with robots.

Despite their higher valuations, investors can continue to benefit from owning stock in robotics companies, A.I. firms and semiconductor producers like Qualcomm. The same goes for FAANG darlings Meta (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOG) (formerly known as Google).

And according to IBM’s U.S. Retail Index, the impact of COVID pulled the consumer curve of e-commerce forward by five years and kicked off even greater investment in digital supply chains and payment systems.

Booth has also argued in favor of bitcoin because of its deflationary nature.

“Bitcoin is already the best store of value on the planet measured by stock returns, or price returns over the last 13 years,” Booth says. “Everything measured in bitcoin is coming down in price. It’s telling you the truth. It is a free market. When I say deflationary currency, that allows for deflation. If we have real growth, we have real growth, and prices should rise, the price should rise. We shouldn’t manipulate them.”

In the next decade, the number of able-bodied Americans out of the workforce may surpass the number working, while the debt-based system continues to drive asset prices higher and enrich wealthy shareholders in companies that are replacing workers with robotics.

LUCKBOX LEANS IN WITH

ED YARDENI

Measuring Misery

BY JEFF JOSEPH

Yardeni, an investment industry veteran known as the “Wall Street Seer,” has held positions with the Federal Reserve Bank of New York, the Fed Board of Governors and the U.S. Treasury Department. He served as the chief investment strategist at Prudential Equity Group and Deutsche Bank and as chief economist at Prudential-Bache Securities and EF Hutton. He’s currently president of Yardeni Research and has written seven books on the markets and the economy. His latest, In Praise of Profits, is profiled on p. 49.

The Misery Index, one of the indicators that helps Yardeni analyze the economy, combines unemployment and inflation rates. Higher readings indicate increased economic and social woes.

Just before press time, Luckbox leaned in with Yardeni to discuss October’s inflation numbers and the latest Misery Index reading.

You’ve observed the Misery Index for decades. What is it telling you right now?

It’s clearly flashing orange. It’s always better to see the Misery Index near its historical lows. And now, we’re seeing wages going up, costs going up, supply disruptions and, as a result, the CPI inflation rate has been moving higher. The inflation rate is a very regressive tax on everybody. It’s important to see wage increases in nominal terms, but if they’re eroded by rising inflation, it doesn’t do anybody any good—all you get is a wage-price spiral.

For the stock market, a falling unemployment rate should indicate a very solid improvement in earnings. On the other hand, a rising inflation rate tends to be negative for the valuation multiple. So now we may see the market challenged by concerns about inflation because the Fed cannot continue to maintain ultraeasy monetary policy when inflation is clearly accelerating.

If the Misery Index is flashing orange, what would cause it to flash red?

If it begins to appear that the inflation we are seeing here is similar to what happened in the 1970s instead of just a passing problem related to the pandemic. But we have had experiences where soaring energy prices caused recessions, so I would be concerned about that possibility. We clearly have seen fossil fuel prices increase dramatically in China and Europe and even in the United States. If prices continue to

Mere inflation–that is, the mere issuance of more money, with the consequence of higher wages and prices may look like the creation of more demand. But in terms of the actual production and exchange of real things, it is not.”

HENRY HAZLITT, business and economics journalist

go higher, we could get a recession, which then would cause a bear market.

Are you surprised that the Fed’s prior tapering announcements didn’t precipitate a market adjustment?

Not really. The Fed has provided so much liquidity in the system that even when they start to taper they’re still buying bonds—just at a slower pace. They’re still adding liquidity to the system, and they’ve added so much liquidity since the start of the pandemic. There has never been so much liquidity. So much of it is sitting in bank deposits earning absolutely nothing. The Fed is only talking about adding

More Misery rum punch into the

And other economic punch bowl at a indicators slower pace. They’re not taking the punch bowl away.

Do you view the Consumer Price Index (CPI) as an adequate and appropriate measurement of inflation? Do you think it overstates or understates inflation?

Considering all the components of the CPI, the one that has the most immediate impact on whether we’re more or less miserable is the price of gasoline. We all pass a gas station, one way or the other, and we all fill up our tanks and see what that price is doing.

October’s 6.2% CPI number is the highest reading in 31 years. What does it tell us?

There was a morsel of good news. The yearover-year comparisons saw base-effect slowing in some segments such as airline fares. But rent costs and new car prices picked up substantially. The bottom line is that October CPI confirms that inflation isn’t transitory. It’s persistent.

What else does the recent increase in the Misery Index suggest?

Well, when the Misery Index is rising, political incumbents become more vulnerable. This could have a tremendous impact on who’s in the White House. Jimmy Carter arguably lost largely because inflation was viewed as out of control. If there is no change come midterms, the Democrats are vulnerable to losing their majority in both houses. And if Biden runs again he’s vulnerable to losing to a Republican.

Assuming energy prices do not move materially higher, does the market continue to advance?

Yes, I believe so. I’ve got 4,800 [for the S&P 500] by the end of this year, 5,200 by the end of 2022 and 5,800 by the end of 2023.

Misery, the Markets and Presidents

Market technicians and economists note the inverse correlation between the Misery Index and the stock market. Former Presidents Nixon, Carter and Trump could attest to its ability to predict political shifts.

25 Misery Index S&P 500

20

15

10

5 5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,000

1,000

500

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 2021

Source: Misery Index

19.5%

The highest two-year average for the Misery Index since the Great Depression occurred in 1979/80 during Jimmy Carter’s administration.

10.8%

The Misery Index (as of 11/25/21)

CRYPTO CURRENTLY THE STATE OF CRYPTOCURRENCIES AND DECENTRALIZED FINANCE

Inflation Has a New Hedge

BITCOIN OFFERS INVESTORS A WAY TO OFFSET THE DECLINING VALUE OF ASSETS

By MARK HELFMAN

The best hedge against inflation? Bitcoin.

Because no matter what happens, the world will never have more than 21 million bitcoins. Plus, no one has shown that the price of bitcoin is tied to any other asset class.

With growth averaging 200% annually since its inception in 2009, bitcoin occupies a unique place in the world. It defies comparison with just about anything, including inflation. Think of it as an entity onto itself, uncorrelated with any realworld asset or even any financial asset.

What’s more, there’s no way to produce more bitcoins to meet increased demand. Once miners have created enough bitcoins to reach the cap of 21 million, they’ll have no way to produce more.

That’s not the case with gold, the go-to inflation hedge of the 1970s. The supply of Au, as it’s called in the periodical table, is virtually infinite. Latter-day ‘49ers will always be able to extract more of it from the earth. That’s true because mining gold that might seem inaccessible right now will become worthwhile if the price of the precious metal climbs high enough.

That will never happen with bitcoin. So, stripping out the volatility, the value of bitcoin will increase in price as long as governments print money and investors continue to move some of that money into bitcoin. It’s programmed to do that, and no one can change it.

However, investors should bear in mind that the supply of most other cryptocurrencies isn’t capped. Anyone can sit down at a laptop and magically create a new cryptocurrency with infinite supply. As long as people buy it, the price will continue to go up.

Cryptocurrencies like that don’t neces-

Institutional investors appear to be returning to bitcoin, perhaps seeing it as a better inflation hedge than gold.”

JPMORGAN, October 2021

sarily provide a hedge against inflation because more tokens can keep coming into the market. That’s exactly what can happen with some of the big names in crypto—like Dogecoin.

But don’t disparage the thousands of cryptocurrencies now circulating just because they weren’t designed with inflation-resistant ceilings on the number of possible tokens. Some have other advantages.

To program a decentralized-finance crypto that facilitates borrowing and lending, for example, the creator could build in inflation by increasing the number of tokens outstanding by 1,000% annually. That results in a high APR (annual percentage rate) for those who lock the tokens into liquidity pools to build capital. The problem is those tokens can lose value quickly.

Using another tokenomic model— called pre-mining—someone manufac-

tures a huge quantity of tokens and keeps a lot of them. Ripple, a currency exchange, did that by minting 100 billion XRP tokens, retaining 65 billion and paying itself up to a billion tokens each month for years. So how good a hedge against inflation is that?

Meanwhile, institutional investors and even a few countries, such as El Salvador and Bulgaria, are buying bitcoins or investing in funds that track bitcoins. Endowments that include the Houston Firefighters Relief and Retirement Fund are taking positions in bitcoin, too.

Often the investment in bitcoin remains small relative to total portfolios. The Houston Firefighters, for example, have $5.5 billion in their pension fund, and about $25 million of it is in bitcoin and ethereum.

Inflation has made those cryptos more attractive to investors, but other factors are at work, too. In the modern investment landscape, it’s so difficult to generate safe

One of these not is like the others

While the Consumer Price Index has increased 7%, bitcoin has increased dramatically and gold has remained relatively flat.

Consumer Price Index

272.5

270.0

267.5

265.0

262.5

260.0

257.5 60000

50000

40000

30000

20000

10000

Bitcoin

Mar2020 May2020 Jul2020 Sep2020 Nov2020 Jan2021 Mar2021 May2021 Jul2021 Sep2021 Nov2021 2000

Gold

1900

1800

1700

1600

1500

yield that investors should have exposure to new opportunities to grow or at least preserve wealth. Having a little bitcoin does that.

Mark Helfman, crypto analyst at Hacker Noon, edits and publishes the Crypto Is Easy newsletter at cryptoiseasy.substack.com. He is the author of Bitcoin or Bust: Wall Street’s Entry Into Cryptocurrency. @mkhelfman

HOOKED Visit DailyFX.com for continuous updates on global markets in currencies, commodities, and ON THE stock indices.

MARKETS?

How China “Controls”

Inflation THE MIDDLE KINGDOM’S COMMAND-STYLE ECONOMY IS KEEPING CONSUMER PRICES ARTIFICIALLY LOW. IT CAN’T LAST.

By ANDREW PROCHNOW

As most of humanity grapples with inflation, China finds itself in an unusual position. Consumer prices have barely inched up there, while the cost of doing business has increased substantially.

The divergence, rooted in the nature of the Chinese economy and the country’s system of governance, demands a closer look.

The price of household goods in China—as measured by the Consumer Price Index (CPI)— came in at 0.7% in September and is expected to average about 1.4% for all of 2021. That’s remarkable compared with the 6.2% CPI for the year in the United States.

But that doesn’t tell the whole story.

In China, the Producer Price Index (PPI) has skyrocketed this year to nearly record highs. The PPI records prices of industrial goods produced for the domestic market, a key metric in an industrial country like China.

By August, the PPI in China rose 9.5% compared with a year earlier. That’s the third highest reading since the Chinese PPI was first published in 1996. It was higher only in July and August of 2008, when it reached 10% and 10.1%, respectively.

Taken together, the CPI and PPI suggest inflation has taken hold in China but indicate that businesses, not consumers, are shouldering the burden.

CHINA’S COMMAND-ISH ECONOMY

In the United States, the difference between the CPI (5.4%) and PPI (8.6%) seems a lot less extreme.

That balance suggests U.S. businesses are absorbing some of the shocks of rising prices but passing along part of the problem to consumers. Chinese businesses are apparently bearing a much bigger load.

That disparity arises because China doesn’t operate as a free-market economy. Instead, it mixes free-market principles with characteristics of command economies. Ultimately, China leans toward the latter, which means the government exercises heavy control over how the nation uses land, capital and resources— in other words, just about everything. In the United States, the private sector holds sway to a great degree.

So in China, the government decides—to some degree—who pays more when prices are rising. Moreover, it has been cracking down this year on what some see as the excesses of free enterprise, calling upon domestic businesses to embrace “common prosperity,” as opposed to pure profits.

And because of the country’s totalitarian system of governance, Chinese leaders can order factories and businesses not to raise consumer prices, which

China’s burgeoning debt

Businesses in China owe so much that economists fear too much additional borrowing there could trigger a financial crisis. $ tn

Cumulative TSF increase since 2002 Cumulative GDP increase since 2002 40

35

2009 - 2020 $1 debt = $0.45 GDP 30

25

20

2002 - 2008 $1 debt = $0.41 GDP 15

10

5

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: pH Report, China National Bureau of Statistics

$21t

U.S. GDP (world’s highest)

$15t

China’s GDP (world’s second highest)

is undoubtedly what transpired this year.

This arrangement causes problems because most Chinese businesses are competing in global markets for raw materials and other commodities. After all, the Chinese government can’t order foreign suppliers to charge lower prices—especially in highly efficient markets where demand outweighs supply.

Hence, the current inflationary environment is forcing Chinese businesses to operate on thinner profit margins—if not at a loss—and that’s not sustainable.

Chinese corporate debt is already extremely high, which means increased lending would aggravate an already tenuous situation. The challenge of rising costs, combined with a slowdown in corporate lending, might explain why some parts of the Chinese economy are starting to exhibit signs of distress.

Chinese property developers have been under pressure in recent months as they struggle to service mounting piles of debt. The China Evergrande Group, one of the most often cited examples of a company circling the drain, reportedly has liabilities in excess of $300 billion.

Economists warn that onerous debt in China could

The price of household goods in China is expected to rise about 1.4% for all of 2021, compared with 6.2% in the United States.

By order of the Chinese Communist Party, businesses—not consumers— are shouldering the burden of inflation.

Annual U.S. inflation

American consumers are feeling the pain of rising prices, but China is forcing its businesses, not consumers, to bear the brunt of higher costs.

6.2

3

1.7

1.5

0.8 0.7 2.1 2.1

1.9 2.3

1.4 6

5

4

3

2

1

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

U.S. Bureau of Labor Statistics

trigger a financial crisis. That fear is based on red-lining levels in the Chinese ratio of debt-to-gross domestic product.

The debt-to-GDP ratio measures a country’s total debt (government, corporate and consumer) relative to what’s produced in the country. That metric is commonly used to evaluate a country’s financial health and ability to make good on its debts.

In the last quarter of 2019, the Institute of International Finance estimated the public debt-to-GDP ratio in China at 302%. And by May of 2020, it had risen to an estimated 318%—the largest quarterly increase on record for the Middle Kingdom.

For context, the World Bank has characterized debt-to-GDP ratios above 77% as suboptimal and warned that the resulting debt service could threaten a country’s economic potential. By comparison, the U.S. debt-to-GDP ratio is roughly 98%, based on estimated net public debt of $20.3 trillion divided by estimated GDP of $20.6 trillion.

With Chinese corporate debt already high, the government probably wouldn’t want to combat rising inflationary pressures with additional lending. Inflation is essentially antidemocratic.”

LUDWIG VON MISES, Austrian School economist

Those hard realities may help explain why the Chinese stock market has been under pressure in recent months. For reference, the KraneShares CSI China Internet Exchange-Traded Fund (KWEB) is down more than 50% from its 52-week high, currently trading at about $50 per share.

With the system straining under these pressures, it seems likely the Chinese government will soon be forced to capitulate and allow manufacturers to pass along a higher portion of rising costs to consumers. In fact, those changes may already be in motion.

THE PRICE OF SOY SAUCE

One sign of a shift in the Chinese inflation story can be tied back to one of the country’s most iconic inventions: soy sauce.

Soy sauce, a staple in every Chinese household, might be compared to table salt in the United States— it’s ubiquitous. Soy sauce, brewed by fermenting soybeans, grains, mold cultures and yeast, is believed to have been created in China 2,200 years ago.

In October, one of the best-known soy sauce manufacturers in China, the Foshan Haitian Flavouring and Food Company, announced it was raising prices by about 7% across the board. Besides soy sauce, Foshan Haitian also produces and distributes vinegar, chicken stock and cooking oils.

The company cited the rising cost of raw materials, transportation and energy in the announcement.

With soy sauce such a staple in China, it appears that the government has finally agreed to pass on some portion of inflation to consumers. Foshan Haitian could not have made such a move without the government’s tacit approval.

So cracks are now forming in the protective shield for consumers, who will apparently be shouldering a larger share of the inflationary burden.

That shift should help alleviate some of the pressure building in the Chinese business sector. But the government will still need to resolve the country’s long-ignored problem of corporate debt or else international equity and debt markets might do it for them.

Andrew Prochnow, an avid, longtime options trader, has written extensively about professional tennis and contributed articles to the Bleacher Report and Yahoo! Sports.