Age Of Disruption Part 4: Between a Rock And a Hard Place
The US economy, while recovering, is now at a pivotal juncture. We are facing both slowing growth and increasing supply-side inflation. The Federal Reserve Board (FED) has to decide between two different paths, maintain its dovish easy money policy in an attempt to keep growth strong or switch to a hawkish path of less stimulus and higher rates to keep inflation in check.
The Dovish Path
It seems that the FED prefers to take a dovish path, with countless examples in recent years of central banks being too hawkish too soon, only to backfire. Instead of reacting to high inflation now, the FED adopted a new policy framework of average inflation targeting, which includes previous low inflation levels in the calculations. They think that this catch-up inflation will provide a buffer and enough time for inflation to subside on its own. If inflation is going away anyway, then acting now could hurt the economy. It seems the best choice of action is to wait and see.
The FED has many reasons not to act:
- There hasn’t been significant inflation in over 40 years and they don’t believe that would change now.
- The FED projects inflation is persistently transitory or episodic and will fade in H2 2022.
- GDP growth slowed to 2% in Q3.
- The removal of fiscal policy stimulus will create a 3.5% drag on GDP in 2022.
- Congress is seeking to raise taxes on wealthy companies and individuals, which according to supply-side economists, could further slow growth.
- Raising interest rates could cause the Dollar to appreciate in value, making foreign goods cheaper and increasing imports when the supply chain is already overburdened.
- Worker participation rates are still below pre-pandemic levels. The FED believes the worker shortage will resolve as people return to the labor force, stabilize wage growth, and keep inflation in check.
- The FED is very concerned about repeating the 1980s recession caused when FED Chair Paul Volker rapidly raised interest rates. Today, companies are even more vulnerable to rake hikes due to the record $11.2T of corporate debt.
- Companies are already dealing with labor shortages, supply chain issues, commodity price increases, and an energy crisis. Raising interest rates would only increase corporate borrowing costs while pushing those unable to refinance at higher rates into bankruptcy.
- Even the slightest interest rate hike could add hundreds of billions in interest payment obligations to the US government in a very short period of time.
At the end of 2020, Total US government debt reached $27.7T with interest payments of $345B, roughly a 1.2% interest rate and 5.2% of the annual budget. The US government is highly dependent on short-term financing, with an estimated 50% of its debt being rolled over every two years. This scheme saves the US hundreds of billions of dollars but also makes the government vulnerable to interest rate shocks. Take your pick of how borrowing short-term for long-term debts works out through history, Lehman Brothers 2008, Asia Currency Crisis 1998, etc.
At best, raising rates would push the government to raise taxes or pursue austerity measures, and both options would hurt the economy. At worst, it puts the United States Federal Government’s solvency in question.
The doves think that many of the inflation scenarios are simply overblown and it isn’t worth the risk. After all, hyperinflation in the US is a crazy idea, right?
The Hawks Are Circling
According to the hawks, the FED has lost the plot.
The FED famously claimed there wouldn’t be any inflation. Then, they claimed there would be inflation, but it would be transitory. Now, they have moved the goalposts again and claim that the drivers of inflation are transitory. The FED is quickly losing credibility, and the markets are slowly pricing in them being wrong again, currently predicting multiple rate hikes in H2 2022.
Inflation continues to increase because people have money and they are looking to spend. The fastest wage growth in 20 years and $2.7T in pent-up savings has created demand in the US and Europe that hasn’t slowed since the recovery began. This excessive demand is driving inflation by putting more pressure on the supply chain than it can handle. Until consumer demand declines or there is an increase in production capacity, inflation will likely accelerate.
Yet, production capacity has declined due to the climate crisis, the energy crisis, continuous COVID outbreak lockdowns, demographic decline, and labor shortages. Meanwhile, the FED continues to stimulate demand with ultra-low interest rates and Quantitative Easing (QE). This stimulation when consumer demand is already too high could result in unmitigated runaway inflation.
These issues won’t resolve themselves on their own. For inflation to abate, the FED and policymakers must take stock of what’s driving these crises and intervene. Money supply and labor supply are two critical drivers that warrant a closer look.
Too Much Money
One school of thought, from the Monetarists, believes the rapid increase in the M2 money supply is driving inflation and will lead to hyperinflation in the US.
The typical thought experiment used to explain monetary inflation is to imagine everyone wakes up one morning and finds their bank accounts all of a sudden have $10K more dollars in them. If everyone went out and used that money to buy goods, the sudden increase in consumption without equal production would vastly increase prices.
But that isn’t exactly what has happened. Over $4.25T entered the money supply through QE. While QE increases the money supply on paper, it never enters circulation. The FED buys assets from banks and increases the bank’s reserves at the FED, earning the same rate as the underlying asset. It’s a non-cash transaction.
Several trillion more came in the form of loans, which will leave circulation as they are paid off.
Finally, the direct payments that went to individuals were used to offset a significant loss of income and didn’t create additional consumption.
Much of the money that did end up in circulation didn’t go to buying additional goods. Money that is used to buy goods and services is measured by monetary velocity, which has plummeted. While the stimulus measure may have some contribution to inflation, its impact pales in comparison to the other drivers. According to the FED, the American Rescue Plan only contributed 0.3 percent to inflation. The pent-up savings demand we see now has much more to do with people earning full salaries during the pandemic and not having enough places to spend it.
The other explanation of monetary inflation is due to printing dollars: as the US currency becomes devalued, making US goods increasingly cheap and spurring foreign demand for US exports. This happened during the 1970s. But, today every other nation has been pursuing the same stimulus strategy. However, the dollar’s value has only lost 7 points since the start of the pandemic and is on the mend. This is far from the 40 point drop seen in the 1970s. And, while US exports are above pre-pandemic levels, they haven’t taken off, as would be expected by the hyperinflation model.
There are several other reasons the monetarist explanation doesn’t add up:
- The Monetarist school believes the 1970s stagflation cycle was caused by the government spending on Great Society programs in the 50s and 60s, not getting off the gold standard, and the energy crisis outlined in Part 2.
- The US government has been deficit spending for decades with minimal inflation which Monetarists can’t explain.
- No country in modern world history had experienced hyperinflation when their debts were denominated in their own currency. The Weimar Republic’s debts were in Dollars as they printed Marks.
Not Enough Labor
In the 1970s, there were oil shocks that shook the economy. In the 2020s, we have labor shocks. A lack of labor is one of the biggest drivers of supply-side inflation, from clogged supply chains to increases in food prices, medical care, services, and shelter. Demographic decline only accounts for the loss of 650K workers per year from the labor force, yet there are currently 4.2 million fewer workers in the labor force than before the pandemic.
- 3M went into early retirement and aren’t likely to return in mass.
- 700K are immigrants waiting on a visa backlog from 2020.
- The remaining 400K are believed to be either:
- Limited due to the lack of child care and waiting for the kids’ vaccine rollout.
- Living off of savings and will return when those become depleted.
- Are one of the 1 million who became entrepreneurs and often don’t appear in the unemployment data.
- Got long Covid and are permanently disabled.
- Are one of the 750-925K excess deaths during the pandemic and are never returning to the workforce – no one knows for sure.
In all likelihood, we will never reach pre-pandemic levels of employment. Even if you assumed the physically impossible and the US achieved 100% employment, there would still be 2.8 million vacancies, which continues to grow as we create jobs faster than we can fill them.
There are a handful of ways governments can address the labor shortage.
- Automation (420K Jobs): There are 3 million industrial robots currently in use, up 14% in 2020. While automation is being pursued, it will also be slow to roll out. Many jobs can’t be automated and won’t fix the current shortfall.
- Immigration (750K Jobs): If immigration to the US returned to 2016 levels, that would amount to 1 million people a year, with 3/4th participating in the workforce. But we’re unlikely to reach those levels anytime soon due to pre-existing backlogs.
- Criminal Justice Reform (1.5M Jobs): Currently, about 1 million people are incarcerated for non-violent drug offenses, and an additional 500K are presently incarcerated because they can’t afford bail. Mass pardons and bail reform are strategies that could help alleviate the labor crisis, but implementation is doubtful.
Zombie companies are the only source of labor large enough to address the crisis. An estimated 10-20% of American businesses are considered zombies, only making current interest payments on debt but not growing or able to refinance at higher interest rates. They are only kept alive through government stimulus programs and ultra-low interest rates. Their existence is a misallocation of both capital and labor and is a continuous drag on GDP.
Most importantly, zombie companies create a contagion effect across the US economy, subsidizing losers and harming winners. According to the National Association of Business Economics survey, 47% of US businesses have worker shortages, up from 32% in Q2. Those extreme shortages hurt company’s revenue, productivity and drive inflation.
Raising interest rates would force zombie companies to decide: either restructure their debts and re-enter a growth phase, much like we’ve witnessed in the retail industry in the past year, or liquidate their business, freeing up labor to more productive ends.
What to Do? What to Do?
The FED, and for that matter, policymakers in general, have few levers they can pull or leave untouched. Every potential move is fraught with peril.
Price Wage Spiral
Letting inflation catch up means wages will also need to catch up. In the 1970s, ample labor markets, combined with supply-side shocks, led to mass unemployment and inflation outpacing wage growth, effectively destroying all wage gains from the 1950s and 1960s. Today’s declining working-age population and workforce shortages mean wages will exceed inflation, causing a wage-price upward spiral in the new year after workers receive their end-of-year cost of living adjustments. The pursuit of higher wages and benefits is the primary driver in the great resignation. In professions where jumping ship won’t improve wages, strikes are starting to break out.
If the doves are concerned about the sheer amount of debt, then raising rates is the only way to stop debt accumulation. Super-low interest rates cause governments and companies to overspend because the actual cost of borrowing is hidden. The only way to end deficit spending and create budget discipline is to increase rates. The longer this goes on, the worse the debt situation will be.
Taxes and Liquidity
And then, there is the option of taxation. This isn’t 2008. Instead of a lack of liquidity, we’re drowning in excess liquidity. There is simply too much money chasing too few deals and products. The banks have run out of places to stash cash. They have put $1.5T in the FED’s reverse repo facility, earning negative real rates, because there is nowhere else to put it. Taxes on stagnant capital, far from hindering growth, could create a budgetary surplus used to pay down the debt and fix the crumbling infrastructure that has contributed to inflation.
Decades of divestment in ports, roads, trains, and bridges is a significant reason our supply chain cannot keep up with consumer demand. Port operations are cobbled together with email and spreadsheets. Trucking is still managed through online forums and Facebook, both lacking modern automation. Bridges are falling apart and causing 100-mile detours and potholes are destroying truck chassis and exacerbating the shortage. All of this puts increased pressure on the FED to take action and limit inflationary forces.
No matter which path the FED decides, there will be consequences. The best-case scenario is they are able to thread the needle by increasing rates slowly and giving companies time to adapt. The worst-case scenario is they wait too long and are forced into a handbrake maneuver and effectively ensure the recession they wish to avoid.
How Companies Can Thrive During Disruption
Be prepared for whichever path the FED ultimately decides to take, which will likely result in some or all of the items below. With these in mind, focus on creating independence and a buffer so you can remain flexible as this plays out.
- The current economic condition is stagflation: Expect continued runaway inflation and slow GDP growth until the FED is ready to take action.
- Be prepared for interest rates to be raised drastically in a short period of time.
- Expect the de facto minimum wage to reach $25/hr by the end of 2022.
- Be prepared for a 15% minimum tax on all businesses and the rolling back of many tax provisions in the Tax Cuts and Jobs Act of 2017.
- Expect the energy and food crisis to worsen over the winter, along with sustained higher commodity prices.
- As we exit the super low-interest-rate environment, government deficit spending will become a thing of the past. Taxes will continue to increase as governments find ways to cut expenses. Additional government spending that doesn’t increase productivity (infrastructure), get people back into the workforce (childcare), or address further demographic decline (paternity leave) may be considered wasteful and on the chopping block. If you received any government subsidy or tax credit, be prepared for those to go away.