Inflation Conflation: An Economic Chicken/Egg Question

“In theory, there is no difference between theory and practice. In practice, there is.” - Yogi Berra

The concept of situational irony is so old and abstract, featuring from ancient Greek poetry, to Shakespeare, to Yogi Berra, that it seems more suited to a classroom than to modern day financial markets. But just as H.G. Wells described World War I as “the war to end all wars,” not realizing that it planted the seeds of an even greater conflict, irony has the habit of striking when and where we least expect it. Today, policymakers face a set of increasingly critical choices that could end up shaping our quality of life for a generation. We think some changes in their inflation framework, without being fully debated and understood, may ironically end up exacerbating the very problems that such policies were intended to alleviate.

Fed Policy, Demand Growth, and the Quandary of Inflation

One could paraphrase the Fed’s dual mandate of full employment and stable prices as being intended “to preserve the purchasing power of as many as possible” – or, to create the best quality of life for the community it serves. So, how do varying levels of inflation impact this mandate? On one hand, prices that are falling too quickly have the potential to hurt purchasing power by raising the real value and servicing cost of liabilities. On the other hand, prices that are rising too quickly can hurt purchasing power by reducing the real value of income, and both these extreme situations can be detrimental to psychology and economic decision making (see Figure 1).

Not all price changes impact purchasing power the same way, but in aggregate, there is a healthy middle ground that allows for a sustainable debt load while also supporting the quality-of-life-enhancing process of creative destruction. On the back of a blockbuster April inflation report that hinted at overheating, the question of what constitutes that healthy middle ground, and whether it needs to be above 2% or not (Federal Reserve policymakers tend to believe that it does), has never been more important.

Figure 1: Prices That Fall/Rise Too Rapidly Can be Economically Detrimental

Growing demand, or expanding investment, are typically supportive of quality of life improvements, an idea that likely draws little argument. More debatable though is a theory that inflation proponents often peddle, stating that higher levels of inflation foster growth and incentivize expansionary investment. Yet, we think there is a “leap of logic” embedded in this theory; an incredibly important nuance that must be isolated and understood: Inflation is a consequence of demand, not a catalyst for it.

From the demand perspective, higher prices typically quell consumption, or can lead to product substitution. Very rarely, if ever, do higher prices perpetuate greater demand. Historically, it was easy to conflate the relationship between inflation and expansion, because in the world of hard assets and tangible goods demand growth inevitably drove inflation higher until long-lived supply expansions could come on-line. Demand wasn’t following the inflation; it was causing it. Investment wasn’t following inflation; it was chasing the demand. So, while higher prices can be alluring for enterprising businesses, durable investment needs sustained demand growth. Otherwise, above-market inflation profits can be quickly arbitraged away with only marginal supply. In short, policy should be set with an understanding of where demand is and can be durable, rather than on managing temporary swings.

From the 1950s through the 1980s, residential real estate investment was the single largest contributor to private-sector fixed investment, accounting for more than 50% of all private investment on a price-adjusted basis (and about 30%, on a nominal basis). That investment was chasing a multi-decade boom in demand as over 17 million new households were formed from 1960 to 1985. However, in the 25 years since 1995, household formation dwindled to less than half that rate, and probably unsurprisingly on the back of that lower demand, the residential real estate share of private investment declined by more than half, to less than 25%. Moreover, in full concert with those demand/investment trends, shelter inflation that had averaged 6.0% from 1960 to 1985 subsequently sunk to just 2.7% for the 1995 to 2020 period.

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Still, why was shelter inflation running so hot in the mid-20^th century, rising from 5% to 20% per year? There was a multi-decade runway of demand growth, and expanding supply was a very labor, materials, and commodity-intensive process, with years-long lead times with no real scalability. It wasn’t until demand slowed that inflation softened as well. Further, the investment boom/bust in the oil industry over the last 10 to 15 years followed a similar pattern: China emerged as a massive new energy user, more than doubling its oil consumption from 2000 to 2014, which inflated prices to well over $100/bbl before supply could adjust. However, in another long-lead-time, labor and materials intensive industry, an innovative new technology (shale fracking) brought efficiency and scale, unleashing an equally large supply wave. As China’s consumption growth eventually slowed, U.S. consumption declined and the launch of electric vehicles dented the forward demand outlook, so prices collapsed to levels not seen in decades, in part because those efficient, technological breakthroughs pushed marginal production costs down dramatically, enabling profitability at lower prices.

So where are Demand, Investment (and Capacity) Growing Today?

The largest contributors to private fixed investment today are information processing equipment, software IP products and research and development, which collectively account for 37% of the total. On a price-adjusted basis, information processing equipment investment has grown 8% annually since 2000, taking its share of total private investment from 6% in 2000 to greater than 17% today. More staggering: since 2000, these three categories have accounted for more than 84% of the marginal investment spending in the U.S., on a price adjusted basis. Amazingly, U.S. production capacity for computers, communications equipment and semiconductors has increased an astounding 111x in the last 30 years, and all of this investment has taken place in an extremely deflationary price environment (see Figure 2).

Figure 2: Technological Production Capacity has Soared in the Last 30 Years
(US Industrial Capacity Index)

As a case in point, fifty years ago, a new HP 3000 computer would have set one back by $95,000. Had one made such a cutting-edge purchase back then, one might have felt cheated when about a decade later, Apple’s Lisa computer hit the market at a mere $9,995. Yet, another decade later, IBM managed to add a CD player to its ThinkPad laptop (a novelty at the time) and still lop 20% off the Lisa’s price. Of course, these are almost comical examples when compared to the prices and relative computing power of today’s laptops, and where smartphones are handed out for free by service providers trying to attract customers. In an age where internet access is bordering on joining food, shelter, and clothing as one of life’s basic needs, accessibility to computers has never been more important and has never been cheaper.

In a world without the demographic tailwinds of the 1960s, where U.S. per capita oil consumption is down nearly 30% from its peak, and in which industrial capacity utilization makes new lows with each successive cycle, the demand that investment is chasing today is the demand for efficiency. And durable demand exists alongside of disinflationary, efficiency-driven trends. The big five tech companies; Amazon, Apple, Google, Facebook and Microsoft are not investing hundreds of billions of dollars annually because they expect higher prices in the future – they are investing that capital because they see tectonic shifts taking place in the demand for content, 5G networks and cloud computing. Notably, this demand is raising the standard of living for Americans, and in many cases is doing so at an ever-cheaper cost.

How Does this Relate to Policymakers’ Inflation Mandate?

Through the 1960s and into the 1980s, the primary contributors to inflation were shelter/rent, food, transportation, medical services, and fuel/utilities. Taken together, these categories routinely contributed 5.5% annual inflation over the course of those three decades. And while we acknowledge that much of that inflation was a by-product of Baby Boom-led demand growth and standard-of-living improvements, and should perhaps therefore be more patiently tolerated, we must also call out that these consumption cohorts are all human necessities. And because of this truth, pursuit of inflation for inflation’s sake poses as a very real problem.

That problem is that inflation in daily necessities is disproportionately felt by lower-income cohorts. For example, lower income earners spend around 35% of their income on rents, while that figure is negligible for upper-income households (see Figure 3) that mostly own (and are in that manner benefiting from brisk home price increases). The same concept applies to such basic needs as food, apparel, transport (used cars or rental cars) and healthcare (medical services). From the most recent inflation report, used car inflation of 21%, or water utilities inflation of 3.6%, or gasoline prices up 50%, are a direct hit to lower income households, especially as they attempt to re-enter the job market. For a Fed that is embracing more socio-economic indicators in its quest for a sustainable recovery, it seems highly ironic that policies which would disproportionately harm the purchasing power of lower-income cohorts are being pursued in order to achieve inflation goals. Indeed, it’s hard to explain how the rising cost of such basic needs as healthcare and shelter are beneficial to greater economic equality?

Figure 3: Inflation Differs Greatly By Income Cohort

If core goods prices are in deflation over the next 20 years, like they have been for the past two decades (taking about -48 basis points off of annual core PCE), then let it be (see Figure 4). And rejoice in the fact that it improves the purchasing power of lower income households. Goosing demand today to goose inflation only creates a contractionary, deflationary hole tomorrow, in a way that worsens income and wealth gaps. If the result is an inflation “index” that averages 1.5% instead of 2.25%, isn’t the system still meeting the Fed’s statutory mandate of price stability?

Figure 4: Core Goods Price Deflation Has Aided Lower Income Households for 20 Years

An incredibly benign economic backdrop preceded the pandemic, such that the temporary shock associated with the sudden economy-wide shut down could be overcome with a swift, aggressive, one-off policy response that bridged the temporary gap associated with lost income. Indeed, the combined monetary and fiscal response in the second quarter of 2020 was highly effective in this regard, and the U.S. economy was recovering solidly even before vaccine ubiquity became a reality. However, ongoing adherence to the newly minted Average Inflation Targeting (AIT) framework in the face of a torrid 2021 economic recovery that is visibly supply constrained, risks upending the very stability that the AIT framework claims to seek to achieve.

The Oxford English Dictionary defines irony as “a state of affairs or an event that seems deliberately contrary to what one expects.” The lessons from the classroom suggest that it is not out of the realm of possibility that should overly easy policy measures overstay their welcome, we may end up moving not toward the goal of “preserving the purchasing power of as many as possible,” but precisely in the opposite direction.