INTRO: Eversince the fed started
to print boatloads of money, people have been concerned about the potential of high inflation.
For quite some time, Jerome Powell dismissed these concerns claiming that if there was
elavated inflation readings, it would be transitory. Despite his confidence, many were
still skeptical about inflation being transitory. I mean, basic logic would tell you that increasing
the money supply by $6.4 trillion would have some sort of economic consequence. Nonetheless,
Jerome continued to claim that inflation would be transitory meeting after meeting after meeting.
After a meeting with Joe Biden near the end of last year, however, Jerome would basically turn
on a dime. Suddenly, Jerome thought that the word “transitory” should be retired when it came to
describing inflation. Aside from admitting that inflation had gotten way out of hand,
the entire fed became extremely hawkish. They went from raising interest rates 0.25% per meeting to
0.5% per meeting to 0.75% per meeting. Now, there’s even rumors that the fed will raise
interest rates by a full percentage point in one meeting. Despite all of their efforts,
we have yet to see inflation reading peak in a meaningful way. In fact, the latest CPI reading
put year over year inflation at 9.1%, and it seems like 10% could be just around the corner.
So, whatever happened to “transitory” inflation and how did the fed get inflation so wrong?
TRANSITORY INFLATION EXPLAINED:
Before we get into why the fed thought inflation would be transitory,
I think it’s important to discuss what exactly they meant by transitory inflation
in the first place. Many often people associate transitory inflation with transitory price hikes,
but this is not what transitory inflation means. Transitory inflation simply means that the
inflation reading itself will come down to normal levels of 2-3%. In such a scenario, the price
hikes would still be permanent. It’s just that the time period in which prices were being hiked
wouldn’t last that long. For prices to actually go down, inflation would not only have to come down,
but it would have to go negative and we would have to see deflation. This is obviously not something
that the fed promised. So, hopefully that cleared up the confusion between transitory inflation and
transtiory price hikes. But, why did the fed even think that inflation would be transitory in the
first place. They literally just increased the money by 33% within a matter of 2 years.
Well, one of the reasons the fed believed inflation would be transitory is surging demand.
You see, the first time we saw elevated inflation readings was in the second quarter of 2021.
This was shortly after vaccines started to become widely available throughout America.
So, the theory was that economic participation rose significantly throughout this time period
as people started to freely go to restaurants, bars, hotels, vacations,
shopping, etc. This unprecedented influx of demand would of course allow companies to raise prices.
But, overtime, it was expected that people would pull back spending to normal levels which should
theoretically ease demand and allow prices to stabilize. Aside from this surge in demand, the
labor market was still rather weak. Throughout the first half of 2021, we primarily saw unemployment
figures in the 5 to 6% range. As you can see, this is a rather high reading on a historical basis.
So, even though some people were getting their vaccines and spending like crazy,
a good portion of America was still struggling to get a job and make ends meet. These guys were
obviously not going to be spending a bunch of money, so it was expected that these folks would
continue to weigh down demand which should keep inflation in check. The problem with this theory,
however, was that the labor market would recover faster than anyone expected. Usually, it takes
several years for unemployment to drop from 6% to 3%, but this time it only took a matter of months.
So, not only were people spending more money, but the labor market was stronger than ever.
On top of these theoretical reasons, I suspect recency bias also played a role in the feds
perspective. Eversince the 2008 financial crisis, inflation has been extraordinarily low.
In fact, throughout much of the 2010s, the fed had to fight to prop up inflation to 2% because it
kept dropping towards 0. Not to mention, it’s been nearly 50 years since we saw high inflation, so it
wouldn’t be that surprising to hear that the Fed’s perspective was skewed by recent economic history.
WHY THE FED WAS WRONG:
Alright, so we’ve discussed some of the reasons that the fed believed high inflation would be
transitory, but why did they end up being wrong? Well, there were a lot of factors that were out of
their control and they simply didn’t pay enough attention to these factors such as the supply
shortage. The fed along with business leaders have been discussing the supply shortage since
the beginning, but none of them really expected things to get this bad. The overwhelming consensus
was that supply chains were simply having a bit of trouble getting restarted. A lot of manufacturing
plants had to rehire employees, implement new covid protocol, work around lockdowns, and so
on and so forth. So, it wasn’t that surprising that we were seeing supply chain bottlenecks.
As things eased back to normal, it was expected that these issues would just sort themselves out,
but we’re actually seeing the exact opposite take place. The supply shortage is worse than
ever and economists are predicting that this could easily last for another year.
Even Apple who has one of the most established supply chains in the world was predicting sales to
dive by $8 billion due to shortages and lockdowns. So, not only were we seeing rapidly recovering
demand and labor market, but we were seeing an unprecedented shortage in supply. And this turned
out to be a deadly combination. Supply wasn’t the only area in which we saw shortages either.
Another major shortage we’ve been facing is the labor shortage. The mass layoffs that came at
the beginning of the pandemic caused many to learn new skills, look for higher paying jobs,
and make themselves more valuable. This has made it extremely difficult for companies to find low
level labor. Take Disney for example. They have 33,000 less employees today than they did in 2019.
A similar situation can be seen at Starbucks as well. As these companies struggle to find
enough labor, they’re being forced to pay higher salaries. And while this is great in
the short term, this eventually gets passed onto customers leading to higher inflation.
THE FED’S MASTER PLAN:
So far, we’ve covered the surface level reasoning behind “transitory” inflation.
The fed though inflation would be transitory due to A and B but they were wrong because of
C and D. This is the overwhelming narrative from the mainstream media and even the fed itself. But,
what if they weren’t wrong. What if they knew that inflation would be high for quite some time?
Now, this may sound like a conspiracy theory, but hear me out. Even if the Fed knew that inflation
would be high, do you really think they would just come out and say it? That would simply cause mass
panic and the Fed wants to keep markets and people as calm and level headed as possible. So, it makes
sense that they would try to underplay how bad inflation would be. Also, I know a lot of you guys
think that the people at the fed are idiots and that they have no idea what they’re doing. But,
do you really think they would’ve missed something so big? I mean, literally half of America was
calling for high inflation. If a good portion of everyday people could see high inflation coming,
I suspect fed members with decades of experience could also see it coming. But then, why did the
fed not take any action? Well, the thing to keep in mind is that the fed has two roles which are
to maintain low inflation and to maintain low unemployment. Throughout 2020 and much of 2021,
the need to boost employment was simply a higher priority for them than trying to minimize
inflation. In other words, they were ok with letting inflation run hot for a year or two as
long as their policies boosted the labor market. It wasn’t until the unemployment rate cratered to
sub 4% in late 2021 that inflation became their number 1 priority. Now that they’re focusing on
inflation, I don’t think they’ll go easy on it. I mean, they didn’t hesitate to go from
quarter percentage rate hikes to three quarter percentage rate hikes in a matter of months.
So, I don’t think they’ll hesitate to go to 1% or even higher either. As long as unemployment
is low and inflation is high, they’ll pump up interest rates as much as they need to.
INFLATION OUTLOOK:
It’s great that the fed is finally taking serious action to combat inflation, but how long will it
take for inflation to actually cool down. Well, there is no secret formula to calculate this,
but we can take a look at history to guide our expectations. Over the past 100 years,
we’ve seen 5 notable peaks of inflation. 4 out of these 5 times, inflation reached
levels of over 10% before peaking. But, in 1950, inflation peaked at around the levels that we are
right now. From the peak, it took about 1 year and 1 month for inflation to come back down to 2%.
Now of course, past performance is not indicative of future results, but if we were to assume that
something like that played out right now, we could expect inflation cool down by August of 2023.
But, that’s just the best case scenario. Inflation could easily run to over 10% like it did 4 other
times in history. In 1941, inflation continued to rise for another 7 months after reaching 9%.
After this, it took another 21 months for inflation to actually come back down. Similarly,
in 1974, inflation continued to rise for another 11 months after reaching 9%. And it took 23 months
for inflation to cool back down. So, we could easily see inflation continue to rise into Q2
of 2023. From there, it could take till Q1 of 2025 for inflation to cool down to 3%. So, we’re by no
means close to the end, but we may be close to the peak. The fed seems to finally be taking inflation
seriously, so chances are good that we see a peak by the end of this year, but it’s still a long
way down. Most of 2023 would still be elevated inflation even though it would be declining.
And it wouldn’t be till 2024 or early 2025 that we see normal levels. Even then, we wouldn’t be
out of the woods though. Both times that we saw high inflation in the past 100 years, we
saw multiple peaks. In the 1940s, we saw 3 peaks and in the 1970s we saw 2 peaks. So, if inflation
starts heading back up in 2025 or 2026, we’re likely in for a full decade of high inflation.
“TRANSITORY” INFLATION: In the end, the fed expected inflation
to be transitory due a recovering labor market along with expectations for demand to cool down.
As as result, they were willing to let inflation run hot for a little as the economy recovered.
But, the labor market would end up recovering faster than they expected. Not to mention we also
saw the supply shortage, the labor shortage, and the Ukraine Russia war which screwed up
the Fed’s plan signficantly. At this point, inflation has already rocketed to over 9%,
and all we can do is wait for the feds tightening to take effect and for shortages to slowly ease.
Unfortunately, neither of these are fast processes and we’re likely looking at a minimum
of another year or two of elevated inflation ahead of us. Even if things do cool down fast,
we can’t let our guard down because history has shown us that inflation often comes in
the form of multiple peaks. So, we would have to continue staying cautious to avoid a second or
even third peak. But, that’s just what I think. When do you guys think inflation will peak?
Comment that down below. Also, drop a like if you wish your salary was inflating
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