- Interest rates are on the rise.
The stock market has had its worst first six months
in over half a century.
Prices for everyday goods are remaining stubbornly high
and government support programs
designed to help people through the pandemic
are getting canceled faster than sitcoms from the 1980s.
A lot of people are
in a more precarious financial situation now
than they were at the supposed height of the pandemic.
Just American spending on economic stimulus efforts
adjusted for inflation is the same as America spent
fighting World War II.
Government budgets are very different
from household budgets,
so while a lot of the typical sound bites
about debt and fiscal responsibility
might be a bit overblown, it's also important to remember
that governments aren't magic.
They can't just create value
out of thin air to brush away any problems we face.
If they could, we would live in a post scarcity utopia,
but obviously we don't.
So if governments don't manage their money like you or I,
then how do they pay the bill for living above their means?
The answer to this question can teach us
a lot about what the next few months have in store.
For us, the standard thinking now
is that we are stuck between unreasonably high inflation
and a recession.
Neither of these options are good,
but they are bad in different ways
and they're bad for different people.
So how long will it take our economies to go back to normal?
Who is really going to end up paying
for the record spending done over the past 28 months?
And are we stuck choosing between inflation
and a recession or is there another option?
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Do we have to choose between unreasonably high inflation
and a recession?
Well, no, but that's not the good news
you might think it is.
The US currently has an annualized inflation rate
of 8.6%, which is three to four times
the Fed's target rate and is very securely
in what we would call unreasonable territory.
Growth itself has also been very weak,
with a negative first quarter
and most predictions forecasting
another slow quarter of growth having just passed.
The technical definition of a recession
is two quarters of negative real GDP growth.
Now, most institutions these days
no longer use that rigid framework
for determining if we are or are not in a recession,
but at least by the most solid definition
that we have available, we are probably already there
in most economies around the world.
So yeah, there is another option
besides picking high inflation or a recession.
It's just not the option
that you might have been hoping for because it's C,
all of the above.
This is what economists call stagflation.
And you'll probably start to hear this term
thrown around more and more in the coming weeks and months.
Stagflation was a term first used in the 70s
to describe a period of low economic growth
with high unemployment which still manages
to also have high inflation.
Typically, low growth and high unemployment reduce inflation
because if people don't have jobs
and they are uncertain about the future,
they won't spend as much money.
If people don't spend as much money,
there is less total demand in the economy.
And if there is less demand, then prices fall.
Lower prices are the exact opposite of inflation.
We looked at this last month
in our video on the recession that we need to have.
So I don't wanna repeat too much here
but stagflation is normally a sign
that something has gone terribly wrong in the economy.
It's like somehow dying of dehydration
and drowning at the same time,
and chances are it's something that we are going
to have to deal with.
The question is really becoming
how bad are both of these going to get?
And to answer this question, let's start with inflation.
Inflation is high right now for two reasons.
There has been a lot of money injected
into the economy in the past two years
and there have been severe product shortages
caused by supply issues stemming from pandemic lockdowns,
trade tensions, and now a war in Eastern Europe.
Both of these will increase the prices of goods
but it's difficult to say which is having a bigger impact
at any given time.
Up until recently
the Federal Reserve Bank was primarily pointing the finger
at supply chain issues for price spikes in certain areas.
Conveniently, this would relieve them of responsibility
for inflation because they only have direct control
over cash flows in the economy.
The Fed doesn't involve itself
in trade negotiations or lockdown policies.
This stance has been walked back by the Fed
and their research now indicates that approximately 3%
of the current inflation rate
was caused by income transfers,
which is just a technical way
of saying all of the extra money
that was pumped into the economy during the pandemic.
Now, 3% is actually not that bad.
And the Fed itself also quickly points out
that had these measures not been taken,
we would likely be experiencing deflation
which would've been worse for a variety of reasons.
If the target rate of inflation is 2 to 3%
and we are currently at 8.5%.
Then the 3% caused by stimulus efforts
represents half of the problem.
Of course, the actual calculations
are far more complex than this,
and the Fed themselves have admitted
that this 3% figure is likely to be adjusted upwards,
but for now it gives us a pretty good benchmark
to work with.
So then what is causing the other 3%
of above average inflation
that we are currently experiencing?
Supply chain issues are certainly part of it.
There is no getting around the fact
that the way that we do business
and add value in our economies has fundamentally changed
in the past two and a half years.
But why are we only really experiencing this now?
Industrial output has actually recovered
to all time highs in the US and imports a spike
to make up for the supply shortages and then some.
A few months ago supply chains
were a major part of the inflationary problem
but now there's a little bit more to it.
Of course, there are still certain items
like consumer electronics, food stuffs,
and of course oil that remain problematic
and a lot of these have had knock-on effects.
Almost everything that we consume these days
is transported hundreds if not thousands of kilometers
around the world before it gets to us.
If oil is expensive, then this transport costs more money,
a cost which will sooner or later
be passed along to us as consumers.
If we follow this line of thinking,
we can start to find the real source of this additional 3%.
Paul Donovan, the chief economist
at UBS Global Wealth Management astutely pointed out
in a recent interview that only about 15 to 20%
of what we spend on food is actually going to the food.
The other 80% is being spent on the process
of getting that food from the farm to our supermarkets.
This is roughly made up of transport expenses
like the fuel that we were talking about earlier,
and stuff like packaging and processing,
which with Covid restrictions
has become slightly less efficient.
There is still two other big expenses
that we need to account for when we buy our food though
and that is the profit margins
of all of the companies involved in the supply chains
and the salaries of all of the workers
that made it possible.
All of this toque of inflation has been a golden opportunity
for companies to raise their prices
under the guise of simply keeping up with inflation.
In reality, most companies have raised their prices too far,
either outta fear of inflation persisting
or more realistically because they can.
If people are expecting a rise
in the price level of their goods and services,
they are not going to be surprised
when there is a rise in the price level
of their goods and services.
The last six months have seen record corporate profits
despite a lot of fiscal stimulus measures
been slowly taped off
because these companies can now get away
with charging whatever they really want to.
Now, the biggest slice of this end-good expense pie
is almost always going to be labor costs,
and those two are on the rise.
Unemployment is very low at the moment
and less people are choosing to work at all.
This means workers have more negotiating power
to demand higher wages,
and with all of the talk of inflation
the motivation to do it as well.
going into your boss's office
and telling them that you wanna raise
because in this labor market you're going to be
very hard to replace, probably won't go over very well.
Telling them that you wanna raise to keep up with inflation
is much more reasonable.
If everyone does this,
it's very easy to see how we end up
with higher prices on the goods
that we end up buying off the shelf.
So can we fix this?
Well, yes, actually higher interest rates
will put a damper on business and consumer activity
which will make those businesses and workers
less confident asking for record profits
and salary increases.
Actually, one of the most powerful tools
the government has to fight this type of inflation
is their rhetoric.
By saying very loudly and very firmly
that inflation has now become their number one priority,
we will start to expect that this issue won't last long,
and in doing so we'll be less motivated to take actions
that lead to inflation in the first place.
Of course, they still need to be very careful
about this because the fed may very well
still have to reverse course very quickly
if the economy falls into a recession
doing the opposite of what they promised
will mean that people won't listen to them anymore
which could strip them of this very underappreciated tool.
We are actually seeing this at the moment here in Australia.
The chairman of our Reserve Bank
at the height of the pandemics
that they would not raise interest rates until 2024.
He said this to try and calm consumers
during a time when a recession
was the biggest fear on people's minds,
but now after three record rate increases,
people aren't going to take what he says
very seriously anymore.
Alright, then what about the recession?
Inflation may very well be like Tinker Bell
and that it only exists if people really believe it exists
but that doesn't mean it's not a problem.
Most of the things that the government
and reserve banks around the world do to fix inflation
is exactly the opposite of what they do to fix a recession.
If an economy has inflation that is too high,
the central bank raises interest rates
and the government taxes more while spending less.
If an economy is going into recession,
the central bank lowers interest rates
and the government taxes less while spending more.
So what's the correct course of action
when inflation is high
and the economy is still headed towards a recession?
The answer is really some kind of compromise.
The Federal Reserve Bank's core mandate is price stability
and while they normally try to balance this
with enabling economic growth,
if they are backed into a corner,
they will choose to maintain price levels
even if it comes at the expense of pushing the economy
into a recession.
It sounds kind of heartless, especially when you remember
that these actions will have real impacts
on millions of regular people around the world.
But that's just their role.
It's possible to recover from even very severe recessions,
it's much harder to recover from hyperinflation.
We are already seeing this play out.
At a time like this, with all of the problems in the world
the Fed would never consider raising interest rates
but because of inflation, they're doing it anyway.
The response of the government
is going to be a bit different though
because unlike the Fed, they don't have a narrow mandate
and instead they exist
for the good of the people they represent.
The White House has already announced
that inflation has become its top economic priority
and that it will not interfere
with the Federal Reserve's efforts
to cool inflation even though it acknowledges
that it could put a damper on the economy's recovery.
Instead, the government is trying to roll out
new stimulus measures to alleviate the effects
of both inflation and the potential recession.
But hang on, isn't huge government stimulus efforts
half of the reason that we have the inflation problem
to begin with?
Well, yes it is,
but the difference with these new stimulus measures
is that they are designed to increase the supply
of goods and services in the economy
rather than just the demand for goods and services.
If you give a person a $1,400 check
that doesn't necessarily add value to the economy.
Sure they can go out and spend it to keep businesses going,
but if you do this enough
you're just going to have an inflation problem.
Instead, this new stimulus proposal is targeted
at building out infrastructure, releasing oil reserves,
and building more housing,
all of which will increase the supply
of goods and services in the economy
which should hopefully both taper rising prices
but also provide a certain level
of economic stimulus at the same time.
Unfortunately, we are stuck
between a recession and inflation.
The question is now how bad is it going to be?
I like to end things on a positive note.
So the answer is that it might not actually be
as bad as we have been led to believe.
Doom and gloom articles get clicks,
and as a person whose livelihood depends
on how many people I can get to watch my videos,
I know that bad news sells a lot better than good news.
But I am personally not nearly
as worried as I was six months ago.
Reserve banks have acknowledged the inflation problem
and while they have waited a bit too long,
they are now taking decisive steps to alleviate the issue.
Employment is still strong,
which means that at least people still have incomes.
Yes, the stock market is having a very bad year,
but that might be a blessing in disguise.
Most of the value lost in the headline indexes
has come from tech companies
that were arguably wildly overvalued,
a low interest rate environment met that people
could gamble on what companies would change the world
in the decades to come
rather than investing in good old-fashioned businesses
that were producing value now.
The fall in the value of these tech companies
is most of what has pulled the value
of the total stock market down.
Many of the biggest, more traditional companies
in the world are actually having a great year.
The same decline is likely to be seen
in house prices as well
because these two asset classes
are pretty strongly correlated.
But again, that's not necessarily a bad thing
for the broader economy.
The biggest economic downturns in history,
more or less came as a complete shock
1929, 1937, 2001, and of of course 2008.
This is not an excuse to get complacent,
but the fact that we have been seeing this
coming for years now means that we are less likely
to be blindsided by the impacts of either inflation
or a severe recession.
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