Here comes the pain” has become the mantra over the last year for people holding onto their darling stocks. The NASDAQ Composite has corrected 37% from November to its recent Low, index heavy-weights and blue-chips such as Nvidia, Microsoft, Tesla, Salesforce, PayPal and many others are off their Highs 25-65%.
According to JPM, the average ‘retail investor’ lost as good as half his money year-to-date (and yes, they’re mostly male) – a number that leaves whatever else this newest generation of smartphone traders lost by riding the downtrend in high-growth and pandemic stocks since the internal market top in Feb/Mar 2021 (indicated by the NASDAQ Advance/Decline line, see chart below), mercifully hidden in the dark.
Where we are
Despite the Biden Admin’s gaslighting pre-midterm elections, the US economy had technically already entered a state of recession earlier in 2022. GDP contracted, mortgage rates have reached a 20 year High, and ‘real’ retail sales when adjusted for price changes (i.e. inflation) show a negative trend since spring.
Earnings guidance was adjusted sharply downward for many transports (e.g., FedEx, Union Pacific, Knight-Swift Transportation), a critical “greasing” sector for the economic machine. Consumer confidence is dropping sharply since early 2021, and more and more household names are coming out of the woodwork to openly state their expectations for global recession – Tesla’s and Amazon’s CEOs leading the crowd.
This is merely the tip of the ‘pain’ ice-berg that investors, producers and consumers are facing – both from high inflation and central banks’ ensuing demand destruction. Consumer price growth in the US is at 40 year Highs, and in the Eurozone at the highest level since the Euro was born. Fed Chairman Powell is on a crusade to slay the mighty dragon that he himself bred from a little lizard in a shoebox under his bed, and tried to dump in the toilet when it stopped responding to the daft name he gave it (‘Transitory!’).
The last year and longer, the Fed set events in motion – rate hikes at an unprecedented speed, liquidity drainage via open market operations (bond dumping, reverse repos) – to invoke a demand destruction that might be easing inflationary pressures. The treasury inflation-protected securities market at least believes so, with the TIPS Bond ETF (TIP) discounting heavily and currently trading at multi-year Lows.
“Price inflation”
Politicians, officials, media talking heads, financial commentators – many have voiced supply chain disruptions and shortages of goods from the (after-)effects of pandemic lockdowns or the war in Ukraine as the sole culprit for the price changes experienced across the board. Exacerbating? Yes. Sole culprit?
Modern monetary theory touts such ‘cost-push/demand-pull’ price inflation. Undoubtedly, pricing power from shortages and rising oil prices can introduce shocks and temporarily force high prices.
However, firstly and most importantly, those increases would be limited to the particular goods/commodities that are affected by the shortages, and not linked to a price increase across the board for consumers and producers, as was observed.
Secondly, even in the case of supply chain crunches affecting ‘every and any’ good, demand would drop as soon as bottlenecks ease and pricing power would thereafter ordinarily equilibrate to the level of actual demand again, unless there was an excessive supply of money/credit available and spent to meet these high prices introduced by price shocks. The Global Supply Chain Pressure Index (GSCPI) peaked about a year ago and is at levels of late 2017/18, but consumer prices are near all-time Highs.
Resolving supply chain bottlenecks should have led to rising supply and lower prices for a while now, was the idea true that shortages were the sole cause for price surges. Large increases in inflation would have been transitory if supply chains were the actual issue. If money was still tied to a physical asset, not fiat.
A contradiction in terms
But a more persistent inflation is upon us. What really caused this inflation, and how do the central bank’s actions relate to it? Not the supply/demand of goods/services, but an expanded supply of money and the later spending of it is the causative factor for this inflation … and reckless monetary policy of fiat is the driver behind it.
Let’s take a step back, and look at the economic basics. Inflation is nowadays popularly defined and to a large extent measured by central banks as price inflation – a surge in the prices that consumers have to pay for goods and services.
Following this simplistic definition, it is argued that inflation – the waning purchasing power of currency – is the effect of surging consumer prices. However, this is not only a red herring, but also circular logic that does not make sense. Waning purchasing power means higher prices. And rising consumer prices are the reason for … inflation i.e. waning purchasing power i.e. rising consumer prices?
The topic of inflation becomes easier to understand when the formula is flipped on its head: Surging consumer prices are not the cause of inflation – they are the effect of inflation. And they are not the only effect. Equally, asset prices surge in an inflationary environment. The stock market, real estate, and commodity markets show strong increases in prices, which the common definition of price inflation completely ignores.
Monetary policy
Since taking the reserve currency and with it the various world currencies off the gold standard in the ’70s, money/credit may be created at will – and only so by governments through central banks. In the end, it is as simple as calling it what it really is: pulling money out of the magic hat.
During accommodative monetary policy, central banks expand the money supply by purchasing debt (budget deficit, mortgages) in the form of debt securities. The debt is added to the central bank’s balance sheet, and in turn credit is deposited into reserves of the money centers, commercial- and investment banks and other actors that they buy it from. This pushes this credit/money, i.e. liquidity that was freshly conjured from the aether, into the banking system.
It is crucial to grasp that this newly minted credit is ‘artificial liquidity’. It has not been created by increased production, i.e. it has not changed hands between participants of the economy in exchange for a tangible value that was previously produced. Therefore, the consumption capacity (spending potential) of the economy has increased, but not its production capacity.
This has happened in 2020 to 2022 to an unprecedented magnitude. The Fed’s balance sheet was ballooned to almost 9 trillion USD by March ‘22 – through ultra-loose monetary policy, bond-buying extravaganzas, and economic relief corporate grants, all financed by quantitative easing programs (QE). Where did this artificial money end up?
Money flows along the path of least resistance
Part of ultra-loose accommodative monetary policy is concurrent near-zero or zero interest-rate policy (ZIRP), as seen many times in the last decade and also in 2020-22. Correcting for an average 2.2% annual inflation rate over the last 10 years, ‘real’ lending rates were actually negative for most of the last decade.
In such an environment, consumer loan activity actually remains low as banks don’t see profitability of loaning out money to individuals. “Only” about a couple hundred billion went out for low-interest COVID corporate and business relief loans. Why loan or make mortgages with risk, when you can just ride the stock and bond wave created by the Fed ballooning assets?
Since the banking system was disincentivized to lend to consumers, they put a large chunk of the remaining money where they could get a return – assets: the stock market, real estate, bonds, commodity markets. A disproportionately large amount of artificial money was funneled into assets. In such times, institutional money speculates in equities for profit, while also discounting future currency devaluation from the central bank money volcano.
A lot, but not all of individual stimulus check handouts ended up in savings – US household savings skyrocketed in 2020. Many companies kept paying wages despite lockdowns, and many people got stimulus money no matter the actual necessity.
The money that was not saved was spent – due to fiscal and monetary intervention, consumer confidence never dropped strongly and did not even come close to levels of previous crises such as the 2008/09 financial crisis. M2, the compound measure of money in ‘public hands’ (i.e. cash, money market funds, checking accounts, etc.) is a measure that blew totally out of historical proportions during 2020/21, and is the reason why previous rounds of quantitative easing did not drive price pressures – stimulus checks, relief programs, bailouts and free money to persons, businesses and corporations led to a lot of money entering circulation to compete for goods and services, additionally spiraling up prices.
On the other hand, with real interest rates (after baseline inflation) negative, consumers were overall discouraged from keeping money sitting in cash accounts. The average person did not see a reason not to spent their money directly on goods or services, or join the asset party. A total of $5 trillion went into paying off debt (good!), asset purchases (equities, commodities, real estate), or direct spending before and after lockdowns ended.
Artificial institutional and consumer money flowed into the markets, inflating asset and material prices. Artificial money and liquidity is always absorbed by the financial sector, and can stay trapped there for some time. Liquidity percolates through society and the real economy slowly, and there can be many months or years delay between the cause and the effect. As the stock market was relentlessly rising, asset owners became wealthy; the ‘wealth effect’ of the middle and upper classes.
The stock market actually grew with a rate reminiscent of the late-90’s bubble:
1990s:
2020s:
Balooning assets and material costs
Other assets grew in value as well. The most frequent metric of price inflation (the CPI) is most heavily weighted with housing (house costs, rent costs) and commodities. Consumers, institutions and real estate corporations went on a low-interest loan-fueled buying spree and bid up house prices, which grew in 2020 to ’22 three times as quickly as the years before – magnifying the wealth effect.
Institutional speculation and producer hedging against currency devaluation in commodity markets, exacerbated by lockdown supply chain bottlenecks and temporary supply shocks in commodities, further pushed raw material costs, producer prices, and then consumer prices up.
Crude oil is used to make plastics, and thus thousands of daily consumer items – not to mention its value as an energy commodity. Cotton goes into apparel. Copper goes nowadays into almost anything. Copper, lumber, cement etc. go into houses, pressing their prices and thus the CPI up more. You get the picture.
See a long-term chart for lumber futures going almost vertically up in 2021:
Rising material costs lead to rising producer prices that are nonchalantly passed onto the next guy – the retailer, then the consumer. The result … surges in consumer prices for daily goods and services, real estate, energy, food, etc. A dangerous mixture with a ballooning M2 money supply in circulation. Artificial consumption capacity grew, while production capacity did not – a recipe for price pressure.
The producer price index PPI, a measure of trends in charges demanded on producer outputs, has been rising with the CPI in 2020/21. Most (of course not all) producers are not increasing markups; they are passing on operating margins.
“Money supply inflation”
Speculative capital gains led to a perception of more disposable income, translating to people taking risk-on consumer loans against their assets that showed rising price trajectories (real estate, equities,…). Houses were refinanced with lower interest rates, disposable income grew. More earned or artificial money entered the economy after reopening late-2020/early 2021 when vaccines became widely available, travel became unrestricted, and pent-up demand kicked in.
A buoying wealth effect down the line encourages spending, the artificial money entering circulation, more and more money chasing goods, services, and further causing price inflation at the consumer level.
Coming back to the beginning of the circle, surging consumer prices are not the cause of inflation – they are the downstream effect of inflation. Inflation should thus not be defined as price inflation, but rather as money supply inflation – a surge in the available amount of, and spending of artificial money not backed by a physical asset.
Strawmen
Could pandemic supply bottlenecks have caused the current inflation, as Fed chairman Powell and the government suggested? There is limited historic precedent, but we can look at the present.
Money available to purchase goods/services (consumption capacity) in an economy is limited, and stands in equilibrium with the amount of goods and services available for purchase (production capacity), which is also limited. By introducing artificial money, the consumption capacity rises, while true production capacity stays limited, resulting in misallocation of capital and rising prices.
During the last couple of years, the money supply has obviously risen. The Fed has deposited more than $4 trillion into the reserves of banks from the start of the pandemic to the end of the Fed’s bond buying program in March 2022; the ECB did similarly, creating similar amounts of credit during and after the covid pandemic. This artificial liquidity resembles artificial demand, consumption capacity.
How about production capacity – the supply, the availability of goods and services for purchase? These were argued to be starkly reduced by supply chain bottlenecks, and thus causative of inflating prices across the board. Hypothetically in that case, we should see a drop in global productivity along with inflating prices.
The OECD reported global GDP growth in 2021 at 5.7%; global supply chain constraints started easing globally as per GSCPI, and production capacity and productivity was reaching pre-pandemic levels – all while consumer prices rose exponentially in 2021. This happens when money creation outpaces production, too much money chasing too few goods.
For contrast, in 2020, global GDP growth contracted at -3.4% while the world experienced heavy supply chain constrictions, while consumer prices did not rise – and they should have risen, were the hypothesis of ‘bottlenecks are the sole inflationary pressure’ accurate. This shows that reductions in production capacity (i.e. supply chain bottlenecks) were not concurrent with rising consumer prices (an effect of inflation).
However, the rising prices were present as downstream delayed effects of the creation of unprecedented amounts of artificial money during a period of low productivity. As Milton Friedman wrote, “monetary actions affect economic conditions only after a lag that is both long and variable”.
Prices will respond to how much faster the (artificial) money supply growth and/or spending of that supply outpaces productivity (GDP) growth.
Inflation rises when money growth & spending outpaces productivity growth, and a weakly-growing or contracting economy will not allow governments & central banks to create large monumental amounts of artificial money/credit to be spent without causing inflation. True inflation comes from too much money outpacing production capacity, and is only exacerbated by potential lateral price shocks such as from supply chain bottlenecks.
Where are we heading now?
In 2022, the current Fed actions are depressing values of real assets such as equities, a way to lower consumer sentiment, reduce personal wealth, and curb consumer spending. The central banks’ recklessness is hidden under a veil of ‘serving the citizen’.
You should be worried about it … however, this is not necessarily a meteor that will hit Earth soon. Central banks have been juggling this mess now for multiple decades, and it could take years but also many more decades for any real problems to surface.
And what we have now is not a real problem, yet. In the intermediate- to long-term, raised inflation has a potential to persist. Even if it doesn’t, the baseline 2% inflation erodes the value of money enough as it is.
The big question is, how will they pay off the massive debt, titanic government deficits, without debasing the reserve currency and other world currencies? Odds are … they can’t. And when will the reserve banking systems stop excessively monetizing this debt to produce more empty credit?
By now, it doesn’t matter anymore whether you believe that the Fed’s ‘Sisyphus’ tightening cycle is too much too late, or not – we’re in it for good. Our best hope at this juncture is that the FOMC does not flinch early.
Demand destruction via a ‘reverse wealth effect’ should flash the stock market indices, in my opinion ideally to somewhere around the -50 to -60% mark top to bottom. Inflation needs to come down radically, no matter the damage to the economy – to avoid a dangerous vicious cycle leading to stagflation, or worse, hyperinflation in the (not so) far future.
This may sound harsh, but if money supply is expanded in the next round of QE and the one after that, currency will slowly inflate more and more. The long-term effects will be worse. Rather jump out of the car at 15 mph than at 50 mph.
Free money is opium to the markets, and it will come again. But a nation can’t be bailed out with more free money, when it is suffering just because of the downstream effects of that credit creation. Someone has to foot the bill, and it won’t be the government – it’ll be us.
Your money is already now eroding away and losing about 10% of its value every 5 years if you keep it in cash. Imagine that, instead of an average 2% inflation rate per year, 3%, 5% or 8% depreciation per year would be the new normal. Your money would lose a quarter, a third, or more than half of its value in a decade, not a bright outlook…
