The Heritage of Arthur Burns

The summer is over (at large), but the debate whether the current inflation numbers are a temporary phenomenon or if the price increases will become more permanent and the deflationary cycle ended in 2020. I wrote a little bit about the arguments of the Deflation Camp already back in July,  and that one should always consider their arguments to evaluate the current economic conditions. 

I know, I may repeat myself, but the two main arguments of the deflation camp are that price increases have taken place in very special sectors of the economy, like rental cars, used cars, energy prices or plane tickets, just to name a few, and that we will only observe a substantial increase in inflation when wages pick up. (addendum:  Although no one mentions that 'Over the past four quarters, the United States has generated more wage inflation than at any point over the past 40 years.')

A brief look into recent data shows that price inflation in those affected sectors has slowed substantially (for now). Following chart shows used-car inflation (YoY):

Maybe that is a sign that inflation really IS transitory. Additionally, Commodity prices have topped during the last month. Another argument that the Deflationista's may be right.

Core CPI (consumer price inflation ex. food & energy) also decelerated in July compared to June. Is this a sign that inflation will slow back to pre-crisis levels and another deflationary scenario is right around the corner? Probably the signs can be interpreted in that way. Thus, another restart of the covid pandemic in the upcoming fall and winter and the - expectable - governmental reaction, may support this conclusion. 

Nevertheless, I have thought about the topic a lot about the summer, and I have to say that it is very difficult to make a prediction. Therefore, I will not do that here, but after all things I have read and thought of, I am still not sure that the biggest orgy in printing bank reserves in (at least) recent history will lead to the consequence that bond markets are anticipation: A continuation of the deflationary environment. 

I mean, I am well aware of the Cantillon-Effect. Richard Cantillon has formulated it back in the 18th Century and described that inflation never occurs in a general increase in prices rather than an ongoing wave that spreads over the economy and infects one sector after the other. All depends on where newly created money is flowing. 

Which brings me back to the argument that the Fed and the ECB do not print money. They only print bank reserves and swap them against government bonds, mortgage backed securities and corporate bonds (since 2020). However, the downward manipulation of interest rates benefits certain groups who now are able to load up on even more debt than in an environment with higher rates, for example big business or governments.

Im March 2020, when the pandemic hit the whole globe, not only have stock markets been at all time highs already, the first QE program of the Federal Reserve had already turned 10 years old. 

Not only did QE fueled the bond-bubble and propped up lending of big business and governments, it was also a main driver for the stock market. While big business loaded up on debt to buy back its' own stock, governments loaded up on debt to waste money and resources in some prestige projects. Weak economic growth despite big expenditures already serve as a perfect example for money's diminishing marginal utility.

Thus, one could observe that the party in the stock market has already ended pre-covid. When the Fed started to raise interest rates while simultaneously 'hiking' rates, markets tumbled. You know when stocks started to soar again? When the Fed re-engaged in the repo market in September of 2019, when it wanted to prevent a rise on the short end of the yield curve and thus made stocks more attractive compared to other investments for another time. 

After the big sell-off in March of 2020 began in the stock market and spread fastly to other asset classes, there was only one way out for central banks: Even more aggressive monetary policy. In an emergency meeting, the Fed slashed interest rates back to zero. However, markets continued to crash, and after some time, bond markets also started to collapse, because investors wanted to get cash on the sidelines or had to fulfill margin-calls on their losses in other assets. The Fed had to become even more aggressive: They started the Pandemic Purchase Program (PPP) and bought bonds on an unprecedented scale. This was the turning point, when market participants breathed a sign of relief: In Emergency, the Fed will ALWAYS come to the rescue.

Central banks did what they always do to fight an economic downturn, even a little bit more extreme. Drown markets in liquidity and let liquidity infect one sector after the other. It is just natural, that prices will not rise indefinitely. 

Spring of 2020 marked a simultaneous shock of demand and supply in a variety of economic sectors. Over night restaurants, hotels, businesses and service sector business had to shut down by law, while governments and central banks guaranteed them liquidity to fulfill all their obligations during that time. 

Because there was no way to spend the new money, it rested on the peoples bank accounts and therefore savings rates all around the globe spiked. If one looked closer, one could observed that this was not entirely true: Only the high and medium income earners enjoyed a rise in savings while lower income groups suffered and even lost some of their savings. The only way to 'save', might have been to postpone rental payments, but as everyone knows: Postponed is not abandoned....

Millions of people stuck at home and did not know what to do with all those transfer payments. Why not invest into the stock market? Previously highly engaged in sports betting, now an 'investor'. What to buy? What one knows: Amazon, Apple, Google, Tesla. Those stocks made a terrific comeback and also were the main driver for the big indices to recover. 

It went one after the other: Vaccines, Reopening, Back to Normal (at least partially). The economy reopened, businesses finally open and people were eager to spend government money into the real economy. 

Now it became obvious that one cannot simply switch off an economy and turn it back on, a fact that many people have made since March 2020. A lot of problems also showed up: Commodities, building materials showed big imbalances in supply and demand. For some time, lumber rices have tripled from it's usual levels, but returned to pre-crisis price levels recently. 

Global supply chains were hit harder: Freight prices still go through the roof. Businesses report that they cannot get enough raw materials to produce goods, auto makers cannot get enough chips and as a result, they started to order huge amounts to stay in business. Although order books are full, workers are in Kurzarbeit (working fewer hours) because the material just is not there. 

But, wait -> this will also be transitory, right? When inflation will return to pre-crisis levels, as people like Jay Powell, Janet Yellen and Paul Krugman are arguing. Further, even IF inflation will not come down, Fed and ECB officials (like Isabel Schnabel) have already made up an argument for that: This would be good inflation! Just like in the stock market: Facts do not matter anymore, it is all about the narrative!

Paul Krugman and others have already started to suggest that inflation numbers should be calculated differently, to overlook recent price increases because it is disturbing the inflation picture. Use median PCE instead of core CPI was a terrific proposal of those people.

What they still do not get is that inflation does not mean that everything gets more expensive simultaneously. Money makes its way through the economy, infecting one sector of the economy after another. 

Obviously, the whole debate is not about painting a realistic picture of inflation rather than making sure that everyone believes that it is still below the Fed's (and ECB's) target. That is why the Cleveland Fed for example tweeted out that PCE inflation has been 3.9% in May. But median PCE inflation, which excludes outlier components and focuses on the middle of the distribution, was steady at 2% for the third month in a row.

I could not agree more with Dr. Ben Hunt, who wrote on the topic: To which I’d reply that the Fed can use a median measure of inflation just as soon as I can pay a median measure of my bills.

Another point that I would make (and Ben is making the same point in the article) is that back in 2015, when PCE-inflation was close to zero percent, not one of those people argued that median PCE inflation was steady at 2 % and therefore inflation was high enough. Must have been the wrong narrative back then...

Which brings me to the title of this blogpost. I do not know if you are familiar with the name of Arthur Burns, at least I did not hear very much from him before. Since Richard Nixon had nominated him in 1971, Burns was chair of the Federal Reserve until 1979. In the 80s prior to his death he served as US-ambassador in West Germany. 

Even back in those days, the Fed chair was totally unaware of the Cantillon effect and how inflation spreads out into the economy. Sadly, this has not changed.

Despite a lot of differences between the 1970s and the 2020s, some similarities are very astonishing in my opinion. For example how the Fed is treating the current rise in inflation. Stephen Roach wrote a brilliant essay about Arthur Burns, published on project-syndicate.org. There he writes:

'As a data junkie, he was prone to segment the problems he faced as a policymaker, especiallythe emergence of what would soon become the Great Inflation. Like business cycles, he be-lieved price trends were heavily influenced by idiosyncratic, or exogenous, factors – “noise”that had nothing to do with monetary policy.'

Does this ring a bell? This is more or less the same argument that Fed and ECB officials have nowadays when it comes to the inflation-debate. That inflation is about expectations, wages and other things... but in no way it is about monetary expansion.

Burns saw now relationship between monetary expansion and price inflation, like Jerome and Christine do not see the relationship today:

'When US oil prices quadrupled following the OPEC oil embargo in the aftermath of the 1973 Yom Kippur War, Burns argued that, since this had nothing to do with monetary policy, theFed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index.

Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather – specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertilizer and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food – which had a weight of 25% – out of the CPI.

We didn’t know it at the time, but we had just created the first version of what is now fondly known as the core inflation rate – that purified portion of the CPI that purportedly is free of the volatile “special factors” of food and energy, where gyrations were traceable to distant wars and weather. Burns was pleased. Monetary policy needed to focus on more stable underlying inflation trends, he argued, and we had provided him with the perfect tool to sharpen his focus.

It was a fair point – to a point; unfortunately, Burns didn’t stop there. Over the next few years, he periodically uncovered similar idiosyncratic developments affecting the prices of mobile homes, used cars, children’s toys, even women’s jewelry (gold mania, he dubbed it);he also raised questions about homeownership costs, which accounted for another 16% of the CPI. Take them all out, he insisted! 

By the time Burns was done, only about 35% of the CPI was left – and it was rising at a double-digit rate! Only at that point, in 1975, did Burns concede – far too late – that the UnitedStates had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.'

We do not know if things will play out the same way as they did in the 1970s, but the parallels are obvious. Janet Yellen, Paul Krugman, Christine Lagarde and Jay Powell are using pretty much the same arguments that Burns used when he was Fed chair. 

However, we should learn a lesson from Arthur Burns: That, despite all claims, inflation is always a result of monetary expansion. While the financial and real economy has become by far more complicated than it was in the 1970s, this makes it even harder to predict the outcome. 

Nevertheless one should acknowledge that - without a doubt - expansive monetary policy acts like a tailwind for inflation expectations and could possibly help to drive them higher. And coming up with another measurement of inflation to make inflation look low will not stop it.

Have a great weekend!

Fabian Wintersberger

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