Typically, inflation stems from an overheating economy where companies are expanding rapidly to meet expected sustained growth of demand. Too many companies in the same industry all expand capacity at the same time leading to cost and wage inflation followed by industry-wide overcapacity and recession. Strategies such as raising interest rates to increase the cost of debt to make funding expansions more costly can be an effective strategy for slowing expansion enough to avoid the worst of the economy slowing from overcapacity.
Today, we have nothing that remotely resembles an overcapacity or oversupply of much of anything. We are experiencing quite the opposite with shortages stretching as far as the eye can see. And even if the Fed raises rates high enough to force the economy into a recession, shortages of critical goods and services will not simply go away. Increasing the cost for companies to expand to make up for these shortages is the opposite of what needs to be done. Certain things, such as food, will be in demand regardless of the county’s overall level of economic activity and continued shortages of those items will cause them to be more and more expensive. More expensive because of both the higher cost to produce due to Fed rate increases and the higher cost of financing passing through to the consumer as well, of course, due to the sustained demand for scarce basic necessities. Unfortunately, by using tools designed to prevent overcapacity, the Fed’s fight against inflation will only succeed in making things worse. The Fed is creating a stagflation environment.
Assuming that 100% of a country’s population is consuming goods and services, there need to be enough people producing goods and services to avoid shortages. The U.S. currently lacks a sufficient workforce to eliminate the shortages causing inflation. The obvious solution is to simply return to the equilibrium ratio of working population to total population that existed before the pandemic. The natural laws of capitalism will eventually correct the current imbalance as more people will find the need to work more and harder to earn enough to pay for the higher cost of everything. Raising interest rates will slow this natural corrective process. Sending people more free money from the government also slows the process of getting enough people to produce to increase supply enough to rein in inflation.
We are betting inflation persists longer than expected as 1) the current members of the Fed successfully reduce our country’s economic capacity rather than attempting to assist producers and 2) politicians generally reacting with policies such as price controls and subsidies to consumers that tend to worsen shortages. Using the resulting fiscal deficits as justification to raise taxes further reduces the incentive for people and companies to produce while also increasing prices to cover the higher cost of increased taxes.
American investors tend to think of stagflation as “other countries’ problem” and will likely be surprised to see inflation remain stubbornly high even as demand declines. This will likely keep yields lower than they should be which is both good and bad. “Good” in that it provides a relief to beat up bond investors reeling from the spike in yields this year and “bad” as it means negative real yields for bond investors longer.
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