GavekalResearch Ideas

June 14, 2022

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Five Inflation Fallacies

Anatole Kaletsky Are markets finally getting the message? Two weeks ago, I broke the first rule
akaletsky@gavekal.com of financial forecasting by making a quantifiable prediction and attaching
to it a specific date (see Preparing To Sell The Rally). Reflecting on the
three months since my conversion from Gavekal’s perennial buy-on-dips
permabull to an unwavering sell-on-rallies permabear, I suggested that the
best opportunity to sell equities might be just before June 10. My reasoning
was that the next US consumer price index report might show inflation
rising, instead of falling as almost everyone in the markets was predicting.
The reversal began two days earlier than I anticipated, but recent market
action has certainly been grim enough to encourage my new persona. In
character, allow me to make another gloomy prediction: once Wednesday’s
Federal Reserve meeting is out of the way, the next big event in the present
bear market will not be the July CPI report, but the report after that which
will come out on August 10. Perhaps the next big lurch downwards will begin
a few days before, on July 30, when the quarterly Employment Cost Index—
the most reliable gauge for US wage pressures—will be released.
I point to these bear-market staging posts for the same reason I cited two weeks
ago in my warning about “the Ides of June.” Investors are still, in my view, far
Investors are still far too optimistic about too optimistic about the chances that US price stability will be restored while
the chances that US price stability will be interest rates remain deeply negative in comparison with both the backward-
restored looking and the year-ahead inflation rates. This complacency seems to be
based on five reasons for hoping that price stability can be restored without
additional monetary tightening beyond what the Fed has already announced.
In my meetings with hundreds of Gavekal clients around the world since the
Ukraine war, I have kept hearing these five hopeful arguments. In my view,
they are all fallacious; a useful reminder that investor psychology in bear
markets often slides down a “slope of hope”:
Fallacy #1: inflationary pressures will soon diminish, since high energy
and food prices will eventually stop rising while high energy and food
prices will reduce consumer spending power.
This is the argument that wrongly persuaded the markets that US inflation
had already peaked at 8.5% two months ago. My colleague Tan Kai Xian
gave an excellent explanation of why this turned out to be wishful thinking
(see Inflation And The Reaction Function), to which I will briefly add four
points that could help to anticipate the timing of the next inflation shock.
Firstly, as KX mentioned, headline inflation matters for the real economy of
wage bargaining and price setting far more than the “core” numbers on which
Headline inflation matters more to the markets often focus, which exclude energy and food. Secondly, high inflation
real economy than the “core” numbers on has now spread far beyond energy and food. In last week’s CPI report, 12 of
which markets often focus the 14 broad categories of goods and services experienced inflation above
5%, on both a 12-month basis and annualized in May. The exceptions were

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June 14, 2022
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medical goods and services, presumably because of a lull in medical inflation

after the Covid shock. The chart below, showing the Fed’s calculations of
median and trimmed-mean inflation data, shows in more detail that inflation
of 7% or more is now pervasive across the US goods and service sectors.

A 7% inflation rate is now pervasive across

US goods and services

Thirdly, the favorable base effects that could have curbed US inflation in the
past few months will go into reverse from July onwards. The chart below was
what led me to expect the terrible inflation number published last Friday.
While July’s CPI report may show slightly lower inflation, 12-month inflation
is almost certain to accelerate in August, September and October as the low-
inflation numbers from last summer will drop out of the annual comparisons.

The base effects that could have curbed

US inflation over the past few months will
go into reverse from July onwards

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At present, the hope that inflation will be
self-limiting is another delusion...
...one that will likely be dashed come the
July 30 ECI print
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June 14, 2022
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Finally, what about the widespread belief that inflation is reducing real wages,
thereby subduing consumer spending without the need for much tighter
monetary policy? If wages continue to lag prices, such a negative feedback
loop could occur, but at present the hope that inflation will be self-limiting is
another delusion. The chart below offers an answer: it is true that average real
wages (the blue line) have fallen slightly during the past 12 months (by 1.9%
from March 2021 and March 2022 according to the ECI); but this decline in
average wages has been outweighed by the 4% rise in US employment during
the same period. As a result, aggregate wage and salary income, and therefore
consumer spending power, has continued to grow quite rapidly since the end
of the Covid lockdowns, as shown by the red line below.
If the next ECI print shows slowing wage growth, consumer spending
power may weaken towards the end of this year. But if the ECI shows wages
accelerating (which I think is more likely), hopes of self-limiting inflation
will be dashed once again. This is why I believe that the July 30 ECI release
could be the next important inflection point in the US inflation debate.
Fallacy #2: inflationary expectations are “well anchored” at around 2%
and these moderate expectations will maintain price stability without the
high interest rates of the 1980s and 1990s.
There are two main flaws in this argument. Firstly, the expectations that
determine pricing and wage-setting behavior are those of workers and
businesses—not financial investors, even if these were accurately reflected
in market bond yields and break-even rates. Secondly, the five- and 10-year
numbers usually cited in evidence of “anchored expectations” are completely
irrelevant to wage and price contracts, which are typically set for only one
or two years. What matters in pricing and wage decisions for the year ahead
is the expected inflation rate over the next 12 months, which are currently
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While analysts focus on rates of change,
the real economy is mainly affected by
the levels of interest rates
The Ukraine war is having a greater impact
on global financial conditions than the
Covid bust and boom
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around 6.5%. This suggests that the wage and pricing decisions covering the
next 12 months that are far above Fed targets would be entirely rational for
businesses and workers with the bargaining power to impose them.
Fallacy #3: interest rates are already rising faster than ever; hence, over-
tightening and recession are greater risks than permanently high inflation.
The first statement is simply untrue. The 300bp rate hike expected between
March 2022 and 2023 would be the fastest 12-month rise in 25 years, but it
is no steeper than the hike from 3% to 6% between March 1994 and March
1995. And it pales in comparison with six-month rate hikes of 10pp imposed
by Paul Volcker in 1979 and again in 1980, or of 300bp in a single day in April
1982, which was the last time US inflation was at its present level.
More importantly, whereas financial analysts and investors often focus on
rates of change, because financial prices are “made at the margin”, the non-
financial “real” economy is mainly affected by the level of interest rates. It is the
interest level that mainly influences consumption and investment. Similarly,
it is the level of inflation and unemployment, not their rate of change, that
mainly influence wage bargaining and corporate pricing power. So long
as the level of interest rates to be paid in the next 12 months or two years
remains well below all plausible forecasts of inflation in the same periods,
both historical experience and economic theory suggest that monetary policy
remains accommodative, not fiercely deflationary.
Fallacy #4: inflation is determined by monetary policy, not geopolitics;
therefore, inflation is sure to return to target if the Fed and other central
banks are genuinely committed to price stability.
Inflation is “determined” by monetary policy in the sense that high enough
interest rates can always reduce it, provided that policymakers are willing
to do whatever it takes, for as long as it takes, to restore price stability. And
provided that politicians and voters, who ultimately control central bankers,
are genuinely willing to accept the economic costs and social dislocations
caused by a monetary policy tough enough to lower high inflation.
But what many investors seem to forget is that wars, sanctions and tariffs can
have a huge effect on the degree of monetary tightening required to get inflation
under control. This is why the Ukraine war is having even greater effects on
global financial conditions than did the Covid bust and boom. Because of
the war-related sanctions against Russia, the world’s biggest supplier not only
of energy but also many industrial and agricultural commodities, the global
economy now faces a permanent supply shock that is bigger and longer-term
than the post-Covid disruptions or even the 1970s oil crisis.
The resulting inflation pressures can only be reversed by curbing global
demand sufficiently to match the loss of global supply. The logical conclusion
is that real interest rates may now have to rise to higher levels than in any of
the inflationary episodes of the past 30 years and perhaps even higher than
they did in the 1970s. The markets and policymakers, by contrast, still hope
that the present inflation can be curbed with much lower real interest rates
than ever before. The only plausible reason for this hope comes back to faith
in the “anti-inflationary credibility” of central banks and the governments
they work for. Which points to the last and perhaps most important fallacy.
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Before the Yom Kippur war, governments
believed that full employment was more
important than price stability...
...an assumption that was overturned
by Thatcher and Reagan at the cost of
extreme recessions
The dominance of geopolitics over
economics refutes the notion that the US
and Europe are prioritizing price stability
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Fallacy #5: inflation is so unpopular with voters that politicians and central
bankers will do whatever is necessary and accept whatever economic cost
and social sacrifice is needed to restore price stability.
This seems to be the biggest difference between the present situation and
the 1970s. Back in 1974, when a globally unimportant Arab-Israeli war
triggered the energy shock that transformed world economic conditions
for the rest of the decade, governments in almost every country believed
that full employment was more important than price stability. Voters, when
presented with a choice between high inflation and high unemployment,
were universally expected to choose high inflation as the lesser evil.
This assumption about political preferences was overturned by Margaret
Thatcher and Ronald Reagan and the trend in global inflation was soon
reversed. But inflation was only suppressed at the cost of unemployment
rates and recessions so extreme that they were unthinkable a few years
earlier. The hope today is that businesses, workers and financial investors
will all understand that price stability is the absolute top priority in every
nation, and will therefore behave as if the present inflation is nothing more
than a transitory blip, despite the supply-demand imbalances in energy and
commodities and the tightness of labor markets.
But why should people believe this? In the past three months, the US and
European Union governments have shown very clearly that curbing inflation
is not remotely their highest priority. All the big policy decisions by the
US—the Russia sanctions, barring Iran and Venezuela from the global oil
market, the refusal to remove President Donald Trump’s China tariffs, the
subsidies for reshoring investments and supply chains—have underscored
how geopolitics trump economics whenever there is a clash between the two.
This may be justifiable and even moral in response to the Ukraine war—
although the Russian sanctions have done nothing to help Ukraine directly,
while the effect of rocketing energy prices will likely weaken the West’s
long-term ability to support Ukraine. That governments care more about
confronting geopolitical adversaries than they do about domestic price
stability does not mean that inflation cannot be controlled given tight enough
monetary policy. But the dominance of geopolitics over economics does refute
the notion espoused by US and European officials that price stability is their
absolute priority. This implies that the monetary policy required to restore
price stability will need to be tighter than in previous economic cycles, when
US and European geopolitical priorities were less obviously inflationary.
The upshot of these arguments is that restoring price stability in the years
ahead will be difficult, slow and costly. Meanwhile, investors and policymakers
almost unanimously believe that curbing inflation will be easier in the present
cycle than ever before. This cognitive dissonance is something that asset
prices are only just beginning to reflect. Which is why I believe that the bear
markets in both bonds and equities still have a long way to go.
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