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US Bureau of Labor Statistics

What if the headlines about inflation are all wrong?

You can’t look at the news these days without being blasted with headlines screaming about “runaway” inflation, “soaring” inflation, and inflation like we haven’t seen “since the 1980s.” A recent headline in the New Yorker asks, “Why Is High Inflation Proving So Persistent?” and Friday’s New York Times screams, “Inflation was much hotter than expected, bad news for the Fed.” Everyone is 100 percent sure that inflation is rising at an unprecedented rate.

But what if the headlines and pundits are wrong? What if inflation is not only not rising but has actually been falling for 4 months and the Federal Reserve has already met its target of a 2% rate? If that’s the case, their actions are now counterproductive.

The answer to a question is only as good as the question asked

Recent inflation reports are based on “year over year” (YoY) inflation rates--the rate of increase in prices over the last 12-month period: in other words, how inflation one year ago compares with inflation, today. But what if, under the circumstances, using YoY inflation rates creates a statistical mirage because of the unique nature of the times we live in?

On its face, the current media frenzy about inflation may seem reasonable but let’s take a moment to consider how we got where we are.

Since the 2008 financial crisis, inflation had remained remarkably flat, generally in the 1 to 2 percent range even though real interest rates were at historic lows. Then the pandemic hit and everything changed. In response to this crisis, which had unknowable outcomes, the federal government went on a spending spree that in inflation-adjusted terms had only been seen during the mobilization for World War II. And the Federal Reserve pushed interest real interest rates below zero.

Here's a chart of government spending as a percentage of gross domestic product (GDP).

US-Budget-Deficits-2000-to-2022-copy.jpg

The government’s response made sense at the time and they relied on “tried and true” supply and demand analysis and historical precedents to guide their actions. This approach worked, initially, but it stopped working sometime about a year ago.

The 2020 Covid-driven recession included much more than normal market-driven supply and demand imbalances that typically drive inflationary cycles. It included never-seen-before lock-downs of entire countries (some of which are still ongoing), an almost complete halt to international trade in some sectors, massive travel restrictions, and supply-chain seize-ups that produced shortages of everything from food and auto parts to computer chips and toilet paper. And then, in the winter of 2022, when the world was hoping that maybe things were returning to normal, we were hit with what has become a proxy-world-war-III scenario in Ukraine that has created a whole new level of shortages and supply chain disruptions.

But none of these things are caused by or cured by what any central bank does with interest rates.

This time things really are different.

The Covid-19 government spending was an anomaly that dwarfed historical precedents. The monetary largess that was showered on the public, in combination with the lowest borrowing rates for the longest period we’ve ever seen, led to what has been called the “everything bubble.” Prices for everything started to rise: housing, rent, food, automobiles, insurance, healthcare, and, of course, the stock market. But by mid-2021, the rate of change increased rapidly.

Despite growing concerns about inflation, the Federal Reserve continued its historic financial support (low-interest rates and quantitative easing) throughout 2021. This turned out to be unwise and by early 2022, they began to panic.

The monetary “lag effect” and the “Amazon effect”

One would think that surging inflation as a result of so much government money-printing was inevitable and everyone should have known this, and many did, except the government institutions that created it. So, why did this happen?

Part of the reason was that the thinking and data analysis methods that are still being used by the Fed to assess inflation, its durability, and the ability to predict its future behavior were and still are based on decades-old comparisons to the 1970s and 80s. But we’re not living in the 70s or the 80s or even the 90s. And therein lies the reason for the huge mistakes monetary policymakers are making, today.

The inflation of the late 1970s and early 1980s took more than a decade to develop, based on the combination of deficit spending for the Vietnam War and President Johnson’s “Great Society” running head-on into the “energy crisis” caused by OPEC holding the world hostage for its oil. This is not even remotely similar to the post-Covid situation we find ourselves in now. It’s almost the complete opposite. And the world has changed a lot since the 1980s.

Back in the 80s, if you went to the neighborhood hardware store to buy something and Mr. Jones, the owner, told you he was sorry but he had to raise the price because he didn’t want to let Gladys go even though times were tough, you probably bought the thing, anyway. Today, before you could have even gotten into your car, you’ve already bought it for the lowest price possible from some vendor in God-knows-where and you’ll have it the next day. And you don’t think about Mr. Jones and his store because he went out of business ten years ago.

This principle holds true for every industry and service in our economy.

Today, money moves around the world at the speed of light, and individuals, businesses, and markets react almost instantaneously to change. But unfortunately, markets always overreact and create self-fulfilling prophecies. That’s, in part, why the consequences of misinterpreting data by using backward-looking analytic models can be so catastrophic. By the time the Federal Reserve started raising interest rates in earnest in March of 2022, equity markets had already been falling since January, because they knew what was coming.

The damage from the pandemic has left lasting scars: restaurants that will never reopen, offices that will never be refilled with workers, and a reconsideration of globalization on a massive scale. It’s safe to say we are in a time of significant uncertainty and fundamental changes in our economy no matter what policies government adopts.

It is generally acknowledged that the impacts of monetary policies are not fully evident until 6 or even 12 months after they are implemented. By the time everyone can see the economic impacts, the damage that’s been done can last for years. This will be particularly true for housing affordability.

The counterproductive impacts of rising interest rates on housing affordability

We’re starting to see news stories about how falling housing prices are making things more “affordable.” But just the opposite is actually happening. With 30-year mortgage rates shooting up to 7% from less than 3% a year ago, buyers can only qualify to buy half the house they could have bought just one year ago. Loan payments have doubled. And since housing prices have not dropped by half, housing affordability has already gotten much worse. And when buyers can’t buy, they rent, putting even more pressure on rental rates.

Meanwhile, on an inflation-adjusted basis, housing costs are still rising compared to wages.

This math is not lost on home builders, who have been off-loading inventory as fast as they can and putting the brakes on future projects because borrowing costs have thrown all their best-laid plans for profit out the window.

Real estate development is one of the most interest-rate-sensitive businesses in the country and housing development projects take years to get from concept to construction. This makes housing one of the worst indicators upon which to base any kind of monetary policy, right now. But guess what? 40 percent of the calculation of the much-lauded Consumer Price Index (CPI)—that fills the headlines—is based on housing costs!

Even worse than that, the data that is used to compile the CPI for housing is more than 3 months old! This is absurd.

As a result, if they keep raising rates, the Federal Reserve’s current policy will significantly reduce the housing supply for years to come, as the “pipeline” runs dry.

In a time of supply scarcity, raising rates cannot significantly reduce housing costs because it reduces future supply. The price support of the lack of supply more than offsets any temporary price reductions by individual sellers or wage increases that have failed to keep up with inflation.

None of this makes any sense

Raising rates during a time of supply chain shortages, tariffs, and other punitive trade practices cannot reduce inflation. It can only increase it. Borrowing to invest in productivity, increased free trade, and increased competition can reduce inflation but these are all stunted by rising interest rates (i.e., the cost of doing business).

Yes, certainly, government-induced liquidity produced some wild excesses like meme stocks, SPACS, crypto-currency mania, and too many people buying Peloton bikes that they'll never use again, but that's not worth throwing the whole economy under the bus about.

Ironically, the Fed is now in danger of creating the one thing it is desperately trying to avoid; that the fear and anticipation of future inflation will spiral out of control driving people to buy and horde things to avoid future price increases (which increases demand and drives prices higher) and causing labor to strike for higher wages to survive what they perceive is coming (which also drives up prices), all of which, paradoxically, will only happen if this panic becomes embedded in everyone’s mind.

Let’s look at the real data

The headlines say that inflation is increasing rapidly but the data doesn’t support that. The evidence is found in a more careful analysis of the inflation numbers the government is relying on.

YoY analysis is just what it sounds like: a comparison of the cost of things today compared to the cost a year ago. But considering how the banking collapse of 2008 and the pandemic affected inflation over the past decade, year-over-year comparisons have become statistically aberrant. This is why we know that, anecdotally, prices are falling for many things--stocks and bonds, lumber, many commodities, used cars, the cost of shipping containers, and more—but we’re being told that prices are rising.

To understand this, here is the chart of annual inflation rates (YoY) that the headlines are squawking about.

2012-to-2022-Year-Inflation-Rates.JPG

On its face, it looks really bad. Inflation appears to be out of control. But, now consider the table below, by the U.S. Bureau of Labor Statistics, showing the same YoY inflation rate data on a monthly basis.

Inflation-from-2018-to-2022-copy.jpg

The table shows that from January 2018 to March 2012, inflation was generally less than 2% YoY, on average, on a monthly basis (and this was true since the 2008 financial crisis). But as you can see, when the government’s stimulus started to kick in, in March of 2021, (almost a year after the stimulus and rate cuts started), the comparative YoY inflation rate began to climb, quickly, every month.

This becomes more obvious when we view this data as a bar graph of the monthly YoY change in inflation rates since May 2021.

US-Bureau-of-Labor-Statistics-Monthly-Inflation-7-month-trend-line-copy.jpg

Two things immediately become clear. The first is that the recent YoY inflation rates appear to be stubbornly high because we’re comparing present data to YoY rates 12 months ago: a time when inflation rates were consistently very low. Second, we can see that the change in rates happened very abruptly, starting in November 2021.

The Federal Reserve is fond of scoffing at critics by saying “one month doesn’t make a trend.” But what is also clear is that the average inflation rate trend has been flat for the past 7 months! And, the trend over the past 4 months is decidedly down. (Inflation has fallen almost 10% since June 2022.)

US-Bureau-of-Labor-Statistics-Monthly-Inflation-YoY-TREND-copy.jpg

In this situation, where we’re comparing rates to a once-in-a-century phenomenon that created unprecedented volatility, this more granular, monthly data analysis in the chart above provides a much better picture of what’s happening.

This data is telling us that barring an extraordinary exogenous event (e.g., Putin using a nuclear weapon in Ukraine or another total lock down in China--neither of which is out of the question), we should not be surprised to see the November YoY inflation report (which will be released in mid-December) show a significant drop in the headline number because the year over year comparison, then, will be using November 2021’s 6.8% figure as the baseline. From that point forward, even if the current cost of goods and services remains unchanged at the same elevated prices we’re seeing today, the YoY inflation rate will fall to zero by March of 2023!

What the monthly YoY rate of inflation may also be telling us is that what started at the beginning of 2021 is not the beginning of a new, unstoppable inflationary surge but, rather, an inflation version of a pig being digested by a python. What if these charts are showing us that we’re witnessing something more like a one-time price “reset” than a persistent inflationary spiral?

If this is so, then if the Fed keeps obsessing about the headline numbers and keeps aggressively raising interest rates, by the time the pig has passed through the python, we will have long since passed the point of no return and will be faced with a collapsing economy and a whiplash deflationary environment combined with high borrowing rates that will make it much harder to recapture lost jobs and economic momentum and it will add years to our ability to restart affordable housing construction. Overall, affordability will be further out of reach for the average working family.

Raising rates too aggressively is now a greater risk than the consequences of not raising interest rates.

How could so many experts and news commentators have the inflation story so wrong?

Part of the answer lies in another kind of “lag effect.” Consumer consciousness of what’s going on and subsequent changes in human behavior does not happen all at once. It takes a while for people to stop buying and start economizing. And it takes many months before bottom-up evidence and anecdotal information becomes "fact" in the news. And then, suddenly, it seems to be everywhere all at once.

For example, gas prices in the San Francisco Bay Area shot up into the $6 to $7 a gallon range about 5 months, ago. Yet, it's only recently that most people are starting to cut down on their driving in reaction to it.

Similarly, the data shows that people started to max out their credit cards several months ago (to be able to continue spending as they normally would because they were running out of money). But now, consumers are actually starting to cut back on spending (because they're running out of credit). So now, suddenly, the news is talking about how inflation is impacting consumers, even though they never said anything about the rise in credit card spending in the previous 6 months.

In other words, the “news” and "inflation psychology" are not data just like "investor sentiment" about the stock market (which is typically at a positive peak just before markets tank) is not a leading indicator. Both are contrary indicators. The fact that “inflation” is all over the news, today, is similar to that.

The "story" we get in the headlines is usually a story that already happened and what's really going on won't be in the headlines for another few months. Similarly, that’s why it’s a huge mistake for the Federal Reserve to be obsessed with general YoY inflation data instead of more real-time, monthly indicators.

But something else is very wrong

In 2008, those who had the least to do with the causes of the financial crisis--working, middle-class families--unfairly suffered the most from its impacts. Now, once again, those who did the least to cause our current inflation challenges will be the ones most punished by the Fed’s overly aggressive monetary tightening.

In my opinion, the Federal Reserve’s entire approach to “managing” the economy is outdated and bankrupt.

There is something very wrong with a system that believes its only alternative to the consequences of its own economic mismanagement is to cripple the livelihoods of the working class and attack our financial markets. There is something very wrong with a system that punishes working-class American families, by drastically increasing borrowing costs at a time when prices for basic necessities are high.

Worst of all, much of this is unnecessary.

Instead, how about having the legislature pass laws to reduce corporate profiteering and rampant commodities speculation or instituting temporary price controls on food and energy (as they've started to do in Europe) and putting limits on credit card debt interest rates, and forcing banks to pay a reasonable rate of return on savings to help people get through this unusual time.

Why is the economic pain always felt the most at the bottom and not at the top?

A great deal is riding on the consequences of the Fed’s misguided, sledgehammer approach. College endowments, institutional assets, and pension fund holdings are losing trillions of dollars in value. Retirement funds are dwindling. And the housing mortgage market has fallen off a cliff. If all this is followed by a “hard landing” recession, as more and more bankers and financial experts are claiming, the astronomical amount of current private and public debt means the country is not ready to handle that outcome.

A great deal of this can be blamed on the fact that our government and the Federal Reserve are relying on data analysis methodologies that have been outdated for decades. The Fed is using backward-looking data in a real-time world where money moves and economic decisions are made on the fly.

However, considering that the mistakes they make have tremendous, worldwide impacts, it’s not comforting for me to know that I know more about the real-time, click-by-click behavior and preferences of the readers of the Marin Post and am better able to predict their behavior (likes and dislikes) accurately than the Fed can about the direction of the American economy.


Bob Silvestri is a Marin County resident, the Editor of the Marin Post, and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization funded by individuals and nonprofit donors. Please consider DONATING TO THE MARIN POST AND CVP to enable us to continue to work on behalf of California residents.