The Psychology of Inflation - Inflation series part 3

+Japanese monetary policy

This is part 3 of my series of posts on inflation. Here is part 1 and part 2.

Last Friday, the latest US CPI inflation print for May came out at 8.6%, with the CPI index rising 1.0% over the previous month. This was well above the expectations of the market and economists, many of whom were forecasting a downtick in inflation and the start of a downtrend that would take inflation back to acceptable levels. One research house (which I won’t name) had been forecasting a peak in inflation ever since Q1 of this year, and kept pushing back this elusive peak with each higher inflation print. They finally issued a mea culpa over the weekend admitting that they were early and wrong. They are not alone, and I think the coming months will see capitulation from those who believe inflation can roll over on its own accord, without drastic and violent intervention from monetary policy. The breach of 3.25% in Treasury 10 yr yields signifies a collective flip in sentiment towards the view that inflation is not mean-reverting, but is instead reflexive (a self-reinforcing feedback loop), and therefore will require much tighter policy than even the most imaginative macro analyst can foresee.

On the whole, these moves have been great for my portfolio of positions, and I think even at current levels they still have a long way to run.

The Psychology of Inflation

I feel empathy towards central banks and forecasters for getting inflation wrong. It’s impossible to pin down the drivers of inflation, as the causes are monetary, fiscal, geopolitical, and social all at once. The initial triggers that spark inflation tend to be the first three, but what keeps inflation persistent and accelerating to the upside tends to be the hardest to pin down - social factors.

The topic of inflation dominates dinner conversations these days. People complain not only of higher prices, but also poorer service and quality of products, shortages of goods, and delays in shipping. I’ve accumulated anecdotes of inflation-related challenges that business owners are facing:

-The owner of a burger place down the road says imported ingredients are harder to source and take longer to arrive. Every time I dine there, he is working in the kitchen - not out of choice, but because he can’t find enough labor.

-New car owners are now being asked to manually unlock their cars (like stick a key into the keyhole of the door handle, and twist it like we did in the 80’s!) because manufacturers can’t source the chips that go into keyless entry fobs.

-I interviewed a candidate the other day who is looking for a new job because her current one requires her to be in the office every day until 6 pm. This would not have been an issue pre-covid.

In Robert Schiller’s book “Narrative Economics”, he discusses how narratives can shape economics and perpetuate trends in a feedback loop. On inflation in the 1970’s:

Meanwhile, although US consumers did not agree on the causes of the inflation, they were nonetheless angry about it. When asked to identify the cause of the inflation, their most common response was “greed,” followed by “people borrow or lend too much.” In specifying the targets of their anger, the US respondents listed, in order of frequency, “the government,” “manufacturers,” “store owners,” “business in general,” “wholesalers,” “executives,” “U.S. Congress,” “greedy people,” “institutions,” “economists” “retailers” “distributors”,” “middlemen, “conglomerates, “the President of the United States,” “the Democratic party,” “big money people,” “store employees” (for wage demands that forced price increase), their “employer” (for not raising their salary), and “themselves” (for being ignorant of matters).

Humans have an innate need to blame something for their problems. If this question was asked today, then Putin, Biden, Jay Powell, and fossil fuel companies would be on the list.

Popular syndicated columnist Sydney J. Harris wrote in 1975: What is so frustrating about this kind of thing is the difficulty in pinning down the culprits, if any…

Either somebody is lying, or the whole economic process doesn’t make sense.

If labor is getting “too much,” why are most working families struggling to make ends meet?

If grocers are “profiteering,” why do they get glummer as prices go higher?

Where does the buck stop? Nobody knows. And so each segment blames another for the vicious spiral, and each justified its own increases by pointing to its own rising cost of doing business

The market no longer seems to control prices when they keep escalating despite reduced consumption.

Some strange new twisted law appears to be operating in place of the classical formula of the “free market.”

What is this “strange new twisted law” that Harris is referring to? The answer is inside all of us, and that is human nature. When prices are stable, consumers and businesses act with a set of behaviors that are rational for a stable price environment. They buy enough of the inputs they need, but not too much as that would be capital inefficient. They price their products competitively to maintain or gain market share. They borrow and access credit in a financially sustainable way (for the most part). And companies don’t overpay for talent as there is always someone else who will fill that role (after all, companies need to protect their margins).

However when prices are rising, society and economies undergo a phase change where the previous set of behaviors gets replaced by an entirely new one that favors borrowing and spending more today vs spending tomorrow. When consumers or businesses face rising prices and uncertain supply, this new set of behaviors is perfectly rationale from a game theory perspective. Businesses order extra inventory in case of supply shocks, and try to pass higher input costs on to consumers (cost-push inflation). Consumers tap credit to front-load their purchases to get in front of inflation. Workers demand higher pay to keep up with inflation, and if they don’t have enough leverage on their own, they seek leverage in groups. Higher wages in turn result in greater demand for goods, resulting in the dreaded wage-price spiral.

Unionization is on the rise in the US after being dormant for decades. According to the National Union Relations Board, “During the first six months of Fiscal Year 2022 (October 1–March 31), union representation petitions filed at the NLRB have increased 57%—up to 1,174 from 748 during the first half of FY2021. At the same time, unfair labor practice charges have increased 14%—from 7,255 to 8,254.”

Some anecdotes on unionization:

-More than 250 Starbucks locations filed petitions to unionize, and after notching a first win late last year, 54 Starbucks company-owned stores have formally organized.

-Workers at an Amazon warehouse in New York City recently voted to form the first union at the second-largest U.S. private employer and join the Amazon Labor Union

-Google Fiber contractors in Kansas City successfully voted to unionize their small office in March becoming, the first workers with bargaining rights under the one year-old Alphabet Workers Union

This new set of social and economic behaviors related to inflation is hard to measure and quantify, but economists try their best. The monthly University of Michigan survey asks respondents “During the next 12 months, do you think that prices in general will go up, or go down, or stay where they are now? And by what percent do you expect prices to go up, on the average, during the next 12 months?” There is also a version of this question that asks about the next 5-10 years instead of the next 12 months.

It just so happens that 12 month inflation expectations are the highest they have been since when the survey started asking this question in 1975!

The last peak occurred in May 2008 amid 5.6% YoY CPI inflation and $140 oil. It took the Great Financial Crisis to bring inflation and inflation expectations back down (and there were no energy or supply chain crises back then).

Today’s surge of inflation has taken us past the point of no return. A Fed funds rate of 3% will be like trying to stop a freight train with a cardboard box. Every month the economy spends growing instead of contracting will be another month of accelerating inflation. The financial media talk about how Powell will need to be like Volcker and hike aggressively to stymie inflation. It won’t be so easy for Powell put on his Volcker mask and suddenly get the job done. There was a good reason why the US economy suffered through nine years of inflation before Volcker came along and stopped it. The reason is that it’s fucking hard and painful to stop inflation, politics have to be 100% aligned with you, and you need to take a lot of shit from the public. Here are some excerpts from Volcker’s memoirs, “Keeping At It”.

By December 1980 the Fed insisted I agree to “personal security escort protection.” A year later an armed man somehow entered the Federal Reserve, threatening to take the board hostage. My speeches were occasionally interrupted by screaming protestors, once by rates let loose in the audience, typically organized by the far-right radical Lyndon LaRouche and his supporters.

Will Powell and Biden (or the next president) be able to take the heat? I don’t know.

I’ll end this section with a few words of advice Volcker wrote to journalist Robert J. Samuelson in 2004:

Don’t let inflation get ingrained. Once that happens, there’s too much agony in stopping the momentum. That’s the lesson of central banking all over the world.

Japanese Monetary Policy

Monetary policy in Japan is about to get really interesting. To give you some background, their policy rate has been -0.10% for a long time, and the Bank of Japan has been been capping 10 yr government bond yields at 0.25% by offering to buy bonds from market participants every time the yield reaches that level. They have the loosest monetary policy in the developed world right now, and the Japanese yen has been depreciating aggressively as a result.

Today they got filled on $11bn USD worth of bonds, and even after that monster purchase, JGB futures are even lower, indicating yields that are well through the 0.25% cap that the BoJ has said they would defend. It looks like bond sellers are taking on the BoJ and forcing them to either 1) continue buying an unsustainable amount of JGBs (which fans the inflationary flames and weakens the yen) or 2) lift the yield cap.

Usd/jpy is also trading uncharacteristically weak today, diverging from its usual correlation to Treasury yields. The FX market may be sniffing out the possibility that the BoJ will be forced to capitulate on their loose monetary policy stance and join the rest of the world in fighting inflation. The BoJ meets this Friday, and we get May’s CPI data next Friday. April’s inflation print was 2.5% - low compared to the world but accelerating to the upside. My guess is that the BoJ lifts the yield cap as early as this week, and no later than early July (after next Friday’s inflation print comes in hot). If they lift the yield cap, usd/jpy FX could drop 300-500 pips quickly, and yields may jump to the level of their next yield cap, wherever that is. For a global macro trader, this is a pretty juicy setup that could make a large portion of a year’s profits, if played correctly!