Inflation and Broken Windows
By John Mauldin
I’m often asked if I foresee inflation or deflation. This week we
had an “Ask Me Anything” session for Alpha Society members and it came up
several times.
Both are possible in their own ways, and frankly I feel a little
funny telling people I think we will see both. I would just like to have a
growing economy and dependable money that holds its value.
But for these letters, I have to distinguish between what I want and what I expect.
The kind of
stability I prefer isn’t on the menu right now.
So today we will wrap up my
2021 forecast series with a look at this important debate.
By the way, my Over
My Shoulder macro research service members already saw full
versions of some of the reports I’ll quote below.
If you aren’t one of them,
now is a great time to join. Where else can you find an essay from a music
lawyer comparing Robinhood to Napster?
It was totally on point.
Technology
quickly transformed that industry.
If you are in the market you need to
understand those changes. Someone will become the financial equivalent of
Spotify.
That’s the kind of unique analysis my co-editor Patrick Watson and
I find for Over My Shoulder
members.
We try to help them understand the critical points of our society and
economics.
Our goal is to give them economic and financial news without the
noise... and I think we’re succeeding.
Now on with today’s topic. We will begin with the obvious.
Gripping Hand Update
As I have been repeating all month (see here, here, and here), anything I say about the economy or markets is
subject to the coronavirus “Gripping Hand” It greatly constrains the available
options.
Other possibilities open up if we manage to get and keep the virus under
control.
Bluntly, conclusion first: You cannot predict inflation or
deflation until you understand the extent of the virus this summer. You get to
radically different outcomes, which I will discuss at the end.
The good news is that US vaccinations are accelerating. States and
the federal government are working out bugs in the process. Supply constraints
are easing a bit. It is still going much too slowly, but was always going to be
an ordeal.
The single-dose Johnson & Johnson vaccine should be approved
soon and will help.
With luck, everyone who wants to be vaccinated should have
the chance by this summer.
Let’s look at a few charts.
First of all, hospitalizations are way
down.
That is very good news.

Source: Justin Stebbing
Ditto for ICU patients:

Source: Justin Stebbing
The testing positivity rate and number of new cases are dropping,
too.
Well over 27 million people in the US have had at least one vaccine dose,
with about 1.3 million more doses administered each day.

Source: Our World in Data
Here is another chart comparing the responses of various
countries.
We must remember that we have to vaccinate the world to keep a new
strain/variant from popping out and starting this process all over again.

Source: Our World in Data
The next question is whether that will be enough.
The winter surge
is reversing, but the B117 and other more infectious variants could send case
numbers and hospitalizations higher again, and possibly a lot higher.
And even
with recent improvement, the numbers are still worse than they were at last
summer’s peak.
Back with a Vengeance
Thinking positively, imagine the US and other major economies
vaccinate enough people in the next few months to let semi-normal life resume
We’ll still be cautious, but the generalized fear subsides enough to let us
circulate again. Restaurants, hotels, airlines, and other hard-hit industries
start to get back on their feet. Then what?
Scenarios like that usually point to inflation.
Pent-up demand
will make people spend some of the extra savings they accumulated (often via
fiscal aid programs) in the last year.
Possible?
Yes, but I don’t expect it.
I
think this experience is scarring many people in the same way the Great
Depression scarred our parents, giving their generation a permanently thrifty
attitude. We’ll see.
But inflation can come from other directions, too.
My friend Louis
Gave recently described the larger forces at play.
I think inflation will come back
with a vengeance. One of the key deflationary forces in the past three decades
was China. I wrote a book about that in 2005; I was a deflationist then, as my
belief was that every company in the world would focus on what they can do best
and outsource everything else to China at lower costs. But now, we’re in a new
world, a world that I outlined in my last book, Clash of Empires, where supply chains are
broken up along the lines of separate empires.
Let me give you a simple
example: Over the past two years, the US has done everything it could to kill
Huawei. It’s done so by cutting off the semiconductor supply chain to Huawei.
The consequence is that every Chinese company today is worried about being the
next Huawei, not just in the tech space, but in every industry. Until recently,
price and quality were the most important considerations in any corporate
supply chain.
Now we have moved to a world where
safety of delivery matters most, even if the cost is higher. This is a dramatic
paradigm shift… It adds up to a huge hit to productivity.
Productivity is under
attack from everywhere, from regulation, from ESG investors, and now it’s also
under attack from security considerations.
This would only not be inflationary
if on the other side central banks were acting with restraint.
But of course we
know that central banks are printing money like never before.
(Over My Shoulder
members can read the full Louis Gave interview here, with my summary and highlights.)
The pandemic is clearly accelerating some preexisting trends.
Globalization was already starting to slow and possibly reverse for
technological reasons.
President Trump’s trade war gave more impetus to “Buy
American” and “Buy Local” policies, and Biden seems intent on continuing them.
And now COVID-19 gives national governments everywhere reason to be as
self-sufficient as possible. Businesses feel the same pressure.
But what really matters is how the Federal Reserve responds if
price inflation pushes interest rates higher.
Louis believes the Fed will enact
some kind of “yield curve control” to keep long-term Treasury yields near 2%.
This will tank the dollar, raising inflation but sending “real” interest rates
even more negative than they are now, thereby helping finance fast-growing
government debt.
This scenario would be good for gold and terrible for bonds. But
it’s not the only scenario, so let’s turn next to my favorite bond bull.
Broken Window Fallacy
Lacy Hunt of Hoisington Investment Management has been steadfastly
bullish on Treasury bonds for 39 years.
He saw what Paul Volcker was doing and
became a monster bond bull. He has been exactly right.
His argument is really
just simple math. To summarize:
- Growing public and private debt suppresses economic
growth as the additional debt has a smaller and smaller effect.
- The low growth reduces velocity of money, without which
sustained general inflation is impossible (though there can be inflation
in some segments).
- Inflation being the major determinant of Treasury
yields, those yields will move lower.
In his latest report, Lacy takes on the idea that fiscal stimulus
plus recovery from the pandemic will spark inflation.
He notes that any GDP
growth from here won’t reflect the pandemic’s vast wealth destruction. He
compares it to the famous Frederic Bastiat/Henry Hazlitt story of the broken
bakery window.
Fixing the damage boosts GDP, but you don’t see the other costs
incurred or opportunities missed.
Just as we can’t grow the economy by breaking
each other’s windows, we can’t expect pandemics or other disasters to be
beneficial.
He also points out (and Louis Gave does, too) that most fiscal
stimulus has a small and maybe negative multiplier effect. Governments aren’t
“investing” in new productive capacity or building anything new.
They are
simply transferring money between taxpayers, bondholders, and benefit
recipients. This may be
necessary in the short term, but it also misallocates resources and reduces
future growth.
Lacy saves his real fire for our overuse of debt.
This isn’t new
but the pandemic has accelerated it.
When debt capital, like any other
factor of production, is overused its marginal revenue product declines.
This
serves as a persistent drag on economic activity that restrains growth despite
the best efforts of monetary and fiscal policy.
The decline in the marginal
revenue productivity of debt, due to the pandemic, must now operate with even
weaker demographics around the world.
The pandemic resulted in considerably
lower marriage and birth rates which will have negative long-term consequences
for domestic and global growth.
Based upon the universally applicable
production function, the capability of achieving historical rates of economic
growth will be even more difficult in the years ahead.


Source: Hoisington Investment Management
(Over My Shoulder
members can read Lacy Hunt’s full report here, with my summary and highlights.)
The Federal Reserve is trying to stimulate an economy that already
had too much debt with yet more debt.
No surprise, it’s not working, though it
is boosting stock/asset/housing prices. Most of their stimulus simply stays on
the sidelines.
This is very clear in the velocity of money, which was already
trending lower but fell sharply in 2020.

Source: Hoisington Investment Management
At the most basic level, this is just plumbing.
Water flows
downhill.
Inflation is hard to imagine unless that velocity line turns higher.
But water can still splash for short periods.
Velocity rose sharply in the
post-WW2 years when, not coincidentally, the Fed was engaged in the kind of
yield curve control Louis Gave expects.
My friend David Rosenberg agrees.
He did a very interesting podcast with Grant Williams and Stephanie Pomboy. Quoting
from the transcript:
David
Rosenberg: So look, I would just say that you can almost dust off your slide
package from 12 years ago. The same people calling for inflation now were
calling for inflation back then.
They’re the ones that have to answer as to why
it is that inflation in the final analysis even with a stock market that quintupled,
and even with a bull market and commodities, and even with 3-1/2% unemployment,
we never did get the big inflation.
So they’d have to come and explain why all
of a sudden we’re going to get inflation in the coming cycle that we couldn’t
get in the previous, not just one, not just two, but the previous three cycles.
Stephanie
Pomboy: What worries me about it is that I totally agree with you on
those forces of deflation or disinflationary forces that are clearly evidenced
over that whole period …. But that doesn’t preclude people from getting all hot
and bothered and getting chinned up on an inflation scare.
They see the dollar
going down, they see import prices going up and they assume, okay, well, that’s
going to lead to CPI inflation, never mind that as you point out it didn’t for
the last decade or even longer, but what is the possibility?
David
Rosenberg: [At] the end of the day though, we have the most unpatriotic
development you could ever think of, which is that Americans have paid down
their credit card balances at a 14% annual rate over the past six months.
It’s
never happened before. And so it’s very difficult to get inflation when there’s
no credit creation, which is what the money velocity numbers are telling you,
or where there’s no significant wage growth.
Where’s the wage growth going to
come from? It’s very interesting that the same people that tell you about
inflation are so bulled up on the economic outlook, they believe that full
employment is still somewhere at or below 4%.
And of course the Fed’s forecast is
that the next few years we’re going to get back to that magical level below 4%.
But let’s just say that we have a situation where one in eight Americans is
either unemployed or underemployed.
There’s still tremendous idle capacity in
the labor market. We have a capacity realization rate in industry that’s around
74%. We’re nowhere near the conditions, in terms of the capacity pressures in
the economy, that’s going to lead to a sustained increase in inflation.
It
doesn’t mean that you don’t get some temporary periods of pass through in the
goods-producing side from commodities in the weaker dollar, but that’s not
lasting inflation.
So which will we get?
I suspect both. First off, this summer we
will have very low comparisons for inflation if you only look back for 12
months.
If we get even a modest recovery in the COVID numbers, we clearly could
see some short-term “inflation” in annual data from those weak comparisons. It
won’t last. If you look back 24 months (which we never do) you would see
inflation still under 2%.
And for the record, annualized PCE inflation, the
Fed’s favorite measure, is only 1.3% annually today. We have a long way to go
to get to 3%.
The debt burden will cap growth enough to keep the inflation mild.
It won’t be another 1970s period of sustained inflation.
But it might be enough
to send gold to record highs.
A lot depends on how much inflation the Fed
chooses to tolerate.
Their recent signals indicate it may be a lot more than
we’ve seen in this century.
I don’t think they get worked up until inflation is
well north of 3% for six months to a year. They have made it clear they want
inflation to “average” 2% for a period of time.
That means they have to
overshoot that target to get that average.
Implications
To get inflation, we have to assume that we have controlled the
gripping hand of the coronavirus. Look at what’s happening in Portugal, where
B117 recently began taking off.

Source: Our World in Data
This looks almost exactly like the Irish problem I mentioned two
weeks ago.
Notice that barely a month ago, Portugal was seeing a steep drop in
cases per million, much like the US is today. Then boom!
We really need to avoid such a spike here, first of all to save
lives, but also economically.
People would stay home and businesses close
voluntarily even if governors don’t order it, further devastating our
already-weakened economy.
Former FDA commissioner Scott Gottlieb, looking at CDC data,
thinks 50% of US coronavirus cases will be the B117 variant by the end of
February.
If this is the case (and we will know in a few weeks), then it means
another very serious spike in cases.
This would leave governors no good choices. Lockdowns which are
increasingly shown to be ineffective?
No lockdowns and let it run?
Nothing but
bad options.
Fortunately, we are getting better medicines to deal with the
disease.
The Cleveland Clinic has begun sending nurses to administer IV drugs
in patients’ homes, avoiding hospitalization. We will see more such innovation
and it will help.
Nevertheless, in a variant-driven spike event, the modestly recovering
economy will probably fall back into recession. Recessions are by definition deflationary events.
Obviously we all hope to avoid that, and I think it is quite
possible.
A few more weeks of solid vaccine progress, warmer weather, continued
distancing and other precautions, plus a little luck, might do the trick.
But
there is no time to waste.
I urge everyone: Get vaccinated as soon as it is
available to you, and keep avoiding crowds and all the other standard measures.
That is the best way you can help the economy, and particularly the small
businesses that have been hit so hard. We can get through this but it will
require everyone’s cooperation.
Other risks remain, too. Scientists think the current vaccines
will still work against the known variants, but that is not yet certain.
The
South African and Brazilian variants are already in the US (I have actually
been to Manaus where the Brazilian variant came from). Other variants could
appear, too.
It’s also still unclear how long immunity lasts, whether from
vaccines or from prior infection.
And more than a few people simply don’t want
the vaccine, for whatever reason.
Reaching “herd immunity” is not a sure thing
even when vaccinations crank up.
Then there is the rest of the world. Truly solving this problem
requires global
herd immunity, which means billions of vaccinations.
That part of the battle
has barely begun and could take several years.
So the gripping hand, aside from superior strength, has
independently moving fingers.
We need them all to relax before we can relax.
And oddly,
that happy outcome might trigger the kind of inflation we’d rather not see.
But
I don’t expect it this year.
And the bigger we build our debt in the US and
Europe, the less likely inflation becomes.
If we overcome the virus, the dollar likely continues lower,
although the eurozone is already trying to figure out how to manipulate the
euro lower.
If we get that spike here?
And it shows up in the rest of Europe
like it did in Portugal?
The dollar bears could get their face ripped off.
I
think gold does well in any event.
Sadly, every prediction and outcome is still
in the Gripping Hand. Stay tuned…
Robinhood, GameStop, et al.
There is simply no room in this letter to deal with the whole
trading debacle that is happening around Reddit, Robinhood, and so on. But I
have some comments on Twitter, where it seems to be more appropriate and where
you can follow me @JohnFMauldin. As noted above, we’ve also discussed it in Over My
Shoulder and I highly recommend you subscribe.
And somebody get Dave Portnoy, obviously on vacation, some
sunscreen.
And maybe we just give the poor hedge fund managers $600.
Time to hit the send button.
I am told I will get my first dose of
vaccine next week.
One of the few advantages of being older.
Have a great week
and stay safe.
Your desperately hoping we win the race against this virus
analyst,
|
John
Mauldin
Co-Founder, Mauldin Economics
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