Don’t Trust the Conventional Wisdom: Inflation Isn’t Peaking.


Recent purchasing manager indexes are largely behind the growing assumptions that pricing pressures are topping. Nancy Lazar, chief economist at Cornerstone Macro, says a falling spread between the new orders and production components of the Institute for Supply Management’s national manufacturing survey signals that the demand-supply imbalance is easing. Some economists found evidence of a peak in the December consumer price index itself, with Aneta Markowska, chief economist at Jefferies, noting slower service-sector price increases and a steady rate of shelter inflation. And then came a slip in producer prices from record levels, suggesting that businesses are feeling less pain and soon consumers will, too.

While evidence of sputtering inflation is as welcome as it is compelling, data age fast in this pandemic era. This past week, Barron’s checked in with SpaceKnow, a New York–based company that monitors economies around the world from space in near-real time. The company’s synthetic aperture radar satellites have night vision and see through clouds to scan U.S. ports, thousands of logistics centers, and major trucking stops.

Daily data gathered from space depict high port congestion—a big factor behind broad supply-chain problems—that isn’t actually improving. “We continue to see high congestion at U.S. ports with no major sign of pullback,” say analysts at SpaceKnow. Container data this month, meanwhile, suggest that any supply-chain normalization has halted. That’s not to mention data showing worsening port congestion in China, a dour sign for domestic supplies.

The takeaway? It is premature to expect inflationary pressures to ease because supply chains are still stressed, says Anu Murgai, vice president of commercial solutions at SpaceKnow.

Now for the rest of the story. Since inflation started climbing, economists, policy makers, and politicians have attributed fast and persistently rising prices to pandemic-induced supply bottlenecks. But there is evidence that demand is also driving inflation. That may seem obvious and inevitable, given the amount of fiscal and monetary support unleashed over the past two years, but some combination of faulty predictions, wishful thinking, and politics has made it unusual to hear it suggested that consumer demand is fueling prices.

Michael Darda, chief economist and market strategist at MKM Partners calls it “the Alice in Wonderland monetary debate,” where economists are focusing entirely on supply-side shocks as a source of inflation and failing to recognize evidence of demand-side inflation.

Specifically, Darda points to nominal gross-domestic-product growth. Driven by changes in real economic activity and in prices, he says, NGDP has compounded at a 14.9% average annual rate over the six quarters beginning in the third quarter of 2020. Looking at just 2021, that rate is 11%. We haven’t seen sustained double-digit NGDP growth since the 1970s, when inflation was also hot, Darda says.

“Rapid NGDP growth means easy money and demand-side inflation. End of story,” he says, explaining that NGDP is equivalent to money multiplied by its velocity and thus a proxy for a central bank’s monetary stance. “If we recognize this, we can also see the absurdity of making inflation pronouncements about supply-side shocks, price controls, profiteering, etc., without any reference whatsoever to the central bank’s monetary stance,” Darda says.

The distinction is more than in principle. Inflationary risks will remain elevated until the Fed achieves a more neutral policy stance, says Darda, adding that tightening with the explicit aim of guiding NGDP toward a sustainable 4% to 5% annually would be consistent with a 2% to 3% average inflation. In other words, even if supply chains were to quickly normalize, we still have a problem.

For investors interested in the weeds, there is evidence of demand-driven inflation in plain sight. Consider the Bureau of Labor Statistics’ experimental price index for new vehicles, using data purchased from analytics company J.D. Power. The point of the experimental index, says Rob McClelland, former head of price-index research at the BLS, is to see user trends more immediately.

Published CPI data show annual new-vehicle inflation of about 12%, whereas the experimental index shows an annual rate of about 20%, McClelland says. Why the discrepancy? He says the methodology differences mean that rising demand puts pressure on prices faster in the experimental index than in the published version. Why is it significant? Unlike in normal times, when demand falls or shifts as prices increase, demand is climbing and in a sector that has been the poster child for supply shortages.

There’s more. The so-called chained CPI, which accounts for consumers’ substitutions in response to price changes, is rising faster than the fixed-weight CPI. That unusual dynamic makes it fair to extrapolate from the experimental vehicle index and presume that demand—not just supply shortages—is lifting prices across the economy, McClelland says.

What is the upshot for investors if supply-chain optimism is dated and demand is driving inflation much more than commonly recognized? Things are going to get worse, and they’ll get better only when the Fed begins to tighten at least as aggressively as now forecast. The central bank is part of the problem it must fix.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com



Read More:Don’t Trust the Conventional Wisdom: Inflation Isn’t Peaking.

2022-01-14 18:10:00

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