The Fed continues to attempt to use interest rates, quantitative easing, and other monetary tools and policies to not only provide life-support, and, hopefully, growth for the economy, but also to achieve a 2% average consumer inflation rate (as distinguished from asset inflation), and planning to allow the economy and inflation to “run hot” to do so.
But before inflation can run hot- it has to get hot.
There is no way to have persistent 2%-plus consumer inflation with, and the only way to have inflation is to stop, persistent and pervasive economy-wide offshoring (and outsourcing).
As long as there’s a global workforce of low-cost labor in developed, and, especially, in emerging markets, and, thus a nearly infinite supply of labor, there will never be structural inflation, again* (especially as low interest rates and low yields allow companies to continue to inexpensively scale to keep input costs, including labor costs, suppressed- which inexpensive capital for such uses is, of course, a result of the low interest rates and low yields that resulted from the low wages and low inflation that resulted from the offshoring, in the first place1).
Here are 20 reasons why we will, likely, have both low long-term and low short-term inflation (these reasons are in addition to the prime and root cause of persistently and structurally low inflation- offshoring of U.S. jobs):
- Opening up of Supply Chains (Cost-Push Inflation is Not Inevitable): As the vaccine provides a defense to the virus, consumer demand will rise- but we will also all be back to work, and supply chains will re-open and rapidly expand to meet that rise in demand. The excess capacity in the world economy pre-virus has not disappeared; just the opposite. It has been magnified as equipment and supplies have sat unused for months. The supply shock has already occurred, due to a lack of health and available people to supply needed manufacturing (just ask Peloton and Qualcomm), and will be lessened on re-opening and a vaccine. Remember that a re-opening of the economy means “people” functioning normally. That not only means “consumers”, but also businesses (which are, actually, “people”). Businesses along the entire supply chain just being open could, actually, dampen some of the year-on-year transitory inflation from PCE base effects (when comparing prices to 2020 periods when such businesses were almost completely closed). Demand was lower, but supply was significantly constrained, causing prices to rise, in some cases. Many companies have been slowly ramping operations back-up over recent months, in line with, and ahead of a wider re-opening and the arrival of more demand, such that the output gap is already declining. A slow modest re-opening, rather than “one big day of opening” (the less likely scenario), will help manage the output gap.
- Economies of Scale and Volume Pricing: The more product a retailer, wholesaler, distributor, and supplier order from manufacturers and producers, the lower price per unit they can achieve. It’s known as “economies of scale” and “volume pricing”, which are “disinflationary” phenomena. As the economy opens, retailers and wholesalers will have a natural “scaling” effect, and confidence about the future, such that they can plan ahead and order products in larger volumes, due to more customers and more confidence in the consistency of customers (though see #4 below), than they have been doing, using economies of scale and volume orders to get lower prices- which saving passed-on to consumers. Nothing about this principle will change on re-opening. The more you buy, the less you pay. This tactic to lower prices could, actually, offset some of the transitory inflation which would, otherwise, be at an even higher rate, due to base effects. The price you pay for a plate of chicken in a local restaurant reflects (among other things) the price that the owner paid for the raw food. As he orders more from his supplier, his price can go lower. And this process goes all the way up the supply chain until it hits the manufacturer/producer, whose fixed costs as a percentage of revenues declines as economies of scale take hold. As long as there is no input shortage (such as of labor or energy) that causes a cost-push, the manufacturer has no incentive or need to raise prices as demand rises. The opposite. As orders get larger, unit volume discounts are provided. Further, buying and storing inventory means lower prices than ordering with short windows as and when needed.
- Manufacturing Costs as a Percentage of Revenues: The more a manufacturer makes of a product, the lower its per unit fixed (vs. variable) cost to produce it. As volume, at the same profit margin, rises, the fixed costs go lower as a percentage of revenues and profits. Variable costs, such as labor, can, but won’t, necessarily, rise much, especially where manufacturing is done overseas, and especially with automated and software- driven production. Further, the U.S. unemployment rate is high enough to keep wage pressures at bay for some time. These factors allow companies to grow revenues and profits faster than expenses, and maintain their margins, without having to raise prices- and certainly without raising prices in any significant way. Even a variable cost such as energy may not rise much with greater demand, because we are now the world’s largest producer and we have a lot of oil. As demand rises, so can supply. Plus, energy costs are not in core inflation (though they can spillover into more generalized PPI, CPI, and PCE inflation). (More on energy supply, demand, and prices below).
- Less Hoarding (Less Demand-Pull Inflation in Certain Products): The costs of “necessities”, like food and shelter, and goods for use at home, like gym equipment and electronics, will not be any higher with the vaccine. If anything, the cost of these things, as hording wanes, and as supply chains open up and the output gap narrows, will decline. This could, actually, offset some of the base effects that will cause a higher PCE reading. (If retailers and consumers were clamoring for and willing to pay anything for certain goods last March, April and May, why would those prices not be lower now than they were at such time, rather than higher? I would have paid $400.00 for 2 ounces of hand sanitizer or for a set of dumbbells back then). This reversal of hoarding will do more to alleviate the output gap and price pressures than to cause any price hikes for retailers from a reversal of volume pricing from volume-ordering during the pandemic.
- Switching Spending from Goods to Services: Prices of goods will go lower from consumer dollars moving to service channels. This could, actually, offset some of the base effects that will cause a higher PCE reading, as demand for certain goods decline- especially if other factors discussed herein, such as competition and labor force slack, keep service costs low. Looking at these factors, We could, actually, see lower inflation on a re-opening if service rates remain static, while prices for some goods decline.
- Services Are Labor-Based: Services make up a greater portion of the inflation index, but the biggest input cost of services is labor and wages, and there is plenty of slack in the labor market such that wage pressures are far off. In any event, the Philips curve has proved itself nearly dead (or profoundly incapacitated) – even during the longest and strongest stretches of recent economic growth. Moreover, service businesses have, relatively, low startup costs compared to goods businesses, and, thus, offer less pricing power for companies than manufacturers and sellers of hard goods due to greater competition and the Internet. In many industries, such as digital entertainment, services are free (well … our personal data and lack of privacy are the prices we pay). Entertainment costs will not rise, even as demand rises. A movie ticket in Manhattan, pre-pandemic, was $20.00. That cost will not rise upon re-opening, especially when considering that the new revenue brings down the theaters fixed costs as a percentage of revenues. There’s no inflationary effect there, at all- not even a transitory one, since a movie ticket cost $20.00 in Manhattan in March and April of 2020. And it surely will not go higher from here (because of both competition for eyeballs and entertainment dollars, and health concerns). In the case of movie theaters, in particular, even if wages did rise, inflating the PPI, that cost would unlikely to get passed-on to the consumer, for the aforesaid reasons.
- Basket of Goods Diversity: Some prices in the basket of goods may have increased from and during the pandemic- like electronics and exercise equipment- while others stayed the same or declined- such as transportation and live entertainment- and may not rise, at all, upon a full re-opening of the economy. Some prices that rise from a re-opening (such as for services) may only be rising from their discounted levels that were maintained during the pandemic-driven period of low demand (transitory/reflation). So, prices may be higher than the comparison period, but are not, generally, being inflated for any structural or even cyclical reason that will persist and head upwards. For example, restaurants will not rush to raise prices on new customers, though they may seek to cover new expenses from re-opening, such as basic additional electricity costs. These are one-time considerations, not structural inflation. Still, overall PCE may not rise, even in the short-term or for a transitory period, based on the entire basket of goods, which will have varying consequences from a re-opening. Remember that as restaurants open, the rise in demand improves their economies of scale when buying raw food, liquor, and other cooking and service products. So prices per unit can decline. Further, keep in mind that a business’s need and desire, respectively, to raise prices to operate in a re-opening can be offset by declining expenses as a percentage of revenues and profits and by competition, respectively.
- Competition: Companies can only raise prices if they “have to”, or if they “can”- if competitors also do the same (such as due to a new regulation or a supply shock). Otherwise, competition and the Internet will keep prices in-check. Lowest price is still the largest objective of companies in markets- especially as top line growth and regaining customers becomes vital upon re-opening. Technology, and, specifically, the Internet will continue to be a price and margin depressant.
- Market-Share Expansion During the Pandemic: The pandemic has allowed large companies in all industries to achieve scale and gain market-share, such that those companies have achieved economies of scale to allow them to keep prices muted as the economy opens. While their market-share gains give them pricing power, that pricing power will not be exercised immediately as the economy re-opens, and price hikes will not take place without justifiable cause just for the sake of raising prices. Scale as a tool to maintain low prices– rather than as a tool to raise prices– has the weight of recent history on its side.
- Entrepreneurs: New businesses financed with private equity will be trying to compete on price in their markets to gain market-share. Free, or profitless, has often been a new company strategy (which is part of the cause of persistent disinflation, as private equity throws around cheap capital in its nearly-riskless hunt for yield.
- Low Interest Rates, Cheap Debt, and Private Equity (and Value and Small Cap Investing): In a time of offshoring and low inflation, companies seek to achieve scale and market-share using cheap debt and an abundance of available risk capital with the objective of obtaining more revenue growth to replace hard-to-achieve margin growth (due to wage stagnation for employees- who are their consumers) as a path to bottom line profit-growth. This means lower, or, at least, stagnant consumer prices, where possible, to take over market-share. This phenomenon has been compounded by private equity investments into new companies that scale-up rapidly through low prices, free services, and loss-leaders. In practicality, such market power that results from “size” can be disinflationary (keeping prices low to maintain all the customers), rather than providing power (or incentive) to raise prices. Large companies, like Amazon and Apple, diversify into various industries through loss-leaders and vast economies of scale. So, higher prices are often not incentivized or planned, even as demand rises (such as upon a re-opening). Strategies to lower prices are more likely- and, as companies have scaled and grown market-share in the pandemic, more possible to achieve. (Some equities and credit market investors are, probably, underestimating the level at which large companies have taken market-share from smaller competitors during the pandemic by marketing and scaling, while smaller competitors have lost the price and delivery-speed wars, and, thus, how, at this time in history, unlike in other economic recoveries, a rotation into small-caps and value (or “value traps”), is not financially sound, as “value” really may mean an unrecoverable loss of customers to secular growth trends- especially in small cap value companies. In other words, secular trends have caused structural shifts, not only in behaviors, but in our entire economic structure. The definition of proper and sensible asset reflation “trades” (buying small cap and value stocks) based on where we are in an economic cycle must change and evolve, just as many other economic principles have changed and evolved- including how the entire structure of our economy has changes and evolved. As persistent and structural low inflation leads to alterations in financial strategies for growth, resulting in practical-monopolies in industries, so, too, should these phenomena change the case for owning certain value and small cap stocks (and, specially small cap value stocks) where “no” economic climate will allow them to improve their customer levels, market-shares, or margins (I’m excluding value that is inherently cyclical, such as financials, where cycles, due to interest rates, can directly affect margins), as companies in industries and sectors have scaled ever-larger to take most of the market share to offset low growth (and low margin expansion), leaving little room for competitors. This does not mean that small companies can’t have earnings growth, especially in comparison to their 2020 earnings, it means that their respective pricing powers and abilities to attract and keep skilled and unskilled labor are structurally challenged from their highly-scaled, well financed competitors, in the long run. Small businesses are, inherently, structurally challenged in a time of cheap money, offshoring, and the Internet. Moreover, if government infrastructure legislation passes, the government (the largest employer of them all) will suck-up a lot of the labor pool. And the government will likely seek bids from lowest-price goods and services providers- which will, in many cases, be from the largest companies who can afford to be the lowest cost providers- which is why companies like Microsoft and Amazon get the Pentagon contracts.)
- Beach and Country: Rents in cities are where most of the rent pressure usually builds. Rents in cities have taken a significant hit as tens of thousands of people across the country have relocated from cities to smaller cities, suburbs, the mountains, and to beach towns. Owner equivalent rent data will remain weak as the nation has spread-out due to virus concerns, high taxes, crime, and available technology tools. (Housing prices are asset inflation, but rents are consumer inflation). While rents in the areas where masses of people have moved are rapidly rising, it is easier to add housing stock in the suburbs to prevent a structural rent problem than it is in cities. Cities, particularly Democrat run cities, have more regulations, stricter building codes, longer time periods between planning and building, less space to add square feet to the local inventory, and, most important of all, because new housing in cities is built vertically and have multiple units, it takes much longer to add inventory to the area than in places where houses- single family houses- can rapidly be constructed. Further, the available land to expand housing stock in the nation’s suburbs is far vaster than in the nation’s limited “safe and public transportation heavy” urban areas. So rents can be managed in hurting cities an in growing suburbs, simultaneously. Moreover, vacant and failing retail properties in the suburbs could be re-zoned, or “up-zoned”, to residential rental use more easily and readily than can retail spaces in cities.
In addition, as low Treasury yields send investors hunting for yield and home prices are rising as houses are used not only for living, and not only for ROI, but for rental income. Houses are, historically, not as readily available in communities for rental use as are apartments. As single family home ownership from investors seeking rental yield rises, so will available houses that have been purchased for rental income. Rental stock in communities, with the addition of so many single family rental properties, will outstrip demand- a deflationary outcome for the OER data point of the PCE. Plenty of rentals in cities due to relocations, plus new rental capacity, and the space for even more of it, will keep OER figures low.
- Misunderstanding of Inflation: Recall how the “experts” predicted that a direct hike in prices– a/k/a import tariffs- would cause generalized inflation. That never happened. Even a direct unequivocal hike in input prices, a tax, (while unemployment was at a historic low) did not cause generalized consumer inflation.
- Continuing Health Concerns: Certain services that have seen big cut-backs in capacity (gyms and hotels) will remain slow until the vaccine proves itself, over time. Exercising at home and Airbnb will prevail for quite some time (in the former case, that equipment has already been bought, so prices will not rise; in the latter case, services, such as hotels, will remain challenged). So these certain, very virus-driven spending trends will not change much. Same goes for movie theaters vs. home viewing on larger screens that we already bought last year.
- Savings Rate: The savings rate could rise as multi-generations of people have now learned how quickly a virus can spread and cause income and/or job loss (not to mention loss of life). This psychological outcome of the pandemic may be getting underrated by economists. Consider how many of our grandparents’ and great grandparents’ psyches and spending habits were influenced for decades following the Great Depression.
- EM and DM weaknesses: Even as the U.S. economy improves, Europe may still remain troubled due to the virus as well as due to its long-term structural economic problems, and China is still an export, rather than a consumption economy. This means low competition for goods and services, even as the U.S. gains its footing. As for China, as our economy opens, our spending will shift to services over goods, hurting China’s exports.
- Corporate Debt. High levels of corporate debt taken on in 2020 can act as an economic depressant for growth (though in many cases, this debt is at very low rates. Still, many companies took on such low-cost debt just to survive- and some still won’t).
- Consumer Debt. Many consumers at higher economic levels have used stimulus to pay down their household balance sheets, rather than on new spending.
- Capital Misallocations and Dislocations. Low interest rates and cheap capital cause money to be misallocated so that profitless companies expand and zombie companies survive. These are disinflationary phenomena that result from excess (or, excessive) stimuli.
- Energy Supply-Demand Balance is an Unknown (Demand, Legislation, and Corporate Policy): Will energy demand from airlines and commuters to work be inflationary? Will domestic oil drillers and producers offer enough supply to meet new demand? Have people been using their cars, boats, and RVs much more during the pandemic such that there would be an offset to new traveler and commuter gasoline demand pressures as these recreational uses wane? Will airline prices only rise once- from a very low pandemic induced rate- to account for new oil demand, rather than be a structural upward trend? Will limits on international travel persist, even upon a full U.S. re-opening? Will work from home trends persist, such that commuter demand will be far lower than pre-pandemic levels, during which time energy inflation was already being muted by the available supply? 2020 supply cuts from OPEC and production cuts in the U.S. can be ramped-up and add supply to meet new demand, if they so choose. At the end of the day, as long there is no regulatory issue, energy prices are controlled by the economic concept of “demand destruction”. Simply put, there has to be a true unresolvable limited amount of something to create persistent price inflation. This is why labor costs were always inflationary- because there are only so many Americans in the nation. But offshoring created a global workforce- one comprised of people who have a very low cost of living, no employment protections or rights, and little health and bodily safety at work. Presently, if exploration and production is re-started, and OPEC releases more supply, the overall oil supply can rise to meet demand. There is no inherent or natural limit on supply. To be sure, a lack of new exploration and production or of more OPEC supply to meet any new demand could lead to much higher prices and spillover into general inflation- and would be economically harmful. On the other hand, supply cuts worldwide during the pandemic, particularly by OPEC, can be reversed as demand rises to prevent “demand destruction”.
Policy, through legislation, that limits onshore oil production, particularly in the shadow of a major U.S. infrastructure plan, could (or would) be inflationary (through both less supply at a time of much more demand)- and while energy prices are not in the core inflation numbers, such a policy change would, undeniably, be a structural event that has long-term economic implications- inflation of producer, transportation, and, thus, general consumer prices. This type of scenario would be a case of “bad” inflation, input cost inflation without wage inflation, like those situations that occurred in the 1970s, where supply constraints steeped in politics (due to an OPEC embargo and Iranian supply cuts) caused rising prices.
Further, a national infrastructure plan combined with oil supply cuts, due to legislation, corporate balance sheet management, or long-term corporate strategies, or all of these, would be a toxic mix (or, if you want inflation- a perfect elixir). If the government, in a large infrastructure plan, becomes a bigger energy customer, “demand destruction” would not take hold for a long time. But- if higher energy prices are a result of not only legislation and corporate policy, but also due to unemployment and higher wages (from a national infrastructure plan), this is a “good” type of inflation- when, and if, it remains under control.
Nothing will cause sustainable 2%-plus “core” price inflation (or even very high transitory inflation)- nothing-
*except legislation that mandates onshoring and reshoring (or other market-protection laws)- which can help achieve “good” structural inflation- i.e. wage inflation- and reinstate the business cycle.2 But growth in domestic jobs and expansion of demand for domestic labor that could lead to upward wage pressures (a de facto minimum wage hike) could result from a de facto onshoring policy, one arising by virtue of a significant infrastructure plan where the government puts it resources behind economic activities, production, and development- which, by their very nature, require domestic, as opposed to offshore, labor. A significant infrastructure plan could be inflationary for wages and for commodities- especially if China also expand its infrastructure plans- and transmit into general inflation. (Note that China has actually started to reel-in its excessive spending.)
Combine a national U.S. infrastructure plan that creates demand for energy (and other commodities, like copper and lumber) with higher oil prices as the result of corporate decisions and/or federal legislation or Executive Order, lower unemployment from government hiring in connection with a national infrastructure plan (with higher wages .. which will allow companies to have pricing power to offset the expense3– and throw in a China infrastructure plan, which is always something to which China resorts in order to keep its economy moving …
… and you will get lots and lots of long-term, beyond-transitory inflation.
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- I refer to this circle as the “Circle of Rust”. We offshored manufacturing jobs, which caused the need to keep prices low as wages stagnated, so that consumers (employees) could afford products. This, in turn, required even more offshoring of Rust Belt jobs to keep prices heading lower as wage stagnation reverberated throughout society and it demanded companies achieve more scale to get prices lower (and to get profit growth through revenue growth, instead of through margin expansion). The more Rust Belt jobs that were offshored, the more that had to be continuously offshored in the future to keep pushing prices downward so that Americans losing manufacturing jobs in the Rust Belt and across America, and Americans across the nation suffering wage stagnation and even real wage loss, as a consequence, could keep buying stuff. And the Rust Belt got rustier and rustier. “The Circle of Rust”- a self-fulfilling disgrace.
- A business cycle requires that business investment expands on the back of low interest rates as the Fed attempts to stimulate the economy following a Fed-induced recession designed to stop inflation (and, usually, following a predictive advance yield curve inversion) and the employment rate rises, available labor pools shrink, and wages rise. As wages rise, household spending rises, consumer demand rises, the velocity of money increases, and inflation takes hold as demand causes input costs (like wages, oil, and lumber) to rise.
This cycle no longer exists, as the “rising wages” element has been extracted from the mix through offshoring of manufacturing jobs (causing the death, or, at least, the profound incapacitation of the Phillips curve). This means lower wages and it means less consumer demand from American workers (i.e. consumers), and it surely means that they can not pay more for products. This leads to the need for companies to keep costs and prices low through scale, and by offshoring more jobs. This results in low wage inflation, low CPI inflation, low interest rates, asset bubbles, capital misallocations, propping up of zombie companies- and an uneven, unpredictable society. - When companies have a strong consumer base with upward income mobility, they have pricing power, and they can grow profits through margin expansion, rather than needing to grow revenues as the path to higher earnings- which is the cause of U.S. companies’ desperate need for Chinese consumers, and the related and resulting national security problems from accepting China’s bad and illegal behaviors. Tariffs on foreign imports are required to create and complete a proper domestic manufacturing renaissance. With a true business cycle, one with onshore jobs and the resulting wage pressures, we’d get the benefits of a strong dollar’s effect of attracting capital, while not being as concerned about our exports. Other nations need us more than we need them- especially export driven economies. Widespread onshoring in the U.S. would compound that reality.
ENDNOTES
- I’m only discussing cost-push and demand-pull inflation here. Federal Reserve polices and actions could, potentially, (but not inevitably), debase the currency and result in inflation (though debasement is a sort-of cost-push phenomenon- it raises the cost of input elements, such as commodities). In the long-run, capital will flow from the U.S. to Europe’s damaged and structurally-weak economy and low rates and yields, and will revert to the U.S. from China, which has opened the floodgates of its renminbi printing press, while forcing its banks to make loans to struggling Chinese companies, while needing a weaker currency to maintain its exports, as its objective of a more domestic consumer-driven economy continues to flounder. As the U.S. economy opens and consumers shift from good to services, China will suffer. These factors will drive capital to the United States and mean dollar strength.
- For those who believe the wages inflation lags more general price inflation, rather than being the root cause, in such case, my 20 points above explain why even other types of input-cost inflation will not materialize without a national infrastructure plan. Low wages are one big reason, in my opinion, for continued low inflation- but this is in addition to any other type of low input-cost inflation.
- There are consumer prices that will probably continue to rise, such as health care and education costs. How they transmit into general inflation is a separate matter from vaccine and stimulus-driven inflation being discussed here.
- If certain nations do not have vaccine success and health improvements, while we do, that could cause certain supply chain problems and certain supply shocks affecting certain input elements and supplies and, thus, inflate certain prices in the United States.
