Economic Predictions for H2 2022, Part 1: This is not Your Father’s Inflation

The following is the first part of a broad overview of the major trends I believe are going to be the dominant stories for the rest of the year with my own projections for where these stories are going. This first part covers what I believe is going to happen (in broad terms) my prediction for the number-one story of the remaining year and into next year.

Over the days ahead, I will cover the rest of the barrage of troubles and bubbles I listed in my article “An Apocalypse Upon Us: How much more can we take?” Because there is so much to cover, I am breaking the predictions into several parts. I’m going to make every other part available to all readers, partly to keep content coming on my site while I work though this long list of predictions, partly to make sure everyone gets a little help, and partly in hopes of encouraging a few regular readers to become patrons because ONLY PATRONS at the $5 level or above will have access to every part of this series of economic predictions and I need the support more than ever as I’ve decided to semi-retire in order to focus exclusively on The Great Recession Blog and my patrons to see if I can make this work well enough to stay focused on it. The next couple of months may tell.

These are the trends I see happening in the economic news that I read daily, which you can now read with me as I post links to all those stories each weekday morning and late afternoon in “The Daily Doom” section I just added to my website at the top of my home page. Patrons are the only ones who will get to see the whole list of predictions — the broadest overview. This is your first installment, and thanks for staying with me.

Inflation will keep the Fed engaged in firefighting all year

My key prediction back in 2021 for 2022 is not about to let up just because it has already happened. Inflation remains the driving economic event that will dominate the economy, crush markets and bewilder the Fed and befuddle stock investors for the remainder of this year and into next year. The easing days of intentional inflationism where the Fed had to try its hardest just to get inflation up to its target of 2% are history. Investors are now beguiled by their belief in a Fed that had the liberty to stimulate the economy whenever it wanted to with nearly infinite money. They have not fully accepted the fact that the Fed no longer has that luxury, so they keep returning to peculiar belief that bad news is good news because it means the Fed will pivot and come to the rescue. It will not.

For a decade, the world was abundant with supply and because all of the Fed’s foundational support for banks to create money was targeted to financial markets, no significant inflation happened on Main Street. Technical innovation, the rapid expansion of the Chinese economy and availability of its cheap labor, and a well-lubricated free-trade world (albeit highly unbalanced) kept prices down. Globalized trade with several other nations also helped keep production costs down. That free trade is gone now at the same time that Fed liberty to work in a nearly inflation-free environment is gone due to supply shortages. The shortages are also currently crimping technical efficiency by making high-tech parts less available. So, the practical things that helped suppress inflation have suddenly vanished like a waterspout that is there and then retracts back into the sky and is gone.

These shortages mean excess money will be used to bid up prices as people and companies compete for the limited availability of things they need. Those who say “Inflation is always and only a monetary phenomenon” are only half right. We all know prices are determined by supply and demand. It is just extremely rare that there is a deficiency in supply in almost everything all over the world at the same time. An increase in the supply of money all over the world at the same time — thanks to numerous central banks — increases the ability of demand at a time when supply is short everywhere, so that means inflation everywhere due to the imbalances, for shortages are simply an imbalance between supply and demand. (You’re not short of any given item, even if there is next to none of it around, if no one wants it.)

Because we compete globally for those products, that makes this a highly complex inflation problem to resolve, made more complex by global sanctions that many politicians don’t want to let go of because of the war, even though letting go of them would solve a big chunk of this problem (but not all of it because we had serious shortages well before the war). It all means there are many problems involved in even trying to resolve these shortages — left over trade wars with their tariffs, a world where nations now hate to trade with each other and where politicians would prefer to fight a war with sanctions than with direct involvement of their own militaries, supply chains that broke down due to the Covid lockdowns, and shortages of workers who said, “I’m never coming back.”

With all of that, this is a very complex inflation problem that could easily get much worse. And that is only part of why this inflation is not your father’s inflation, and why it is a greater battle than the Fed can handle, as I’ll show there are more ordinary parts to it below that are, in themselves, hard to fight.

While the Fed could still target all of its money to financial markets so that it only created asset inflation with its money printing, it is unlikely the federal government would sit back and watch. The Biden administration is highly prone to use Fed largesse, if the Fed wants to open the floodgates again, to fund big spending projects that distribute the money directly into the general economy as we saw happening since spring of 2020. So, a return to easing would assure much higher inflation.

Also keeping up inflation pressure for, at least, the remainder of this year, the producer side of the economy is experiencing double-digit inflation and will be trying to pass those higher costs along wherever possible. That’s inflationary back pressure that is already extant that will keep pricing charged to possibly push the consumer price inflation rate even higher through the remaining months of the year.

Inflation psychology is also already getting baked into all layers of the economy. That represents a sea change from the last decade that causes everyone to start setting prices now based on what they believe inflation in their own costs will be doing to them in the months ahead. When inflation was a standard 2%, producers and retailers didn’t have to worry about it as much and could predictably plan for it. Now, no one knows what it will be, and that creates a tendency to buffer your prices for the worst to the extent your competition will allow.

Contractors bidding a house, for example, are buffering their bids with inflation expectations because materials may rise so quickly during the time it takes to build the home that they’ll lose money if they don’t include enough for inflation. The need to guess what that will amount to causes builders to play it safe and guess a little high. Because all the competition is starting to think the same way, that makes it more possible to buffer high and still get the bid. While we know that is happening in home construction by the testimony of many builders, that same dynamic is likely happening in many industries now.

The Fed greatly fears inflation psychology becoming part of everyone’s thinking, and it has to be aware it is already happening pervasively. So, that is why you know the Fed is going to continue to take the inflation war seriously now that it sees inflation expectations starting to form and will lean on the side of fighting inflation versus the side of saving the stock market or preventing the economy from going into recession. (Even though it is already in recession, the Fed denies that because it has to fight inflation and cannot have you thinking it is continuing to tighten into a recession, or you’ll know it lost control.)

Having been so wrong about inflation in their public statements, I think it will be a long time before the Fed becomes complacent about inflation again as they see all those forces crowding against them. So, investors salivating for a quick pivot are highly likely to be wrong, BUT they believe they are highly likely to be right because the Fed has always pivoted in recent history. That doesn’t mean the Fed won’t return to QE, but that it won’t return to QE until the economy clearly lies in ruins. The fact that shortages are likely to remain a problem for the next couple of years, in the very least, certainly means the return to easing is unlikely to happen anytime soon. The Fed is not going to throw a torch in the tinderbox the second it manages to suffocate the fire.

Here’s the worst part: If the economy dies quickly so the Fed is pressed to return to easing, they will turn today’s hot inflation into hyperinflation in the present environment where the only thing that is abundant is shortages and troubles! I can’t rule that out because it is not as if the Fed never does anything dumb, but that would be truly horrific as no amount of monetary easing will end shortages, but it will certainly fuel everyday prices to explode during a time of shortages in the same way the Fed fueled skyrocketing housing prices over the past two years when housing inventory was low. Moreover, small numbers, such as the cost of a ham, can more easily go up by bigger percentages than very large numbers, such as the cost of a house.

Peak inflation is not the hope many expect it will be

Inflation is probably near a peak — or, at least, won’t be rising as fast as it has been since the Fed is now strangling the limited life back out of the economy by raising the cost of financing and reducing the foundations of money supply. Inflation will likely now see ups and downs, rather than a straight climb up, given that the economy is clearly now back in a recession, and recessions create strong deflationary forces.

The present situation is, however, highly unusual because shortages will counter those recessionary demand-destruction pricing forces and have the potential to become severe enough during this time of global sanctions and droughts to drive inflation higher later in the year when existing stocks run dry and the areas with the worst shortages start to appear like the higher areas in the tidelands as the tide runs out. Why? Because, as said, shortages are an imbalance between supply and demand; so, if demand is driven down by lack of money but supply falls further due to war and sanctions and droughts, then a shortage still exists, pushing prices up. In the present situation where shortages are the other story dominating the news, we can have inflation in spite of the deflationary forces that come with a recession.

So, while I think we are near a peak, you can see that is with a major caveat that we all have to keep our eyes on due to dynamics more complex than anytime in my life or J Powell’s. My best-case scenario is that inflation remains above 6% all the way into 2023, but I think it most likely doesn’t come below 8% this year and probably still rises slowly along a jagged line of ups and down. Bear in mind, there is a long lag between Fed monetary policy and inflation or economic change. Stocks can turn in seconds like a speed boat in response to the Fed, but the economy is a supertanker and changes course lethargically.

The commodity supercharger

The biggest risk for inflation right now is in commodities. That is where the hyperinflation risk I wrote about earlier comes into play IF the Fed really is dumb enough to pivot back to easing (which I highly doubt, but it has been known to do some really dumb things). In that case, traders will see their best bet is commodities and, instead of supply and demand from producers being the primary driver in the price of commodities, speculative trading will drive the show, assuring commodities become the new asset bubble for the Fed’s easy money. That would put thrusters on the inflation of everything.

Simply put, liquidity is a river, and it flows along the path of least resistance, which means the channels that have the deepest inflationary biases are the ones where great volumes of easy money will flow because asset inflation is what all investors seek.

Commodities have unique risks, such as the need to take physical possession of them at some point, shelf lives, and storage fees, so they are not usually the most broadly preferred asset trade; but in times of shortages, they provide the hope of the most rapid inflation, making them a lot more tempting; and special vehicles may develop, such as new ETFs, to make those trades easier or seemingly safer. The reach for yield, which pressed people to riskier bonds when the Fed kept interest low, may press people all they way out into commodities. The money river will flow where the channels are deepest.

I don’t, however, think the fed will reopen the liquidity taps. I’m just saying, if they do get that dumb, then look out in the commodity direction … at least, during the present time of shortages that give natural lift to commodities anyway, making them less risky, if not yet priced too high, than they are in normal times. Once the pricing rises quickly, however, then FOMO begins, and momentum can sustain itself even in rising risk … just as we saw with stocks and houses … and with commodities in the first phase of this inflation.

Other central banks of more desperate nations will get that dumb because third-world nations have always had a hard time resisting the money-printing temptation. It never works, but there is always some country that has to try it. Central banks can’t print potatoes. They can only devalue the currency that buys potatoes by making more of it when it is potatoes, not paper, the people want.

So — as I said for the first time in my writing back in 2020 before any rise in consumer prices began to keep your eye on inflation as it may finally start to become a problem — now I say to keep you eye on commodities to see if we are going to go into a hyper-inflationary cycle if the Fed starts to ease due to the present recession in a time of shortages. They could be the supercharger that turns high inflation into a fire tornado.

Another thing to note about inflation is that it has become quite broad as well as historically intense:

Ninety-seven percent of the items in the CPI basket have their three-month average inflation rate moving upward. [And] the Federal Reserve Bank of Cleveland’s “Trimmed Mean” inflation measure, which strips out the items with the highest and lowest numbers, is at its highest level ever.

Neuberger Berman

What this breadth means is that, as some areas are easing off, such as fuel at the moment, other areas are still building. So, the drop of inflation in some areas will not necessarily cause a decline in overall CPI because other areas will continue to rise. Food inflation, for example, is almost certain to run hotter as crop failures due to drought and livestock slaughtered now, also due to drought, leaving less to slaughter later, become worse over the summer and into fall and as war continues to hurt the breadbasket of Europe, causing more European demand for US crops. Right now, for example, a pathway has supposedly been opened for shipping last year’s grain out of Ukraine to make room for this year’s grain; but this year’s grain is likely to be a small crop due to war making it highly risky, if not impossible, to farm in some of the best farmland areas. So, this winter’s food shortages could be even worse.

Similarly, the housing market is clearly cooling off quickly now, and prices may start to decline more generally this fall, but housing has a long lag time in getting reported in CPI. So, the housing component of CPI should keep rising for half a year or more, even if prices soon turn the corner. The housing inflation of this past spring won’t be fully hitting the CPI numbers until late fall or winter. (People are already experiencing those increases, but they are slow to be reported.)

High prices may not cure high prices

Finally, many believe high prices are the best cure for high prices because consumers cut back when prices get too high. While this is generally true, the investment analysts quoted above present a good contrarian view for why that may not be true now.

In addition to the underappreciated breadth of inflation, in terms of both items and regions, we think the consensus overestimates the potential for price mean reversion, particularly in commodities—the idea that high prices are the natural cure for high prices.

That belief in substantial mean reversion appears to be based to some extent on fundamentals, such as the potential for recession and the relief of geopolitical and supply-chain bottlenecks. But it also appears to be dependent on signals from futures markets, which, for example, are pricing oil for delivery this time next year at around $83 per barrel.

We would question the quality of the information that far out on futures curves, where there are low trading volumes….

We think the level and stickiness of inflation will require the Fed to raise its policy rate substantially above its estimate of the neutral rate (which is the rate that neither restricts nor stimulates the economy)—and hold it there for some time.

I think so, too. The battle against high inflation has never been so easily won in the past as the stock market seems to be hoping it will be today, allowing the Fed to make a quick pivot. I see no historic basis for thinking that. It seems more like wishful thinking to me, baited by the Fed’s recent past with little recognition that Fed pivots were easy when there was no inflation. That world, where the Fed couldn’t create inflation when it wanted to, is gone, but wishful thinking dies hard.

The market is currently pricing the long-run neutral rate at around 2.25% – 2.50% (a range that we expect to shift higher); at those levels, we think the Fed will go to a terminal rate between 3.25% and 3.75% and get there by the first quarter of next year.

Normally, the Fed would have to price interest higher than inflation to stuff inflation back down. I don’t think it will have to do that this time BECAUSE … NORMALLY … as in during those rare times when the Fed does have to fight inflation, it is fighting inflation when the economy is hot! This time it is fighting inflation when the economy is riddled with more troubles than I have ever seen (as listed in my earlier article that I noted above) and is already six months into a recession, whether the officials declare it so or not (as I explained in this article: “REAL GDP SAYS: “Get Real!“).

Therefore, the badly battered economy will crumble into ruin long before the Fed gets interest above inflation, and the crumbling will probably kill inflation so long as the Fed doesn’t make that mistake of trying to resurrect the economy with more QE. But, what will it matter that inflation is finally dead if the economy is, too.? In that case, we enter another Great Depression, which gives stocks lots of additional room to fall for a long time.

This is where we are in deep trouble no matter what the Fed does because of the trap the Fed created for all of us … not just for itself.

Thus, the analysts quoted state,

In our minds, it is at least as likely that inflation proves even more stubborn than our above-consensus view, forcing the Fed to a terminal rate in the 4.00% – 4.50% range.

I don’t think the Fed will even make it that high, so it won’t get inflation down by making interest higher, but only by destroying the economy trying. So, hold on to your seats because things are going to get weird (as if they were not weird everywhere already). This is a far more complex inflation fight than we’ve ever seen.