The inflation monster: it is worse than we thought, and it has not grown up yet
Monetary expansion creates inflation where the money flows. For twelve years it flowed into assets. The question was where it would go when the assets fell.
The consumer-price report for May 2022 came out on 10 June and showed inflation at 8.6 per cent, a new forty-year high after a month in which many had expected it to have peaked. This page argued that the number, bad as it was, described a monster that had not yet grown up, and set out the mechanism by which it could, in a shorter time than anyone in authority appeared to expect. The mechanism does not depend on believing any of the people quoted in the video that opened the original, and it is kept here on its own.
Follow the money
The starting point was a fact that puzzled many people through the 2010s: the Federal Reserve created trillions of dollars and consumer prices barely moved. The explanation offered here was that money creates inflation where it flows. The money the Fed created went to banks, and banks put it into stocks, bonds and property, and those inflated, and everyone called it wealth. When, in 2020 and 2021, the government put money directly into households and businesses for the first time, consumer prices moved within a year. Same money, different channel.
That left a channel nobody had used. The created money was sitting in assets. If the assets fell, the money would have to go somewhere.
The everything collapse
By June 2022 stocks and bonds were falling together, which had not happened in the memory of most investors. Bonds are where money from stocks usually goes; with the Fed raising rates, they were falling faster than stocks. Property was next in line as mortgage rates doubled. There was no longer a large safe haven inside the financial markets. Some money had already begun moving into the one major market still rising, commodities, which were short in supply for reasons of war, sanctions and two years of underinvestment. But there had been no rush yet, no capitulation out of stocks and bonds, because a great deal of money was still waiting for the Fed to relent, the “Powell put”, and return to easing.
The argument was about what happens if the rush comes. Money leaving stocks, bonds and property simultaneously flows into commodities, because they are the only thing left that is going up. Commodity prices are the input cost of everything a consumer buys. Asset inflation, held in financial circles for twelve years, would be converted into consumer inflation in one move, and the size of the move would be the size of the asset bubble.
Two scenarios
The first, called here the least-worst case, was that the Fed kept its word and kept tightening. The markets would keep falling; at some point something large would break, as Lehman broke in 2008, because there is always a weakest hand holding something nobody knew about; and the ordinary response to that, a Fed rescue, is what the second scenario describes. Without the rescue, the fall would be severe and would eventually take inflation down with demand, at a cost in employment and wealth the Fed’s soft-landing language did not admit.
The second scenario was the one investors were hoping for. If the Fed capitulated and returned to easing into an inflation already at 8.6 per cent, with shortages unresolved and the asset bubble still deflating, the created money would have both channels open at once: new money flowing to assets and old money flowing out of them into commodities. That, in the judgement made here for the first time, would not be inflation but hyperinflation. The scenario investors read as their best case was the true worst case.
Who to believe
The people forecasting a return to 2 per cent had been the people calling 8.6 per cent transitory a year earlier. The forecast offered instead was not a number but a shape: worse before better, with the size of the worse depending on which of the two scenarios the Fed chose.
Later note. The Fed chose the first. It did not relent; rates rose to above 5 per cent and stayed there through 2023; something large broke in March 2023 in the form of three of the four largest bank failures in American history, and the rescue that followed was confined to depositors rather than markets. Commodities peaked in June 2022, the month this was written, and fell for a year. Inflation followed them down. The second scenario was never run, which is the strongest evidence available that the argument about it was heard.