Dear Valued Clients and Friends,
Last week, I used the Dividend Cafe to do a refreshed assessment of the current state of the economy.
The week before, I used the Dividend Cafe to do an assessment of the impact of tariffs on the economy, not “so far” (when they are still being worked out and just now being implemented), but six months, twelve months, eighteen months out.
And today, I want to use the Dividend Cafe to do a refreshed assessment of the state of inflation. It was quite a week for inflation data (July CPI came on Wednesday and July PPI came on Thursday). The conversation around inflation is highly politicized right now, it is almost entirely assumed to be centered around tariffs, and it is discussed in the media in a way that might make someone who cares about economics a little stir crazy (like the way my wife probably feels when I talk about interior design, which is actually a bad analogy because I don’t talk about interior design). The inflation talk matters right now, but some clarity is needed, and I am here to try to provide it.
Sadly, there is a certain clarity you may have been hoping for after reading today’s Dividend Cafe that you will not get. Economic data is often muddier than we want, especially if our only agenda with economic data is to politically dunk on someone via social media. But the clarity I do hope to provide may just be more important, even in a time where politics has become the god of the age.
So let’s talk inflation, jumping into the Dividend Cafe.
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A Chart to Start Our Analysis
I am not a journalist, so I don’t have to worry about being accused of “burying the lede.” But even as an economic and markets commentator, there is no reason to sandbag the conclusion. Let me start this Dividend Cafe with a very simple thesis statement:
Inflation has been very moderate for 25 years in aggregate – about 2.5% per year, even with the higher inflation after COVID. But the annual growth of CPI of 2.5% has not come from everything going up 2.5%, but rather with a lot of things declining in price, and other things increasing in price above the average inflation rate. And those things that have increased at a higher inflation rate that most matter to people are Housing, Health Care, and Higher Education (all subsidized by the federal government). To the extent the money supply growth has been roughly in line with production of new supplies of goods and services in our economy, inflation has been tame. The reason this has happened is because inflation is, always and forever, a monetary phenomenon.
Executive summary:
- Inflation has been mild for 25 years
- Wages have grown more than prices over these 25 years
- The really malignant price increases we have suffered, affecting the most people, are in Housing, Health Care, and Higher Education, and these three things are the three things the federal government subsidizes. It is either a six-sigma coincidence, or one might actually be tempted to conclude that government subsidizing something inflates its price.
- Money supply has to grow in tandem with GDP, and that level of money supply growth is not inflationary. That does not mean the distribution of impact will be linear or perfect, but in terms of macro aggregates, inflation comes when money supply growth outpaces production growth. The most disinflationary force of my lifetime was the supply-side revolution of the 1980s (which extended into the 1990s).
So, Why is Everyone so Mad?
The good vibrations of the 1980s and 1990s included two really important facets in the U.S. economy:
- Strong growth of supply of goods and services that soaked up money supply and tamed price inflation, especially compared to the inflation of the 1970s; and
- Real wages growing faster than prices.
Yes, asset price growth helped in those two decades, too, but not everyone owns assets. Prices staying tame and real wages growing (income growth > expense growth) make for good economic times and avoid populist revolts, usually.
But if the cost of a VCR drops and yet twenty years later a modest house in suburbia costs more than the state of Rhode Island, at some point those who benefitted from a low video rental expense start to get a little testy. Not being able to afford college or a house creates a social split in society that becomes problematic over time. Prices can be low, real wages can be growing, but price increases in those big categories create a rift that is in tension with the offsetting good news that food and energy prices take up a lower percentage of total expenditures than they used to.
I understand many want a simpler narrative with less commas or more “bad guy” clarity, but all of these things are objectively true at once: Real wages have grown in aggregate more than prices have for 25 years, and yet in housing, health care, and higher education there exists three specific categories that throw a fly in the ointment.
And Then More Recently?
Outside of the 25-year narrative, there is also this specific fact that hits in the post-COVID context:
Essentially, real wage growth is less than “normal” purchases over the last few years (food, energy, shelter, utilities, insurance). Asset price growth has more than made up for that for those with very high incomes and assets, but there is a “middle class angst” that is shorter term in causation around real wages and “everyday expenses” but also has to be understood in the longer term context of good real wage growth up against those big ticket items that created exclusions and societal separation (housing, college).
The Only Formula I Repeat Over and Over Again
MV=PT is the equation of exchange in Irving Fisher’s quantity theory of money, which is tautologically true. It states that Money Supply * Velocity = the Price Level * Total Supply of Goods. It can therefore be rewritten as:
P=MV/T
Price level = Money Supply * Velocity divided by Total Supply of Goods
What pulls inflation down in a GOOD way is NEW PRODUCTION
What pulls inflation down in a BAD way is LOW VELOCITY (collapsing loan demand, crowded private sector resources, low confidence, low investment)
What pushes inflation up in a BAD way is EXCESS MONEY SUPPLY, and/or LOW PRODUCTION
The and/or in that last one is somewhat disingenuous because it is almost always BOTH.
The greatest misunderstanding of what I have spent years and years talking about is the idea that “inflation being low” for the “wrong reasons” is somehow a good thing … And downward pressure on inflation post-financial crisis was NOT because of the 1980s and 1990s GOOD reasons. Mild inflation because of controlled money supply growth and impressive production is the economic dream; low inflation because of collapsing velocity is a predicate to low/slow/no growth.
So you don’t have to so much be careful about what you wish for, as why the thing you wish for happens.
But Tariffs?
If there is a new tariff of, let’s say, 30% on imported coffee and coffee prices go up, it can be said that there was “coffee inflation.” But assuming there was no new money supply or change in production, all that higher price in coffee means is that something else must cost less. So what happens when people say, “coffee prices are higher – inflation! gotcha!” … Well, it is unlikely that the TV camera interviewing the guy on the street complaining about the 30% increase in a cup of joe is also going to capture that something, somewhere, has declined in price. Tariffed items that go up in price will be deemed inflationary, and everyone is looking to say, “Ha! – caught you red-handed” – OR ELSE THE OTHER SIDE – “See, no inflation! Tariffs are awesome!” It is all so, so, so incandescently stupid. But these are the times in which we live.
But I wrote about this two weeks ago. A price increase from tariffs is potentially the first-order effect. Coffee importers have inelastic demand for their product, so prices may stay higher. Other importers face substitution risk (if prices go up, demand may erode), so they have to choose between protecting market share with lower profit margins or losing business. The demand curve moving forces decisions, and neither of them is good.
So no matter how much one tries, they will not get a black-and-white answer about tariffs and inflation. The old joke about a recession is when your neighbor loses their job and a depression is when you lose yours – well expect that kind of selectivity in the inflation description around tariffs for some time to come: When prices on something we are buying go up it is “inflation” – when prices on something we are buying do not go up it is “tariffs work.”
So What Did CPI and PPI Say This Week?
Before I answer this question that I typed myself into the sub-heading line, allow me to first say that no serious economist believes one month’s print is dispositive. A good CPI number one month or a bad PPI number one month does not mean anything more than that one month might be indicating something. All monthly data require follow-up and multi-month running averages to achieve validation. So no matter what the data said or says it would be dangerous to over-read it.
That said …
The Producer Price Index was up +0.9% in July, the highest in years. And we can’t speak to excluding food and energy or including food and energy as a reason for lumpiness (I see excluding OR including because people have a funny way of doing either/or depending on which one suits their priors) since both the core and headline were up +0.9%. Wholesale prices for services over the last year were up +4% and for goods, they were up +1.9%. There is a good chance that some of this is lumpy. And there is a good chance that the rising goods prices are capturing tariff impact, and that even services are capturing retaliatory tariff impact. We are a net importer of goods but a net exporter of services, and there is a bi-directional impact in the current tariff moment.
Goods prices had a big move higher in July, but the six-month average has been tame. Does this mean it is a lag effect, or does it reflect that most tariffs were not really in effect for most of the last six months? Quite possibly.
Go Figure
The five-year TIP spread right now is about 2.4% – the best implied expectation for inflation that trillions of dollars of market actors have to offer. Is that clear as mud? Something higher than 2%; something lower than 3-4% … not good, not bad, and not clear.
Conclusion
If we are talking about INFLATION, properly understood, the policy prescriptions are: Constrained money supply growth and supply-side incentives for productivity. Think of it like Volcker and Reagan having a love child and naming it the 1980s. And to be bipartisan, the Gingrich/Clinton moment of the 1990s was pretty strong for the supply-side of the economy, too, and the Greenspan/Rubin framework was a strong dollar and kept interest rates in check via low fiscal deficits. These kinds of modest inflation decades (for good reasons) are available for those who want them. “A knowledge of the past prepares us for the crisis of the present and the challenge of the future” (JFK, a supply-sider).
If we get LOW INFLATION because of LOW VELOCITY leading to stagnant growth, no one is going to be happy – no matter what the political commercials try to say.
And if we get a couple of months with low CPI or high CPI or low PPI or high PPI, no one reading in the Dividend Cafe should say, “What is going on?” Even if prices are higher, which I expect they will be for a time, the questions should be: What is this going to do for production?
Because my knowledge of the past tells me that this has more to do with prices, with inflation, with real economic growth, and with a truly better quality of life than anything else we are talking about right now. To that end, I work.
Chart of the Week
The partisan hackery of this whole subject is why I felt today’s Dividend Cafe needed a refresher in definitions and concepts.
Quote of the Week
“Patience sometimes requires more strength of character than does action”
~ Ferdinand de Lesseps
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My inbox has become a comical depository of conflicting accusations every weekend. I am thick-skinned, but it has become amusing to hear one person say I am saying X and two minutes later someone else accuses me of saying the opposite of X. But for the record, I just want to say that today’s Dividend Cafe mentions the current President’s name exactly zero times.
Have a wonderful weekend. Summer is nearing an end. Enjoy it. But we are on the brink of true joy. And you football fans know what I mean.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
