A table set for inflation

| February 5, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Fiscal and monetary policy have been extremely aggressive in attempting to sustain the economy through the pandemic. However, the standard prescription for bringing the economy out of recession is not well-suited for fixing what currently ails us. As unused stimulus accumulates, the economy is at risk of a severe supply-demand imbalance. It is a table set for inflation.

Demand Side Economics

Since the Keynesian revolution in the early- to mid-20th century, the bulk of macroeconomic analysis has focused on the demand side of the economy. The crux of the Keynesian insight was that a market economy would not always find its way back to equilibrium, the just-right combination of potential GDP growth and full employment. Instead, it could get stuck, as it did in the 1930s, in a depression, with a vicious circle where high unemployment leads to insufficient demand which, in turn, forces firms to continue laying off workers. Keynes hypothesized that a government in such a circumstance could employ people and inject money into the economy, in essence propping up demand artificially until a virtual cycle kicks in and gets the economy back on track.

That concept was taken to its extreme after World War II, as economists came to believe that government policy could be used to fine-tune the business cycle, eradicating recessions. When the constraints that prevent the government from offering nimble adjustments to fiscal policy became evident, the primary responsibility for managing the business cycle was shifted to central banks and monetary policy.

Monetary policy can boost and curtail the demand side of the economy by raising or lowering interest rates, or, alternatively, by speeding up or slowing down the pace of money creation. When the economy is facing a temporary bout of insufficient demand, an easing of monetary policy can often be a perfect antidote, as lower interest rates encourage businesses and households to borrow more, spend more, and save less, pulling demand forward and hopefully getting the economy back on track.

The Covid pandemic: a supply shock

The Covid pandemic has not brought on the garden-variety post-war demand-side recession. The economy was thrown off track in two ways: first, huge swaths of the economy were essentially forced to close or at least to curtail activity, and, second, million of workers at those firms were laid off and lost the wherewithal to spend. In this situation, the Federal Reserve did all it could, quickly taking policy rates to the zero bound and pursuing innovative methods to foster easy financial conditions. However, the pandemic presented a classic supply shock, when the productive capacity of the economy is damaged, a circumstance that the Fed has limited ability to address.

Fiscal policy moved to the forefront of the policy response. But there was no fixing the contraction to the supply side of the economy until the pandemic was brought under control. The federal government arranged to lend money to small businesses through the PPP and offered rebate checks and bonus unemployment benefits to keep workers whole while they were forced to sit at home. These programs worked fantastically well at boosting household and business income, preventing the vicious cycle described above, but the economy is still not going to be able to get back to normal until the pandemic ebbs sufficiently to allow the economy to fully reopen. In other words, the federal government offered massive amounts of demand-side stimulus to an economy with a supply-side problem.

An illustration

Here is an illustration to explain the difference between supply and demand side shocks, and the impact of various responses under different scenarios:

Imagine someone sitting at a dinner table, ready to eat. A demand side shock would be the equivalent of taking away the person’s food source. He goes hungry because he has nothing to eat. The government, via either fiscal or monetary policy, can relatively easily fix this problem by providing him with plates of food until his regular source of food returns.

A supply side shock would be the equivalent of the person developing a stomach problem, say an obstruction or stomach virus, that prevents him from being able to process food properly. The net result is the same as a demand shock: he is unable to provide his body with the proper nutrition that it needs to maintain health. Seeing this, the government steps in again, providing him with plates of food.

The person dutifully tries to eat the food, but his capacity to digest it is compromised. Two things may ultimately happen. He may continue trying to eat, which is likely to produce indigestion or nausea. Or he may, knowing that he can’t digest the food, set it to the side and save it until he is able to fully enjoy it. The current economy is showing clear signs of both.

Signs of saving

Households have accumulated massive amounts of liquid assets, waiting for the day when they can spend on activities that are currently constrained, like eating out, traveling and attending spectator events. Businesses have also amassed a huge cache of liquid assets, in many cases waiting for more clarity on revenue prospects before executing on investment plans. In short, the savings rate is quite high.

Signs of indigestion

There are also signs all around us of the indigestion that occurs when the person tries to eat but cannot digest properly. January’s ISM Manufacturing Survey report pointed to a sector in some distress. Supplier deliveries are lengthening nearly as broadly as any time since the 1970s, aside from April, when the economy was mostly shut down. Order backlogs are increasing at an accelerating pace, and the gauge of input prices was at high levels usually reserved for periods with sharp oil shocks. Here is a sampling of comments from survey respondents:

  • “Supplier factory capacity is well utilized. Increased demand, labor constraints and upstream supply delays are pushing lead times. This is more prevalent with international than U.S.-based suppliers.” (Computer & Electronic Products)
  • “Business remains strong. Manufacturing running at full capacity.” (Chemical Products)
  • “Very strong demand with limitations in supply to meet increased demand.” (Transportation Equipment)
  • “Labor continues to be one of our largest challenges.” (Food, Beverage & Tobacco Products)
  • “Our current business demand is going way past pre-COVID-19 [levels].” (Fabricated Metal Products)
  • “Business is very good. Customer inventories are low, with a significant order backlog through April. Supply base is struggling to keep up with demand, disrupting our production here and there. Raw material lead times have been extended. COVID-19 continues to cause challenges throughout the supply chain. Huge logistics challenges, especially in getting product through ports and in getting containers. We are seeing significant cost increases in logistics and raw materials.” (Machinery)

There are ample other signs of indigestion. A Bloomberg news story this week detailed the troubles in the freight industry, as delays in international shipping have multiplied and freight rates are surging. There was a picture in the newspaper recently that showed dozens of freighters parked in the ocean outside the ports in southern California, waiting for their turn to get a berth.

Supply chains have been unreliable. The global automobile manufacturing industry has been hit by a shortage of semiconductor chips used in their vehicles. GM announced within the last few days that it would have to cut production because it is running out of chips.

Too much of a good thing

Watching the TV show Survivor was a frequent activity for my family in the early days of the spring lockdowns. If you are unfamiliar, a group of contestants are dropped off on a deserted island and have to form tribes and compete to stay in the game, all the while trying to survive in the wild. The production crew of the show gives them just enough food to prevent starvation and then they are on their own to procure more by fishing, hunting, finding snails or worms or other exotic sources of protein, or, if they are lucky, perhaps some tropical fruit. Suffice it to say, that the contestants tend to get quite hungry. Periodically, as part of the game, the teams will compete for a food reward, and the winners, after days of starving, are suddenly able to binge on an array of foods to their heart’s content. Often, their stomachs can’t handle the sudden influx of nutrition and they end up in one form or another of gastrointestinal distress.

I am reminded of this dynamic in thinking about our illustrative diner when his stomach is healed—representing the reopening of the economy after the pandemic is tamed—and he begins to tear into the piles of food that he set aside during his illness. The distress faced by the Survivor contestants will not be experienced by individual consumers. Rather, it will be the economy as a whole that faces an imbalance between supply and demand. And that imbalance could get even wider if the administration and Congress move forward with efforts to inject another $1.9 trillion dollars of mostly demand-side stimulus to an economy that is nearing the point where its supply-side capacity could be restored.

Think of the supply side of the economy as trying to take a nice drink of water (representing demand) from a garden hose and suddenly realizing that it is holding a fire hose to its mouth that has just been opened up to full blast. The old-school Economics 101 definition of inflation is “too much money chasing too few goods and services.” I realize that inflation has pretty much been a no-show for 30 years, but if ever it were going to make a comeback, the stage would seem to be set.

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