Archive
The Dollar – Best House on a Bad Block
I’m here to draw your attention to something alarming happening in currencies at the moment. Here is a picture of the US Dollar, which has lost a huge amount of value in the past year.
Now, before certain ones of you get all excited and say that this proves Trump is ruining the dollar and forcing foreigners to vamoose out of the United States, take a look at the Euro.
I’m not going to tease you too much with this. The first chart is just the dollar in terms of ounces of gold; the second is the Euro in terms of ounces of silver. Don’t worry, longtime readers: I’m not about to go all gold-bug on you. I could have done those charts with almost any currency against a wide variety of commodities: the Bloomberg Commodity Index is up 23% since mid-August, and +12% since the end of the year. So this isn’t just a precious metals story, and it isn’t just a dollar story. It’s a fiat currency vs ‘stuff’ story.
The recent breathless coverage of the melt-up in precious metals seemed to me to miss the bigger point of what it means. It’s awesome if you’re long precious metals. But the abrupt turn vertical is – or should be – alarming. But nothing looks alarming when it’s pointed higher.
Treasury Secretary Bessent, as I write this, just came out and stated that the United States has a strong dollar policy and has not intervened (at least not yet) to push the dollar lower against the yen. That’s all very nice but I don’t worry a lot about the level of the dollar against other currencies in the medium term and here’s why.
Let’s look at the monetary pipes, which to me imply an increase in the dollar and/or a sharp increase in long-term interest rates regardless of what happens to overnight policy rates. (Many people are concerned about long-term rates because of some vague sense that we are borrowing too much or because everyone is going to sell their US bonds – to buy what with the dollars they receive, no one seems to mention – but there is a mechanical/accounting relationship could cause that outcome).
To this end, the illustration below (Source: Enduring Investments[1]) is a helpful visual guide. For this analysis we are interested in the flows of the dollar system, more than its stock. And the important flows are – or have been – pretty stable. The US has for a long time run a substantial budget deficit, which means the government needs to source dollars by borrowing them. The three sources of those dollars have historically been foreign investors, the Fed, and domestic savers. Foreign investors have extra dollars because the trade deficit means that Americans send more dollars to foreign producers than foreign consumers send to US producers, and those extra dollars are invested in the US into government bonds (spigot on the lower left) or otherwise invested in markets or direct investment (spigot on the lower right). The Fed balance sheet, over the last decade or so, has often been a supplier of dollars to the system when it has been expanding more often than not. Finally, there are domestic savers who buy Treasury bonds among other things (but consider that when they’re buying US stocks, for example, the dollars are just sloshing from one domestic saver to another – that’s why there’s no flow shown for domestic savers buying US stocks). Those three ‘suppliers of dollars’ are the top hoses filling up the barrel of dollars in the illustration below.
Those flows tend to reach stasis via automatic stabilizers. For example, if the government is draining more money (with a big budget deficit) than is being supplied elsewhere, then either interest rates rise to induce domestic savers to provide more money, or the trade deficit expands. My concern is that automatic stabilizers tend to take time to stabilize, and currently there are some big changes. See the next illustration and focus on the differences compared with the prior one.
The cessation of the expansion of the Fed’s balance sheet has been happening for a while, and the balance sheet has even been shrinking a little. But the Trump Administration’s trade policies have caused two major changes: first, the trade deficit has been shrinking sharply (see charts below, source Bloomberg; the first shows the net trade balance monthly and the second shows the recent trends of declining imports and rising exports).
Some of this may be ‘payback’ for the surge in imports at the beginning of the year by importers trying to beat the imposition of tariffs, but there seems little question now that the trade deficit really is closing substantially. At the same time, foreign companies have been tripping all over each other to start making substantial investments into the US. In the second ‘barrel of money’ chart above, note the spigot at the lower right is really gushing, and two of the hoses supplying dollars have slowed to a trickle or stopped.
If that’s a fair representation, then what are the implications? If those trends persist, then the demand for dollars is going to outweigh the supply of dollars, leading to two outcomes. One of those is that in order to induce more dollars to fund the federal deficit, interest rates will have to rise. The Fed can control the policy rate, but in order to keep long-term rates down the Committee may eventually be forced to start up their hose again – intervening to buy Treasuries in the market to prevent long rates from rising, and expanding the balance sheet. The market stabilizer here would be for interest rates to rise and induce more domestic savings; if for policy reasons the Fed doesn’t want that then they’ll have to add more money themselves, with inflationary consequences. (It’s inflationary either way, but if interest rates rise it’s only indirectly inflationary in that higher interest rates also increase money velocity).
The other implication is that the dollar would strengthen on foreign exchange markets, since if foreigners are going to invest in the US in financial markets (or with direct investment, building new plants and so forth) they will need dollars to do so and the trade deficit is no longer providing a surplus of those dollars. It’s likely also that, with fewer dollars being sent abroad, domestic stock and bond markets would struggle more than they have been. A stronger dollar would be disinflationary at the margin, helping to hold down core goods prices, but this effect is fairly small…especially in the broader context I’ve mentioned, which is that all fiat currencies right now are getting smashed versus real stuff.
These are the implications of the recent large changes in financial flows. There are potential offsets available. If the trade deficit declines and the federal budget deficit declines also, it diminishes upward pressure on interest rates since domestic savers do not have to be incentivized to provide as much of the dollars in deficit. You can infer this from the barrel illustrations as well: if the federal budget moves towards balance, it lessens the net change in the system.
And there had been some positive signs on that score. The tariff revenue has been large, and some of the spending priorities of the prior Administration have been de-emphasized. These are positive developments which could lessen the pressure on the dollar and interest rates…except that the Trump Administration has been mooting the idea of ‘tariff dividend checks,’ increased defense spending, buying Greenland, and other significant spending initiatives.
It is also possible, even probable, that the Fed or Congress could change banking liquidity regulations in such a way that banks are forced to hold more Treasuries, which would add an additional hose to the top of the barrel. However, the more assets that banks are required to hold, worsening the return on assets of traditional banks, the more banking functions will start to move to non-bank entities or into crypto, increasing the money supply while decreasing the Fed’s control of it.
The upshot of all of these changes is that – based on the flows as we see them now, which could change – I believe we are going to see a significantly steeper yield curve and a significantly stronger dollar over the next few years.
Having said all of that, let me circle back to the start of this note – while the USD is not likely to collapse against other currencies, the movement against commodities (not to mention equities) and other real assets is disturbing. The US money supply has been accelerating recently; M2 is only +4.6% in the last 12 months, but that’s near (or may even be above) the maximum rate that is sustainable without causing inflation in a country that is deglobalizing and in demographic reverse. I am not bullish on gold and silver at these levels, and am more cautious on commodities than I have been in a while. But while I am a dollar bull against other currencies, I am a bear of fiat currencies against real assets generally…and I am concerned that the recent waterfall-like behavior of fiat presages a re-acceleration of CPI-style inflation. Commodities feed broadly into prices, but so do wages and lots of other things that are measured in terms of dollars. If the problem is fiat, and not gold and silver themselves, then it’s a bullish signal for inflation.
[1] These images were generated using AI image generation tools to create an illustrative representation for explanatory purposes.
When and How Much Tariff Effect?
As we look forward to the CPI report next week, the monthly-repeating theme is ‘when will the tariff effect show up?’ The answer, so far, is ‘not yet,’ but economists who had forecasted the end of life as we know it when the Trump tariffs went into effect have been befuddled.
I’ve already admitted in this column that I was educated in the tradition of ‘tariffs bad,’ but that over the years Trump’s insistence otherwise has made me carefully re-think of which ways tariffs are truly bad, and which ways they’re not so bad. Naturally, if tariffs were uniformly bad – which seems to be the orthodoxy – then it would be really hard to explain why almost every country levees tariffs. Maybe forty years ago we could blame the benightedness of those poor policymakers in other countries, who clearly just didn’t understand how bad tariffs are. But now? Heck, all someone in one of those countries needs to do is ask ChatGPT ‘are tariffs bad,’ and they’ll learn!
… Conclusion: Tariffs can be useful tools in specific, limited circumstances — like protecting vital industries or responding to unfair trade practices. But long-term, high or broad tariffs often do more harm than good, especially in highly interconnected global economies. (ChatGPT, July 9, 2025 query ‘Are tariffs bad’)
But it seems every country has these specific limited circumstances! It’s evidently only bad when the US does tariffs. And that is what made me ask whether maybe there is some nuance. My 2019 article “Tariffs Don’t Hurt Domestic Growth” was really good, I thought.
Even as there has been some small movement in the economintelligencia, though, about whether tariffs are all bad there has been very little movement in the notion that they are clearly inflationary. No doubt, implementing a tariff will raise prices at least a little, but how much is the important question. And regardless of that answer, tariffs are a one-time adjustment to the price level even if that effect is smoothed over a period of time. (This is why it’s weird to hear Powell say that the Fed can’t ease because they’re waiting to see the effect of the tariffs on inflation. That’s economic nonsense. The Fed can’t possibly believe that keeping rates high is the proper response to a one-time shock.)
On this question, I thought I’d share something I wrote in our Quarterly Inflation Outlook from Q1 (in mid-February), in which I roughly estimated the effects of a 20% blanket tariff. I know the answer isn’t “right,” because that’s the wrong question – there isn’t a 20% blanket tariff. But I undertook the estimate to get an idea of the relative scale of effects. (I included in the piece some parts from that 2019 article mentioned above, because I’m not above stealing from myself!) I will add some concluding thoughts after this ‘reprint’ from our QIO – which, by the way, you can subscribe to here.
Tariffs as a Tool to Promote Domestic Growth and Revenue
In the President’s view, the fact that the U.S. has a very low tariff structure compared to the tariffs (and arguably VAT taxes) that other countries place on U.S. goods is prima facie evidence that the U.S. is being taken advantage of and treated unfairly on world markets. The U.S. has, for the better part of a century, been the main global champion of free trade and this tendency accelerated markedly in the early 1990s (as the familiar chart below, sourced from Deutsche Bank, illustrates well).
The effect of free trade, per Ricardo, is to enlarge the global economic pie. However, in choosing free trade to enlarge the pie, each participating country voluntarily surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off. To the extent that a person is a citizen of the world, rather than a citizen of a particular country – and the Ricardian assumption is that increasing the pie is the collective goal – then free trade with every country producing only what they have a comparative advantage in is the optimal solution.
However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the U.S. went through a period of being incredibly bad at automobile manufacturing, there are still several very large U.S. automakers. On the other hand, the U.S. no longer produces any apparel to speak of. In fact, the only way that free trade works for all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability, and permanently at peace so that there is no risk that war could create a shortage in a strategic resource, or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself and/or to establish the conditions that ensure permanent peace by being the dominant military power and enforcing peace around the world. We would argue that (b) is what happened, as the U.S. was willing to let its own manufacturing be ‘hollowed out’ in order to make the world a happier place on average.
The President (and many of those who voted for him) feel that (b) is inherently unfair, or has reached extremes that are unfair to U.S. citizens. Essentially, the President is rejecting the theoretical Ricardian optimum and pursuing instead a larger slice for his constituents. This is where reciprocal tariffs (where the U.S. matches the tariff placed on its exports by a trading partner, with a tariff placed on the imports of that product from that trading partner) or blanket tariffs (where the U.S. imposes a tariff on all imports of a product irrespective of source – e.g. aluminum – or on all imports from a given trading partner) come in.
Blanket tariffs are good for domestic growth,[1] but definitely increase prices for consumers. How good they are for growth, and how much prices rise, depends on how easily domestic un-tariffed supply can substitute for the imported supply and also on whether your country is a net importer or exporter, and how large the export-import sector is in terms of GDP. Because this is an inflation outlook, let’s make a very rough estimate of the impact on the overall domestic price level of a blanket 20% tariff (such as the one Treasury Secretary Bessent has proposed). We suppose the average elasticity of import demand in the U.S. to be 3.33[2] and the elasticity of export supply to be 1.0[3]. In that case, the incidence of a tariff falls about 23% on consumers: [1.0 / (3.33+1.0) ]. So, for a 20% tariff, prices for the imported goods would be expected to rise about 4.6% (20% tariff x 23% incidence). However, imports only account for about 15% of US GDP, which means the effect on the overall price level would be 15% x 4.6% = 0.69%.
So, for a 20% blanket tariff on imports, Americans should expect to see a one-time increase in the overall price level of something on the order of 0.7%, smeared over the period of implementation. This is not insignificant, but it is also not calamitous. It does affect our estimates for 2025 and 2026 inflation, shown in the “Forecasts” section (somewhat less than 0.7%, because we do not expect a blanket tariff but rather reciprocal and targeted tariffs). Also note that the retaliatory tariffs on US exports have no direct effect on domestic prices, so that whether or not trading partners retaliate is irrelevant to an analysis of first round effects, anyway.
Thus my wild guess back in February was that a 20% blanket tariff would result in a bit less than 0.7%, smeared out over 2025 and 2026. That doesn’t answer the ‘timing’ question, but the delays in implementation (so as to not affect Christmas 2025 prices of the GI Joe with the Kung-Fu Grip) and the importer/retailer initial reaction to try and absorb as much as possible for optics – presumably, easing price increases into the system later – mean that it shouldn’t be shocking that we haven’t seen a big effect yet. My point in the above calculation, though, is that we really shouldn’t expect to see a big effect, regardless.
For what it’s worth, the Budget Lab at Yale estimates that currently “the 2025 tariffs to date are the equivalent of a 15.2 percentage point increase in the US average effective tariff rate,” so if we take my 0.7% guess for 20% then we would be looking closer to 0.5% in total. And in fact, lower even than that since the 15.2% average will have less impact than a 15.2% blanket tariff, assuming that the tariffs will be highest where domestic substitution is easier.[4]
Wrapping this up, let me make one final observation. Current year/year headline CPI inflation is 2.35%. The inflation swaps market, specifically the market for ‘resets’ where you can trade essentially the forward price level, currently suggests that traders expect y/y inflation to rise to 3.29% over the next six months: almost 1 full percentage point from here. But that actually flatters what the market is pricing, because the shape of the energy curves suggests that rise is being dragged about 20bps lower by the implied moderation in energy prices (give me a break, inflation traders: I’m doing this in my head).
So, the market is pricing core inflation peaking about 6 months from now, about 1.2% higher than it currently is. Not all of that is the effect of tariffs; some is due to base effects as the very low May, June, and July 2024 numbers roll off of the y/y figure. But if we get that result, you can be sure that economists will put most of the blame on Mr. Trump, while Mr. Trump will put most of the blame on Mr. Powell. Either way, I think the interest rate cuts that the President would prefer are unlikely unless growth takes a significant stumble.
[1] …but bad for global growth! There is no question that unilaterally applying tariffs to imports is bad for all suppliers/countries providing those imports. If Ricardo is right, the overall pie shrinks but the domestic slice gets larger…at least for the dominant players who already have a large slice. If everyone raises tariffs in a trade war outcome, the less-productive countries suffer the most loss of growth and the most-productive countries likely still benefit. But prices rise for all.
[2] Kee, Nicita, and Olarreaga, “Estimating Import Demand and Export Supply Elasticities”, 2004, Figure 5, available at http://repec.org/esNASM04/up.16133.1075482028.pdf Your answers may vary!
[3] Estimates are wildly all over the map, depending on the exporting country and the product. In general the smaller the country, the more price-inelastic it is. We chose unit elasticity here (a 1% increase in price cause a 1% increase in the quantity supplied) just to be able to get a rough guess.
[4] To be fair, the Budget Lab at Yale also estimates the effect on PCE inflation of a whopping 1.74%. They must be really surprised at the impact so far.
The Twin Deficits – One Out of Two IS Bad
From time to time on this blog, I circle back to the question of the balance of deficits. In my mind, as our economy goes through whatever the “Trump Transition” is, the biggest risk to the bond markets is not from some fear about whether the Treasury will default or whether the US dollar will cease to be the world’s currency of choice for reserves (neither of which I think is going to happen any time soon) but that large secular changes in the balances of savings and dollar demand could lead to outsized moves in interest rates.
First, let me remind you that the deficits are all intertwined. When the US Federal Government runs a deficit and borrows money, they have to get it from people/entities that have saved that money. One place that the government bond salesmen know they can turn to is non-US investors, who are in possession of those dollars because the US runs a large trade deficit with most other countries. When we run a trade deficit, it means we are importing more stuff than we are exporting or, equivalently, we are exporting more dollars than we are importing. Those dollars are pretty useless except to buy things that are dollar-denominated. By construction, we know that the new owners of dollars aren’t buying goods, because if they did there wouldn’t be a deficit; the main other thing they buy are securities or real property.
So if you don’t want other countries buying US stocks, buildings, and farmland, run a big trade surplus and they won’t have the dollars to do it.
It’s a good thing they have all of those dollars, because the Federal government needs them! The federal deficit needs to be funded by those foreign dollars, or by domestic savings (banks, individuals, companies, e.g.), or by the central bank buying up those bonds. And that’s pretty much it. Over time, the trade balance plus the budget balance plus the central bank balance plus private savings equals zero, more or less. During COVID, the massive expansion of the federal deficit was only possible because the Fed bought about the same number of bonds as the government sold. Had they not, interest rates would have risen precipitously because private savers would have had to be induced to put those dollars into bonds.
(Or, the government would give incentives for banks to hold more govvies, say by exempting them from the SLR. Not that such a thing would ever happen!)
Let’s pivot this then back to the Trump Transition. The stated goal of the Administration was to lower the trade deficit a lot, lower the budget deficit a lot, and lower interest rates. That all makes sense and is internally consistent. It could happen that way, if all of it happens that way.
What if, though, the President’s team makes more progress on one front than on the other? Early returns on the tariff front seem to imply that the US will face a smaller trade deficit going forward. Now, the latest spike higher (smaller deficit) here is at least partly and maybe mostly due to a ‘payback’ of the pre-tariff front-running that led to massive deficits in the prior three months. But it should not surprise us that increasing tariffs should cause the trade deficit to decline. That is, after all, sort of the point.
If we concede that the trade deficit is actually heading back towards some better semblance of balance, then that’s plank 1 of the Trump agenda. That will supply fewer dollars to cover the federal budget deficit, though. As long as the federal budget gets into something closer to balance…
That was the promise of DOGE, and of the revenues from tariffs. The latter will indeed be yuge, and will help balancing the budget. Or it would, if we weren’t about to run an even bigger deficit with the Big Beautiful Bill soon passing into law. The trailing-twelve-month budget deficit is just less than $2 trillion, which was a number we never even sniffed prior to COVID. So that’s the demand for savings: the feds look like they’re going to keep on spending more than they take in.
Unlike during COVID, too, the Fed is now letting its balance sheet shrink. No help there.
Now, there is also a movement in Congress to pass legislation preventing the Fed from paying interest on the reserves that banks hold at the Fed. For decades, the way the Fed managed the money supply was to adjust the quantity of reserves, which rationed credit and caused the price of credit (interest rates) to move as well. But it was the rationing of credit, not changing the price, that affected the money supply. Beginning with the Global Financial Crisis, the Fed flooded extra reserves into the system, forcibly deleveraging banks (look at that chart above again) – but, since that would also crush bank earnings, they started paying interest on reserves (IOR). Since, if banks were not being paid to hold reserves, they would hold as little as they could, the Fed had to pay interest or the excess of reserves in the overnight market would cause interest rates to always be zero. So the Fed started to manage the price of credit, rather than its quantity. The central bank fully intends to always hold way more in securities and therefore force way more reserves into the banks, going forward – but has gradually been reducing its portfolio securities. As I said, no help there.
If Congress succeeds in preventing the payment of IOR – and the politics on this looks good since the Fed now runs operating deficits, so that it is basically paying banks interest with taxpayer dollars (see chart below…Fed remits to the Treasury have dried up completely), then as I said above banks will try to hold fewer reserves and overnight interest rates will drop as banks compete to lend their excess reserves at anything above zero, unless (a) the fed increases the reserves banks are required to hold (really unlikely) or (b) the fed makes reserves scarce so some banks will have to buy them and some will sell them (the old way) (also really unlikely). In neither case does the Fed expand the balance sheet as a first intention, so unless we get another crisis the expansion of the Fed balance sheet is unlikely in my view.
So that leaves private savings. If the trade deficit declines and the budget balance doesn’t move significantly towards balance, then interest rates will have to rise, potentially a lot. I think the President’s stated plan makes very good economic sense. I just wonder if it’s going to be derailed by the desire to keep the Federal spend going.
Inflation After 100 Days
It is hard to believe that a third of the year is already past. Some people, of course, would say that it seems like a hundred years have passed in the first hundred days of Trump’s second term, but to me it seems like a blink.
Here’s a quick mark-to-market summary of where I think we stand with respect to inflation and the economy generally…after which I actually have another point for this column:
Uncertainty. That’s the watchword, of course. One place this shows up is in the huge spread between survey data and hard data. The survey data is tinted with fear of uncertainty, and is very negative (and likely influenced by the media deciding that Trump’s Administration signals the End of Days); the hard data is clearly softening but not dramatically so – and frankly, that was already under way in some ways since at least 2023 when the Unemployment Rate started heading slowly higher. In my view the softening of the hard data won’t ever get to be dramatic in this recession, and this will end up being more like a garden-variety recession we used to have pre-2000.
Inflation will be higher than it would otherwise be, because of tariffs, but lower than many people think because people greatly exaggerate the effect of tariffs. Tariffs only affect goods, and only significantly if they are goods facing inelastic demand. There will be some shortages in the near-term, and unlike during COVID when many of the shortages were caused by too much demand induced by money-drops to consumers, in this case it really will be supply constraints. Look out for things like ibuprofen, which is 90% sourced from China which makes it hard to completely switch supply to domestic suppliers. But these are short-run or in some case medium-run disruptions as supply chains shift. As domestic or lesser-tariffed countries replace the highly-tariffed suppliers, the supplies will respond and prices will come back down – not all the way to where they were, but it will feel like deflation in some cases because we mentally refer to the most-recent price, not to the year-ago price.
But either way, the tariffs are a jump-discontinuity, a one-time effect. The uncertainty, less so but that will fade (as an aside, and as I’ve noted previously, the high uncertainty had the effect in Q1 of causing money velocity to decline very slightly for the first time in a couple of years). By the end of the year, things will be much more settled and inflation will be stabilizing again…but the story continues to be that inflation will stabilize in the high 3s, low 4s, not at 2%. This probably means the Fed will not be easing much, although if there is a significant slowdown not caused from net trade – the Q1 drag was significantly from the surge in imports due to front-running tariffs – the Fed will ease even if inflation hasn’t come down. They’ll point to tariffs being transitory, although I sincerely doubt they will use that word! And they’ll be right, but they’ll also be wrong. Money supply growth is still too fast to accommodate 2% inflation especially in a deglobalizing world.
We’ll talk more about all of these things in columns here and in my podcasts over the next few months. But today I am still very preoccupied with getting USDi[1] launched, getting investors involved, talking to crypto ecosystem providers, etc. And I want to address one question I get routinely these days – not just about USDi, which exactly tracks CPI but adds nothing on top, but about the underlying investment strategy that I’ve been running/marketing for 3.5 years. The question is, “why should I buy something that returns CPI when inflation is at 3% and I can buy Tbills and earn 4.25%?” Here are two important pieces of the answer – and they’re just as important to investors who operate wholly in the traditional finance world as it is to people operating in the crypto world.
The first part of the answer is that while Tbills are above inflation now, that is not exactly guaranteed. In fact, for the last quarter-century it has been fairly unusual.
Sure, if you go back to the 1980s and early 1990s, when inflation was high and coming down and the Fed was following inflation down, you can find a lengthy period when Tbill rates were above inflation. Is the current period, with inflation where it is, comparable to the period when inflation was descending from double-digits and the FOMC was dominated by hawks? Do you think Trump will replace Chairman Powell and other Fed governors whose terms expire, with hawks? It doesn’t seem that way to me. I think it’s important to realize that is the bet you’re making, if you hold short cash instruments as an inflation hedge.
The second part of the answer is that holding a cash instrument does not protect you during an inflation spike because the Fed cannot respond fast enough, and a cash instrument in nominal space does not protect you from a dollar crisis. Almost nothing does, in fact, as stocks and bonds both do poorly in those cases as do ‘inflation hedge’ products based on equities or bonds. Here is a chart of the recent inflation spike. How well did your Tbills, or short-duration bonds (VTIP) or long-duration inflation bonds (TIP), keep up? Did they ever catch up?
To me, any allocation to low-risk securities that is meant to serve as a volatility buffer for a portfolio, but does not hold inflation beta, is completely missing the value of that beta in certain scenarios where very little else is helpful. When inflation spikes, stocks and bonds become correlated (down). You can (and should) add commodity allocations to your portfolio, but those consume part of your risk budget and push out the equities, hedge funds, private equity, and other higher risk asset classes. If you can get the inflation beta from a very low-risk part of your portfolio, you ought.
The foregoing is, transparently, partly self-serving. But the products I’ve been involved with developing have never been developed because they produce big fees or are easy to sell.[2] I’ve developed them because they’re useful to investors. And, parenthetically, I do think that the worker is worthy of his wages.
If you want to find out more about USDi, I urge you to visit the home page https://usdicoin.com, where you can see the current value of the coin increasing minute-by-minute with inflation. If you’re a denizen of the crypto world, then you might also be interested in joining the Telegram read-only group for the USDiCoin, available at https://t.me/USDi_Coin. That group is where we will make announcements about the coin, post the price of the coin periodically (at least daily; automation in process), post the monthly reports confirming the collateralization of the coin, announce new market-makers and markets…and also post some inflation-related charts, such as I used to do on Twitter on CPI morning, when Twitter allowed such automation. If you’re at all interested in inflation and/or the inflation-linked coin, hop on.
[1] If you don’t know what USDi is yet, read my prior article https://inflationguy.blog/2025/04/15/announcing-usdi-inflation-linked-cash/
[2] Understatement of the century.
Trump Tactical Targeted Tariffs: A Reminder of the Impact of Tariffs
Representative Alexandria Ocasio-Cortez, aka AOC, recently railed against the President when he threatened Colombia with tariffs if they should refuse to accept their citizens being deported back to them. In her typical hyperventilated fashion, she implored us to “remember” that “WE pay the tariffs, not Colombia.”
For a change, AOC is not entirely wrong but merely mostly wrong. She seems to remember at least one important thing from Econ 101 and that is that businesses don’t pay anything to anyone, since a business is just a legal structure. Shareholders, other stakeholders, consumers, or suppliers pay and/or receive the cost of goods sold, taxes, wages, and so on. Unfortunately, I don’t think that was her point and she missed the important bit which is that ‘who pays the tariff’ depends almost entirely on the elasticity of demand for the product. Here are two charts. In each case, the tariff shifts the supply curve leftward/upward by the amount of the tariff, the same amount in both pictures. In each picture, the quantity consumed of the good being tariffed goes from c to d and the price goes from a to b as the market moves from one equilibrium to the other.
The first chart shows an inelastic demand curve, which is characterized by the fact that large changes in price do not change the quantity demanded very much. In this case, the main effect is that consumers buy almost as much of the good, but the price moves almost the full amount of the tariff. Consumers end up paying most of the tariff.
The second chart shows an elastic demand curve, in which even small changes in price induce large changes in the quantity demanded. In this case, the main effect is that consumers buy much less of the more-expensive good, and the price goes up only a little so that the seller bears most of the cost of the tariff.
Thus a blanket statement that “we pay the tariffs” is wrong. It is sensitive to the characteristics of the product market. One needs to be very careful about how we define the product market because it matters. I would argue that the elasticity of the demand for coffee is quite low, which is why Starbucks even exists. If the demand for coffee was very elastic, charging $5 a cup for bad coffee would not produce a line around the block at rush hour. But that is not what we are talking about here. The question here is, what is the demand elasticity for Colombian coffee? The answer to that question is very different. Coffee as a way to wake up in the morning has few close substitutes. But Colombian coffee has many, very very very close substitutes. My favorite right now is Ethiopian Yirgacheffe coffee. I also like a good Panama Boquete. Add 20% to the cost of the Boquete, and I think I’ll mostly drink the Yirgacheffe. Add 20% to both of them, and I’ll go to Brazilian Santos, or Colombian, or Kona.
I think the reaction of the Colombian President tells you everything you need to know about what he perceives about the demand for Colombian coffee and therefore the impact a tariff would have on exports of Colombian coffee to the United States. Trump very quickly got what he wanted with his Trump Tactical Targeted Tariffs (TTTT™). So to review: +1 for TTTT, -1 for AOC.
A couple of other points about tariffs and tariff strategy.
First, this episode illustrates a very important distinction to be made between the use of targeted tariffs and the use of blanket tariffs. Blanket tariffs, for example on everything we import from a major trading partner or on every trading partner, definitely increase prices for consumers. How much, and which prices, depends on how easily domestic untariffed supply can substitute for the imported supply. But the answer is certainly that prices go up. But let me point you to two articles I’ve written previously about this:
Tariffs Don’t Hurt Domestic Growth (https://inflationguy.blog/2019/08/28/tariffs-dont-hurt-domestic-growth/), August 28, 2019. This is a really good piece. In summary, tariffs are bad for global growth but they are not the unalloyed negative you learned about in school. How good/bad they are for growth depends on whether you are a net importer or a net exporter, and how large the Ex-Im sector is in your country. Truly free trade works in a non-theoretical world only if “(a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself.” Really, you should read this.
The Re-Onshoring Trend and the Long-Term Impact on Core Goods (https://inflationguy.blog/2022/02/22/the-re-onshoring-trend-and-the-long-term-impact-on-core-goods/) February 22, 2022. This is not directly about tariffs, but the broad imposition of tariffs (if they happen) should be thought of as reinforcing this prior trend. The prior trend, of re-onshoring production to the US, has been under way for several years – the way that COVID exposed long supply lines certainly helped the trend but the long-term globalization trend was already reversing and in this article I argue that this means core goods inflation going forward is likely to be small positive, rather than persistently in deflation. In the context of the current discussion, President Trump has certainly made re-onshoring of production a major goal of his Administration. So whether it happens because of TTTT, or because of blanket tariffs, or because of tax breaks given for domestic production, the direction of the inflation arrow is clear.
I’m not worried about hyperinflation from tariffs and I think that if you’re the biggest and the strongest economic actor they’re probably more good than bad for domestic economic outcomes.
Reality is more nuanced than we learned in school. Not everything that expands the economy is good, and not everything that is good expands the economy. Not everything that is bad causes inflation to go up, and not everything that causes inflation to go up is bad.
Penalizing Apple Pay
Something odd happened to me several times over our Christmas holiday trip back home, and I’ve been mulling it ever since. It feels significant, albeit on a long-horizon time scale.
At least three times, restaurants added a ‘credit card surcharge’ to our check, or had a sign on the door warning customers of the same. The surcharge was small, on the order of what the credit card processors charge the restaurateur (1-2% of the bill), and was often framed that way.
Think about that for a moment. First of all, credit card fees haven’t changed meaningfully in a long time. Probably on balance they’ve risen, but it’s fractions of a percentage point. In the running of a restaurant, it is total rounding error.
Moreover, if the cost of processing credit cards had gone up, say, 1%, then it would be much better to simply raise prices 1%. Diners aren’t particularly resistant to small changes in prices, especially after 2021 broke the skin of the milk so to speak. Adding a surcharge to use a different payment method ticks the customers off, and I saw this a couple of times.
The number of patrons who are using credit cards has probably gone up a lot in recent years. I’ve noticed myself that I so rarely use cash that I sometimes forget my ATM PIN. Apple Pay and other proximity-payment methods make it so easy that carrying my whole wallet so that I can have physical cash seems silly. It has bitten me a couple of times when I wanted to tip someone, but that’s the only time it has made a difference. Almost no one takes only cash any more. We are not yet (in the US) a ‘cashless society,’ but ease of payment has pushed us pretty far in that direction. But still, that effect is simply not big enough to make much of a difference to the restaurateur – and if it was, then it would be simply solved by changing prices just a tiny bit. Your $15 entrée becomes a $15.15 entrée. No one is walking out over that.
When you see something that seems to make little sense economically, it usually means one of two things. (1) there’s some weird behavioral bias happening, or the problem is complex and confusing, so that people are making the non-optimal decision, or (2) people are behaving rationally; you just haven’t figured it out yet. The former point seems unlikely here. The problem is pretty simple, and the behavioral biases work the wrong direction – your customers get irrationally annoyed by a 1% surcharge, so all else equal you’d want to avoid that.
So I have been mulling #2, and I have a possible answer. Why would restaurateurs annoy their customers by adding a 1% surcharge to their checks, which can be easily avoided by paying cash? Obviously, it’s because they want to receive cash. Why annoy their customers over something so small that can be addressed another way? Because the actual cost to them is not as small as it appears.
When a business receives cash, or credit, there’s a small difference in the revenue received. Why does this matter to gas stations, which have applied a discount for cash for decades and not to a service business like a restaurant? Another difference between a restaurant and a gas station is that a gas station’s costs are almost entirely the cost of goods sold – gasoline – while for a restaurant the COGS is more like 25-40% of revenues. In what way does this increase the value of cash to a restaurateur?
The answer is simple – by operating part of the restaurant on a cash basis, a very significant cost can be reduced: taxes. A gas station would have a hard time pocketing cash and not declaring the revenue, because it would be quickly obvious when the tax man looked at the books. If you’re taking in less revenue than the actual cost of the gasoline, something’s fishy. But for a restaurant, that’s harder to establish especially if you pay some of the staff in cash.
The only way it makes sense to me that some restaurants would risk ticking off customers in order to push them towards cash in a very blatant way is if the cash revenue is worth much more than a 1-2% advantage over credit card revenue, and if the number of cash-paying patrons was changing meaningfully. The former has been true for a while, but as long as plenty of people still paid cash there was no reason to risk annoying customers. Only if cash as a payment form is decreasing meaningfully – and I would bet it is – would this make sense.
I’m open to other possibilities.
The reason this is interesting to me is that the driving force here is the desire to avoid metering of revenue. But the habits of the customer base aren’t the only reason this is changing. A sign at my bank warns that anyone who transacts in cash will be subject to extra questions and ID requirements. As government deficits stay wide and taxation rates rise, incidence of avoidance should be expected to go up.
Some people are aggrieved by the movement by central banks towards Central Bank Digital Currencies (CBDCs) because they fear that authorities could abuse having absolute power over the medium of exchange. That only works if it is the only medium of exchange. But the restaurant behavior suggest that moving entirely to a cashless society could also raise prices in some ways.[1] If people simply won’t pay with cash, prices will have to go up to cover the additional taxes that business owners will have to pay on the newly-recognized revenues. Incidentally, to the extent that a movement towards contactless payments (CBDC or no) moves commerce from the cash economy to the metered economy…growth will also appear artificially higher by a small amount and tax receipts will also be higher than would otherwise be expected.
Outside of restaurants, I don’t know how prevalent cash payments for services are. I know that it is a large part of home improvement and maintenance, and I know that car dealers vastly prefer cash. If it’s just 2% of the economy, then this is merely interesting. If it’s 5-10% of the economy, it’s also significant. I don’t know that in either case I can see a trade to be made, but it’s interesting.
What do you think?
[1] Hey, I have to tie this back to inflation somehow.
Three Pertinent Inflation Observations
I have three items to discuss in this week’s post.
The first item is an announcement made by the BLS on Tuesday regarding upcoming changes to how the CPI for Health Insurance will be computed.
The backdrop for this change is that the CPI for Health Insurance is an imputed cost for the CPI. When a consumer buys health insurance, he/she is actually buying medical care, plus a suite of insurance products related to the actuarial benefits of pooling risks (that is, it’s much cheaper for people to buy a share of an option on the tail experience of a group of people, than it is for each person to buy a tail on their own experience – which is the main benefit/function of insurance). If all of the cost of health insurance was actually for health insurance, the weight of medical care itself (doctors’ services, e.g.) would be quite low because most of us pay for that care through the insurance company.
So the BLS needs to disentangle the cost of the medical care that we are buying indirectly from the cost of the embedded insurance products. The link above goes into more detail on all of this, but the bottom line is that once per year the BLS figures out what consumers paid for health insurance, how much of that was actually used by the insurance company to purchase health care, and therefore how much is attributable to the cost of the insurance product. Because they do this only once per year, and smear the answer over 12 months, you get step-wise discontinuities in the monthly figures. For many years this was not a big problem, but since 2018 there have been several fairly significant swings. The chart below shows the m/m percent change in health insurance CPI. You can see it went from stable, to +1.5% per month or so in 2018-2020, to -1% for 2020-2021, to +2% for 2021-2022, to -4% in the most-recent year.
That latest period has been a significant and measurable drag on the overall and core CPIs, and it was due to reverse starting with the October 2023 CPI released in November. Estimates were that it was going to be something like 2% per month, roughly. The change announced above introduces some smoothing so that these swings should be significantly dampened. The basic method doesn’t change, but it should be smoother and more-timely since the corrections will be every 6 months instead of every year. In order to make the new calculation method match endpoints, though, this means that starting in October, the +2%ish impact will bedoubled because the BLS will make the ‘normal’ adjustment but smear it over 6 months instead of 12, then transition to the new method.
The implication is that Health Insurance, which will have decreased y/y core CPI by about 0.5% once we get to October, will add 0.25% back over the 6 months ending April. So, we already know about a significant swing higher in core inflation that is coming soon. Take note.
The second item I want to note is M2. It’s a minor thing at this point, but after three months it is worth noticing that M2 is no longer declining. It isn’t a lot, as the chart below shows, but the three months ended April showed a contraction at a 9.6% annualized pace and the most-recent three months saw an increase at a 3.7% pace.
In the long run, 3.7% would certainly be acceptable but remember we still have some M2 velocity rebound to complete. What is interesting is that this is happening despite the fact that the Fed is continuing to reduce its balance sheet and loan officers are saying that lending standards are tightening. It may simply be a return to normal lending behaviors, with a gradual increase in loans that naturally accompany the rising working capital needs of a growing economy. Remember, banks are not reserve-constrained at this point, so they’ll keep lending. Anyway, I don’t want to make too much of 3-month change in the M2 trend, just as I was reluctant to make too much of those early M2 contractions…but this is what I expected to happen. I just expected it earlier. We will see if it continues. If it does, then that in concert with the natural rebound in M2 velocity means that further declines in inflation are going to be difficult, and we might even see some reacceleration.
Finally, the third item for today. In my podcast on Tuesday, I asked the question whether China’s recent sluggish growth, caused partly by its property bubble and overextended banks, meant that we should be looking at recession and disinflation in the US – which is the current meme being promulgated by many economists. I discussed the 1997-1998 “Asian Contagion” episode, and explained that a recession in a “producer” (net exporting) country hits the rest of the world very differently from a recession in a “consumer” (net importing) country like the US. A recession in consumer countries causes recession in producer economies, because the consumer economies are ‘downstream.’ On the other hand, a recession in producer countries can have the opposite effect on its customers – because, when an economy like China is in recession, that means it is providing less competition in the commodity markets that we also use. In turn, that means we can actually grow faster, all else equal.
This is what happened in the Asian Contagion episode, and I wanted to put some charts around that. The Thai baht was the first domino, and it collapsed in August 1997. It wasn’t until fears that the Hong Kong Dollar would de-peg from the USD, in October of that year – precipitating a 7% one-day drop in the Dow – that people in the West started getting very concerned and the Fed started citing troubles in the former Asian Tigers as a downside risk. Here are charts of the period. The first one shows quarterly GDP, which never increased less than 3.5% annualized; the second is median CPI, which was continuing a long period of deceleration from the 1980s prior to the crisis…but which began to accelerate in mid-1998.
The bottom line is that as long as our export sector is relatively small and as long we remain a developed consumer economy, weakness in producing economies is not a dampening effect for us but rather, if anything, a stimulating effect.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
Who’s Afraid of De-Dollarization?
Do we need to worry about the end of dollar dominance in international trade – the de-dollarization of global finance?
I am hoping to do a podcast on this topic in a few weeks, featuring a guest who is actually an expert on foreign exchange and who can push back on my thought processes (or, less likely, echo them) – but the topic seems timely now. There is widespread discussion and concern in some quarters, as China and Russia push forward efforts to establish the Chinese Yuan as an alternative currency for international trade settlement, that this could spell the sunset of the dollar’s dominance. Some of the more animated commentators declare that de-dollarization will dramatically and immediately eviscerate the standard of living in the United States and condemn the nation to be an also-ran third-rate economy as its citizens descend into unspeakable squalor.
Obviously, such ghoulish prognostications are ridiculously overdone for the purpose of generating clicks. But how much of it is true, at least on some level? What would happen if, tomorrow, the US dollar lost its status as the world’s primary reserve currency?
One thing that wouldn’t change at all is the quantity of dollars in circulation. That’s a number that the Federal Reserve exerts some control over (they used to have almost total control, when banks were reserve-constrained; now that banks have far more reserves than they need, they can lend as much as they like, creating as many floating dollars as they like, constrained only by their balance sheet). The holders of dollars have absolutely no control over the amount of them in circulation! If Party A doesn’t like owning dollars, they can sell their dollars – but they have to sell it to some Party B, who then holds the dollars.
What also wouldn’t change immediately is how many dollar reserves every country holds. From time to time, people get concerned that “China is going to sell all of its dollars.” But China got those dollars because they sell us more stuff than we sell them, which causes them to accumulate dollars over time. How can China get rid of their dollars? Their options are fairly limited:
- They can start buying more from us than they sell to us. We’ve been trying to get them to do this for years! Seems unlikely.
- They can buy from us, stuff priced in dollars, but only sell goods to us that are priced in Yuan. To get Yuan, a US purchaser would have to sell dollars to buy Yuan. Since China doesn’t want to be the other side of that trade (which would leave them with the same amount of dollars), the US purchaser would have to go elsewhere to buy Yuan. This would strengthen the Yuan. This is also something we’ve been trying to get them to do for years! The Bank of China stops the Yuan from strengthening against the dollar by…selling Yuan and buying dollars. Hmmm.
- They can just hit the bid and sell dollars against all sorts of other currencies. This would greatly weaken the dollar, and is perhaps the biggest fear of many of the people worried about de-dollarization.
Supposing that China decided on #3, they would be making US industry much more competitive around the world against all of the currencies that China was buying. Foreign buyers of US products would now be able to buy US goods much more cheaply. It would cause more inflation in the US, but it would take a large dollar decline to drastically increase US inflation since foreign trade is a smaller part of the US economy than it is for many other countries.
A much lower dollar, making US prices look lower to non-US customers, would help balance the US trade deficit. Yay!
A tendency towards balance of the trade deficit would have ancillary impacts. When the US government runs a fiscal deficit, it borrows from essentially two places: domestic savers and foreign savers. Foreigners, having a surplus of dollars (since they have trade surpluses with us), buy Treasuries among other things. If the trade deficit went down drastically, so would foreign demand for US Treasuries. That in turn would (unless the government started to balance its fiscal deficit) cause higher interest rates, which would be necessary to induce domestic savers to buy more Treasuries. Or, if domestic savers were not up to the task, the buyer of last resort would be…the Federal Reserve, which could buy those bonds with printed money. And that’s a really bad outcome.
Now, does any of this cause a collapse of the American system or spell an end to US hegemony? No. If policymakers respond to such an event by refusing to get the fiscal house in order, then things could get ugly. But it would be hard to blame that outcome on the end of the dollar as the medium of international trade – blame would more appropriately be directed at the failure of domestic policymakers to adjust in response.
In the end, it is hard to escape the idea that good or bad economic and inflation outcomes in the United States track mainly, one way or the other, back to domestic policy decisions. Whether the US economic system remains a dominant one is…fortunately or unfortunately…in our hands, not in the hands of foreign state actors.
The Re-Onshoring Trend and the Long-Term Impact on Core Goods
I know that today, and probably for a little while, investors are focused on Ukraine and Russia. I am gratified that for what seems the first time in many years, notes about the conflict tend to include some form of the addendum “and its effect on domestic inflation,” albeit in many cases this is from the perspective of how this engagement will damage or burnish President Biden’s poll numbers at home and the prospects for his party in the midterm elections. How self-absorbed we Americans are! To be fair, in my opinion the importance of the US policy-response operetta was always less about Ukraine than about Taiwan. I hope that doesn’t turn out to be right.
However, today I want to talk about the re-onshoring trend in manufacturing, and the significance of this for inflation going forward.
One of my 2022 themes so far is that the conventional expectation for inflation to peak soon and ebb to a gentle 2% over the next 12-18 months is mostly predicated on the idea that the extraordinary spikes we have seen in certain categories (see: motor vehicles) will eventually pass, and inflation will return to the underlying trend. The simpler observers see it as 12 months since (mechanically) the spikes will all be out of the y/y number in 12 months. Some forecasters are giving themselves a little wiggle-room by saying it will take 18 months as the ports unclog and ‘other knock-on effects’ wash through. But in my opinion, the evidence is strong that the underlying trend is no longer 2%, but more likely 3-4% or higher. Part of that evidence is the great breadth that we have seen in the recent inflation numbers, which suggests either a riot of unfortunate coincidental events all in the same direction, or else a common cause…say, the rapid growth rate of the money supply, which as of the latest report is still growing more than 12% annualized over the last quarter, half-year, and year.
The forecasts of sharply decelerating inflation expect the parade of “one off” causes to end – and, crucially, to be replaced by unbiased random events that are equally likely to be up or down. This is ‘assuming a can-opener,’ and is economist malpractice in my opinion. Because of the continued rapid growth of money, and until that rapid growth slows drastically or reverses, the surprises are mostly going to be on the high side. That’s why I expect inflation to be lower at the end of the year than it is right now, but not lots lower.
All of this, though, obfuscates a trend that had started prior to COVID but has gained great momentum since. When President Trump was first elected, we’d suggested in our customer Quarterly Inflation Outlook that one of the following winds which had kept inflation low despite loose monetary policy throughout the 1990s and 2000s was in the process of stopping and potentially reversing. That following wind was globalization. I eventually ended up talking a lot about de-globalization. Here’s one article from four years ago. I really love the Deutsche Bank chart in it.
In a nutshell, the argument was that domestic goods prices had been kept abnormally low despite strong economic growth and loose monetary policy through the prior quarter-century because businesses had gradually over time offshored production and extended raw materials and intermediate-goods supply chains to cheaper manufacturing locations outside of our borders. But that’s a trick that can only be turned once. When most production is overseas and most intermediate goods imported from the Pacific Rim, costs will resume rising at the rate of inflation in the source country, adjusted for FX changes. For decades, we’d seen core goods inflation near zero despite services inflation in the 2-4% range, as this dynamic played out, but there was no reason that goods inflation should permanently be zero.
So I thought that in 2016 we were already coming slowly to a point where similar monetary policy going forward was going to result in less growth and more inflation because that trick had been used up. The election of President Trump merely accelerated that timeline and increased the probability that the trend wouldn’t only stop but could reverse, causing the division of growth and inflation for a given monetary policy to be distinctly bad and requiring much tighter policy.
COVID-19, and the global response to COVID-19, has more or less totally reversed the arrow of global trade. Businesses are pulling manufacturing back to the US and pulling supply chains back to the Western Hemisphere as much as possible. Geopolitical tensions between the US and Russia, and the US and China, combined with the increased appreciation of the optionality of inventories and the cost imposed by long and variable lead times, which is partly reflected in the need to hold more inventory. And that, in turn, drastically decreases the attractiveness of a long supply chain, especially with global tensions, the rise of democratic populism (“we want what’s ours, not some global citizenship award!”), and the persistent rise in energy and other costs of transportation (driver shortages, etc).
All of which arguments I’ve made before. But I’m not sure I’ve drawn the line clearly enough that the net effect of this changing dynamic – which results in manufacturers choosing higher costs rather than lower costs – is that goods inflation is unlikely in my view to return to being centered around zero. While core services are a bigger chunk of the consumption basket than are core goods, that’s mostly because of shelter services. Core goods is 22% of the consumption basket; core services (less rent of shelter) is 25%. So this is not something that can be idly dismissed. If the mean of the distribution moves from 0% to just 3%, that moves the “normal” level of inflation up ~0.66%. Obviously, I think in the medium-term the number is a lot larger than that, but the key is whether the effect is going to be persistent over a long period of time (think years or decades, not months). I believe it will far outlast COVID, because the causes go far beyond COVID.
