Inflation, Inflation, Inflation (or Not)

Andrew Stuttaford
·19 min read

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: inflation fears, Art Laffer (podcast), the economics of space, another Argentinian default (maybe), Tesla’s nickel scoop, and rich witches, dragon witches, treasure hunters, and the rise of capitalism. To sign up for the Capital Note, follow this link.

Inflation: Grating Expectations
Sometimes markets just don’t like what they hear, and what they heard yesterday was that Fed chairman Powell is staying the course.

The Wall Street Journal:

“Today we’re still a long way from our goals of maximum employment and inflation averaging 2% over time,” Mr. Powell said Thursday during an interview at The Wall Street Journal Jobs Summit. The appearance came as brightening economic forecasts are pushing up long-term borrowing costs, which could complicate the Fed’s efforts to keep interest rates low to support the recovery.

Mr. Powell’s remarks came at his last scheduled public event before the Fed’s next policy meeting on March 16-17. He said the central bank will maintain ultralow interest rates until its employment and inflation goals have been met and it will continue hefty asset purchases until “substantial further progress has been made.

He said he expected it would take “some time” to meet the conditions for considering a rate increase, but declined to be more specific about an anticipated time frame.

Asked if there is a chance the labor market might reach the Fed’s goal of maximum employment this year, Mr. Powell said, “No, I think that’s highly unlikely.”

He was less clear about whether the economy might show enough improvement this year for the Fed to start reducing its bond purchases.

“I’ve so far been able to not reduce it to an estimate of time. I mean, that will come, I think, when we can see that,” Mr. Powell said, referring to the standard that the Fed wants to meet before scaling back its asset purchases.

“Still a long way.” “Substantial further progress.” “Some time.” “That will come, I think, when we can see that.”

Phrases that were both vague and very clear, and so, as the Wall Street Journal notes:

The S&P 500 declined 51.25 points, or 1.3%, to 3768.47, the third consecutive session of declines. The Nasdaq Composite fell 274.28 points, or 2.1%, to 12723.47 and teetered on the edge of a correction—a drop of 10% from its recent high. The tech-heavy gauge recorded its biggest three-day percentage decline since September and has now given up its gains for the year. The Dow Jones Industrial Average lost 345.95 points, or 1.1%, to 30924.14.

In yesterday’s Capital Note, Daniel Tenreiro compared the current sell-off to 2013’s taper tantrum, but in reverse:

This time around, the dynamic is reversed: Investors are responding to an overly accommodative central bank, betting that growing aggregate demand will push inflation up. That’s tempered partially by a change in interest-rate expectations. The Fed has guided near-zero rates until roughly 2024, but investors have priced in three rate hikes by the end of 2023, betting that a persistent inflation overshoot will shake the Fed’s commitment to accommodative policy.

Writing in Capital Matters, Ramesh Ponnuru points out that markets’ inflation expectations were higher in 2019 than they are now:

Based on this calculation, the market expectation of inflation [1.67 percent] over the next five years remains well below the Fed’s target. (Remember, CPI inflation usually runs higher than PCE inflation.) The trend also looks different. Expected inflation, adjusting for liquidity, was 1.83 percent at the end of 2019. It plunged during the pandemic — all versions of the data show that — but it has not fully recovered. (David Beckworth and I wrote as much in the New York Times recently.)

That is a useful corrective to some of the current anxiety, but, to my mind, not complete. In 2019, the economy was in decent shape, and interest rates had risen the previous year. Things were, roughly speaking, “normal” or “new normal” anyway, even if the country’s debt still stood at what was already considered an alarming level. Happy days, in retrospect.

Then 2020 happened, and investors still do not quite know what to make of its effects and consequences — it is hard to blame them — although I suspect that quite a few know that even if exceptional times call for exceptional measures, the basic rules of economics have not, to use a popular phrase, been canceled. Spend enough and borrow enough and print enough and, whatever may have happened after the financial crisis (full disclosure: I expected inflation to take off after that rescue binge, and was wrong), inflation will be highly likely to emerge at some point.

Writing from across the pond, The Spectator’s Kate Andrews reports that the Brits (no paragons of fiscal virtue themselves) are beginning to worry about what may be brewing in the U.S.:

Joe Biden may be far preferable to Donald Trump for most Tories, but his economic agenda is starting to cause real concern in Downing Street. America’s new President is getting ready for the mother of all spending sprees to revive his economy after the pandemic. He plans a $1.9 trillion stimulus package: that is to say, he’s all set to pump more than double as much money into the economy as Barack Obama did after the financial crash.

The worry is that when Biden pours all this free vodka into a post–pandemic party, things could get out of control pretty quickly. Larry Summers, who served as Treasury Secretary under Bill Clinton and as an adviser to Barack Obama, is already warning of inflation danger. An ‘enormous risk we are running’, he said recently: even he is worried by the Biden splurge. ‘We’re gonna set ourselves up for inflation. And then we’re gonna either have inflation or we’re gonna have a collision between fiscal and monetary policy to contain inflation of a kind that usually doesn’t end well.’ . . .

The Brits are not the only observers to be worried.

Writing for Project Syndicate, Harold James, Markus Brunnermeier, and Jean-Pierre Landau:

Some EU member states – especially in the “frugal north” – are beginning to worry about a new and dangerous worldwide inflationary consensus. And some Americans, including former Secretary of the Treasury Lawrence H. Summers, who previously advocated fiscal stimulus, have begun to voice similar concerns.

I wrote a bit about Summers’ position in a recent Capital Note.

Back to Andrews:

Normally, inflation would be fought by raising interest rates: but that’s a tool that’s simply unaffordable right now, with the UK set to borrow hundreds of billions more in the coming years.

I suspect that is a consideration that has not escaped policy-makers’ attention in the U.S. either.


Many economists argue an uptick in inflation wouldn’t be such a bad thing. A rise to 2 or 3 per cent is manageable, and may even help inflate away our debt. But once inflation is unleashed, it can be hard to control. This was Friedrich Hayek’s warning to the Mont Pelerin Society Conference in 1969. ‘If the tiger (of inflation) is freed he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished.’

Last week Andy Haldane, chief economist at the Bank of England, published a speech, ‘Tiger by the Tail’, named after Hayek’s metaphor. The conditions that killed off inflation, he said, are disappearing. Many of the deflationary forces from decades past have shifted or vanished. The impact of China’s entry into the world economy — dramatically reducing the cost of goods and labour — cannot be repeated.

Against that last point, Bloomberg’s John Authers notes that:

Many forces for deflation or disinflation also remain in place. Workplace automation continues apace, reducing prices and the bargaining power of labor.

That’s true enough. (Remind me again, incidentally, why, in an age of automation, people still think that population growth is a precondition of per capita economic growth, the only measure that really counts.) But, in the short term, automation’s effect will be felt (once the pandemic-induced boost to automation eases) only incrementally, and is unlikely to be enough to head off an inflationary surge if that it is what is in prospect after the country reopens properly after the pandemic.

Much of the rest of Authers’ piece is dedicated to (in effect) making the case that Hayek’s tiger may indeed be stirring:

This week’s U.S. purchasing manager surveys found prices in both the manufacturing and services sectors at their highest levels since the eve of the global financial crisis, and rising fast. These have been good leading indicators of inflation in the past.

That may, I reckon, at least in part, simply reflects the inefficiencies that have built up as sectors of the economy have been switched off, then on, then off, then on, but still.

Those factors should fade (although I would be keeping an eye on “Dr.” Copper, which, unless it is distorted by speculative buying, may have something to say about longer-term inflationary trends), but to assume that inflation will fade with them may be to assume too much. As Arnold Kling pointed out the other day (while confessing that he remembered the 1970s, as do I), inflation can feed upon itself:

I think of inflation as an autocatalytic process. Inflation is naturally low and stable. But it can be jarred loose from that regime and become high and variable. Then it takes a lot of force to bring it back to the low and stable regime.

Fed chairman Paul Volcker applied that force, and it worked, but not without plenty of pain on the way. Authers wonders whether we are seeing a similar regime change, but in reverse:

“Volcker said he was going to tame inflation, unemployment be damned,” says Alex Lennard of Ruffer LLP. “Now it’s the other way around. I don’t think people have quite realized that you’ve had this huge change in the mandate of policymakers.”

Added to this, there is now an agreement on fiscal expansion. Politicians around the world appear to be “going big.”

That does not inspire confidence.

Project Syndicate’s Harold James, Markus Brunnermeier, and Jean-Pierre Landau:

Generally speaking, a one-off shock can be accommodated without long-lasting effects, because everyone recognizes that it is an exceptional event. But when there are repeated cycles of shocks and policy responses, a pattern emerges. People’s views of the future start to change as the exceptional becomes normal. In the language of central banks, expectations become unanchored.

Meanwhile and also at Bloomberg, Peter Coy hits back at hyperinflation fears — I think rightly — describing them as “meme economics” (a nice phrase), but he also adds this:

It’s conceivable that inflation will accelerate to 3%, 4%, or 5% for a while because of post-pandemic splurging and production bottlenecks, but the Fed has ways to halt inflation of that sort from snowballing into hyperinflation. The first step would be to stop buying long-term Treasuries and mortgage-backed securities, a move that would cause long-term interest rates to rise. The second would be to push up short-term interest rates—a lot if necessary.

The budgetary consequences (not to speak of the impact on businesses that may have grown too used to low rates) of such a move would be . . . interesting, which is a reason for thinking that this is not something that the Fed will want to rush into anytime soon.

But if it does not, and expectations of higher inflation begin to fester as a result, well, Coy weighs in on the expectations game:

Inflation is hard to predict because the expectations of consumers and businesses play a big role in it. To some degree, prices will go up if people think they will go up and won’t if they don’t think so. In a series of papers beginning in 1896, Irving Fisher argued that expectations of the future inflation rate are influenced by observations of the past inflation rate.

A working paper released in October demonstrates the importance of inflation expectations. It focuses on the early 1980s, when the Fed under Chairman Paul Volcker raised rates to as high as 20%, caused a deep recession, and wrung inflation out of the U.S. economy. Although states’ local unemployment rates were different, their inflation rates were similar. That’s an indication that their inflation was less affected by their economic conditions and more by expectations of future Fed policy, which affects all states equally, says one of the authors, Emi Nakamura, a professor at the University of California at Berkeley. “Fundamentally it’s a confidence game,” says Nakamura, who in 2019 won the John Bates Clark Medal for the best American economist under 40.

In a strange way, then, the hyperinflation talk does matter—because perception can become reality. The more Powell tries to reassure people that inflation isn’t a big problem, the more he alarms those who think he’s dangerously wrong . . .

And here we are.

Wherever that is.

The Capital Record
Please go here to listen to the latest in our podcast series, the Capital Record. David Bahnsen and the father of the supply-side revolution, Art Laffer, wax and wane about 50 years of evolution in economic thought. A not-to-be-missed discussion.

Around the Web
To boldly do business:

Bill Blain:

The SpaceX Starship is truly extraordinary. When fully tested – and I have no doubt it will be supersuccessful – it will sit atop a Super Heavy Booster, providing capability to launch 10 tonnes into Low Earth Orbit (LEO). Both stages will return to earth and be reusuable, a technology SpaceX has proved with its Falcon rockets which have taken crews to the International Space Station.

Wednesday’s launch was not a 100% success, but Musk can afford it. He’s demonstrated SpaceX tech is on course to revolutionise the commercialisation of space. Unlike EVs, space really is new technology and it’s a fascinating market to examine in terms of disruptive tech, what does and what doesn’t work, and tech adoption.

Space X, is a much, much more important company than Tesla. The EV maker simply improved existing battery and powertrain technology, dressed it up as disruptive innovation, and went on the make itself, briefly, among the most valuable companies on the planet. Now it’s becoming clear Tesla faces enormous competition in the space it’s created. Tesla will survive and no doubt thrive – but it’s unlikely to change the world as conclusively as we once thought.

The history of the aerospace industry is instructive. The Wright Brothers didn’t hang around long and within a few short years there were hundreds of aviation firms.

What’s curious about Space is its very slow commercialisation. If you compare space with aviation it’s a very different timeline. In the first 50 years from Orville and Wilbur’s hop on Kitty Hawk beach, the technology advanced quickly to Mach 2 fighters and the initial designs for Concorde. But in the 60 years following the launch of Sputnik, Space was about long-planned government programmes which ran out of funding when the TV audience thinned out. Apollo, Moon-shots and plans to go to Mars were killed by bureaucratic inertia and being last on the list of budget priorities.

Yet, Space was always monetizable. People talked about communications and space mining. Look at the amounts a few very rich individuals are willing to pay for a seat, or the 600 folk who have paid up for Virgin Galatic tickets? Or what NASA will pay to transport payloads into orbit. Of course, Space is also strategic – and the Military aren’t enthused about the space they need for their spy satellites being filled with space junk or commercial satellites . . .

Musk sees the commercial value in space very clearly. SpaceX is not just him joyriding and planning his eventual departure to Mars. Musk perceives massive value from SpaceX as the launch system for his Starlink system of over 12000 LEO satellites providing space-based internet to anywhere on the planet. You can get Starlink now – access the net from anywhere for a mere £500 per annum. The costs will come down.

What SpaceX shows is the commercial reality of space. It is monetizable. It will be worth billions.

Argentina: Another default on the way?

Arturo Porzecanski:

Argentina’s sovereign debt restructuring was unlike most others: It was undertaken in the absence of a confidence-boosting program of economic stabilization measures and structural reforms, and without the financial support from key multilateral organizations like the IMF and World Bank.

To be sure, the COVID-19 pandemic has significantly complicated the exit from default. As in all other countries, the government budget deficit widened significantly last year because of various pandemic-related spending initiatives and revenue shortfalls. Despite the reduction in interest payments on the public debt equivalent to about 1.5% of GDP, the fiscal deficit doubled from 4% to about 8.5% of GDP in 2020.

The key difference between Argentina and most other pandemic-stricken countries, however, is that its outsized deficit spending has had to be financed almost entirely by the country’s central bank, because Fernández and Guzmán were cut off from access to domestic and foreign capital markets during, and even after, their contentious debt negotiations.

As a result, the monetary aggregates have been expanding by between 60-70% per annum in recent months, auguring higher inflation and greater downward pressures on the peso. The latest consensus forecast is that, despite intensified price and capital controls, inflation this year will accelerate to 50% from last year’s 36%, and dollars in the official market will become 40% more expensive still.

Moreover, there is neither societal consensus nor political will to deconstruct the damaging populist legacy of 2002-2015 by making progress on a long list of pending structural reforms capable of fostering confidence and attracting new investors . . .

Here we go again.

Buddy, can you spare some nickel?

The Financial Times:

Tesla has agreed to buy nickel from a mine in New Caledonia in a move to secure its supply of the battery metal, which its chief executive Elon Musk has called the group’s “biggest concern.”

The electric-car maker will become a technical adviser at the Goro mine on the Pacific island and also get long-term supplies of nickel from the project as part of an agreement with the New Caledonian government, according to a person directly familiar with the matter.

The move comes amid growing concerns about future supplies of nickel, following a 26 per cent rally in prices of the metal over the past year and growing investment by Chinese companies in Indonesia. Nickel is needed for the most powerful lithium-ion batteries used in electric vehicles.

“Nickel is our biggest concern for scaling lithium-ion cell production,” Musk said on Twitter last month.

Random Walk
Rich Witches, Dragon Witches, Treasure Hunters, and the Rise of Capitalism:

It’s almost impossible to find an extract that does justice to this remarkable piece from Aeon, but if you are interested in pre-modern economics, witch hunts, and how the rise of capitalism might have marginalized the belief in witchcraft, this is the piece for you.

And, yes, an extract:

Dragon witches and the rich witches were not simply rich. They were newly rich. While the treasure hunters tried to join their ranks, the signal difference was not that they’d failed in doing so. It was that the treasure hunters tried to tap a source of wealth outside of society. They hoped to find a treasure, which by definition meant valuable objects of which nobody could rightly claim ownership. The treasure belonged to the spirit world. Spirits controlled it; spirits could reveal it. Where the treasure came from was so unimportant to the early modern mind that most trials against treasure hunters don’t even ask the question. The money the treasure hunters wanted to get didn’t come out of the resources of the village or region they lived in.

Here the model of the ‘limited good’ is useful. People in pre-modern agrarian societies behaved as if all goods are available only in limited quantities. The economy is a zero-sum game. One person’s gain is necessarily everybody else’s loss. Therefore, innovation and profit-seeking are strongly discouraged. Treasure hunters are excellent examples of persons who accepted the world view of the limited good. They didn’t openly seek profit by working more or working more effectively. They sought profit by using magic. They dealt with the spirit world. Rather than alienating their neighbours, they faced ghosts and demons in order to get the spirit world to hand over its money. This is why the magic of treasure hunters was punished so leniently: even if they used magic, even if they conjured up demons and tried to talk to ghosts, they still didn’t deviate from the standards of economic behaviour of early modern rural society.

Dragon witches and rich witches were the complete opposite. We know from the historical record that they’d become affluent recently and had therefore done everything the treasure hunters avoided. They had engaged in competition, often quite aggressively. They had tried to make money, no matter the opinion of their community. And their fellow villagers knew how to interpret this type of behaviour: dragon witches and rich witches were essentially greedy. They were slaves to avarice, and their avarice made them evil. After all, the Church taught that avarice was one of the Seven Deadly Sins. So both dragon witches and rich witches belonged to the devil because they were avaricious – even before they had made a pact. As a Swabian source put it: ‘Because of her avarice’ a suspect was thought to be a witch, and ‘if she is not one yet, she will certainly become one.’

Rich witches and dragon witches are two sides of the same coin. Both were condemned as greedy and reckless by their fellow villagers and townspeople. Their social advancement, denigrated as profit-mongering, was the very reason why they were believed to be witches in the first place . . .

To make sense of all this you really will have to read the whole thing.

— A.S.

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