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I was reminded this week of the scene of The Fellowship of the Ring where travelers attempt to cross Caradhras, the towering mountain that stands in their way along their chosen path. As they climb, there is a wicked storm that gets worse the further they go, until it seems the mountain itself is resisting them.
“The Company stopped abruptly, as if it had come to an agreement without a word being spoken. They heard strange noises in the darkness around them. It may have been just a wind ride through the cracks and gullies of the rock face, but the sounds were those of shrill screams and wild howls of laughter. Stones began to fall from the side of the mountain, hissing above their heads or crashing into the path beside them…
“‘We can’t go any further tonight,’ Boromir said. ‘Let those who call it the willing wind; there are voices falling in the air; and these stones are directed to us.'”
And that’s what I felt last week. After the previous trading week culminated in a sharp pullback as investors testified loud and clear that 75 basis points were unwelcome, the bulls were ready to scale the highs this week. But the inflationary stones kept rolling down the mountain.
On Tuesday, the (which is a mouthful even if you shorten it) exceeded expectations and hit a new annual high of 20.2%. This is important because house prices tend to lead rents by about 18 months, so if house prices are still skyrocketing, it means rent inflation in the country is likely to remain high and stable until 2023. Remember that rents (equivalent owner’s rent plus principal residence rent) are about a third of the CPI’s consumption basket, and 40% of , so if rents increase by 5%, we don’t going back to 2% CPI unless a lot of other things are in deflation. Which seems, to say the least, fairly unlikely to happen in the near term.
It’s obviously not just housing; last week hit a new high as Indonesia (the world’s top producer) banned palm oil exports. I bet in 2019 you weren’t worried about the Indonesian palm oil action, but here we are as those rocks keep falling from the mountain. also approached an all-time high, thanks to the slowest planting season in the United States since 2013.
Yet on Thursday, the Fellowship made a strong push further up the mountain as the perfect number has been reported. The headline figure was negative, presumably removing a 75 basis point hike from the Fed, but the underlying details weren’t horrible.
Stocks soared. If there was ever a sign that the market today cares more about liquidity than growth, this is it. But it’s not good, it’s bad! Unfortunately, on Friday expectations were exceeded and traders began to put off that 75bp rise… for the June meeting.
It also didn’t help that Treasury Secretary Yellen on Thursday told us everything that “big negative shocks” are inevitable. Whoops. It’s starting to get slippery here.
Take a step back…
Have you noticed that Japan is planning to spend more money to “ease the pain of inflation”? Did you notice that Mexico is trying to control prices, even if so far the government is content to negotiate rather than mandate? Has it made you wonder if these people realize how much more like the 1970s it is every day?
With last week’s GDP report, it’s worth remembering where we are in the process of renormalization after the patently absurd scale of the monetary pandemic response. The graph below shows that the M2 money supply since the end of 2019 has increased overall by around 42%; GDP increased by 3%; and prices have increased by 9%, which makes us all unhappy.
But this is where it helps to remember how these numbers relate. In the absence of a permanent change in monetary velocity, the overall increase in prices plus the overall increase in real output must equal the overall change in money. And that for more than 100 years.
In other words, the only reason the red and green lines currently don’t match the blue line is because the velocity of money has dropped significantly in mid-2020. This was caused by a sharp decline in interest rates (which lowers the opportunity cost of holding cash) and a sharp increase in demand for “precautionary” cash balances.
The first of them is changing, and I suspect the second is too. So far, however, the speed has only retreated slightly from the lows.
The table, however, clearly shows what must happen if we want avoid a much larger price adjustment. It doesn’t have to happen in a quarter or a year, but one of these things eventually has to happen since mathematically it’s all related:
- A dramatic increase in actual output
- A dramatic decrease in the money supply – not its rate of growth, but its level
- Velocity should stay close to historic lows at all times
These can combine, but for now we need to consider the 30% spread (42% – 9% – 3%) in the future, unless the speed of money has really down forever. I’m not optimistic about the decline in M2, especially as it continues to grow at double-digit rates.
Real growth is constrained by physical limits and certainly cannot provide more than 4% per year at best anyway. And that means either speed has to stay low or prices have to go up a lot more in the months and years to come. The market, even after the sale, remains in an elevated, rocky plaza with few smooth paths to the front.
And now is the week, and! Prepare yourselves.
Ultimately, the Fellowship of the Ring was forced to abandon Caradhras and instead take a path through the Mines of Moria. I wonder if it’s next. And if so, who plays the role of the balrog? Fly poor fools!
Michael Ashton, sometimes known as The Inflation Guy, is the Managing Director of Sustainable Investments, LLC. He is a pioneer of inflation markets with a specialty in defending wealth against the onslaught of economic inflation, which he discusses on his Podcast Cents and Sensitivity.