The Economy

Inflation Is Here: What’s Next?

Shoppers at Macy’s flagship store in New York City, May 20, 2021. \ (Eduardo Munoz/Reuters)
It won’t be long before interest rates take their cue and jolt their way higher.

If you invest money in an economy in which the prices of goods are rising, you need to achieve returns on your money that, at the very least, keep up with the costs of those goods. Money is simply a store of value. If the value of money drops, you need to earn enough on your investment to offset that decline in value.

If the U.S. Treasury ten-year note earns you 1.7 percent per year, then you better hope that the prices of goods you buy — or plan to buy — don’t rise faster than 1.7 percent per year. For the past couple of decades, yields on the ten-year Treasury note have roughly achieved that outcome. While investors have not really made any “real” return after inflation was factored in, they have not lost much either. That, however, is likely to change.

Measured inflation, if one adopts the U.S. Consumer Price Index (CPI) as such a measure, recently came in at a whopping 5.4 percent rise over the previous twelve months. Actual inflation is likely substantially higher than that, because of the obvious understatement in housing and food costs buried in that index. I suspect that most Americans would be surprised to learn that “shelter” costs over the last twelve months have increased by a mere 3 percent and that food prices have gone up a modest 5 percent over the same period. Shelter constitutes 31 percent of the CPI and food 7 percent.

Inflation is now well above the yield on ten-year Treasury notes and well above the yields on pretty much any other kind of debt. This means those who invest in Treasuries and bonds of various types are losing money, after inflation is taken into consideration. Money is worth a lot less today than it was a year ago, no matter which yardstick you use to measure its value, and interest rates are not compensating for that decline.

So, what’s next? Something has to give. Either inflation is going to collapse — and collapse quickly — or interest rates will make the obvious adjustment upward.

As we approach the winter amid the bottlenecks of supply and potential supply and demand imbalance in the energy markets, it seems clear that inflation is more likely on the way up than on the way down. It won’t be long before interest rates take their cue and jolt their way higher, too. Given the fact that economists and businesses tend not to factor in higher interest rates, they will produce the same unwanted surprise that inflation did. Not only are rates likely to go higher in coming months, they could go much, much higher.

Employment data suggest a more fragile economy than the happy talk from the administration, crowing about the decline in the unemployment rate. Of more significance is the dramatic decline in workforce participation — Americans leaving the workforce altogether — which is hardly a sign of a buoyant economic future. You can expect to hear growing talk of greedy corporations and, in time, calls for government controls over escalating prices and wages, as inflation continues to exceed Fed projections.

While the Fed has begun to muse openly about the undeniable inflation trends in the economy, there is little it can do at this point. Rates will rise regardless of the soothing comments that emanate from Fed press releases or the self-serving statements that politicians with an axe to grind might put forth. The Fed has rarely shown the ability to tame inflation once it has taken hold, save the heroic battle in the early 1980s by Fed chairman Paul Volcker, who broke the back of the extraordinary inflation that plagued American economy in the 1970s. Even then, it took a sharp reduction in money growth, a tough cure that battered the U.S. economy in 1980–81 (unemployment in fact peaked at a little under 11 percent in 1982), but that first curbed the rise in inflation, and then squeezed it out of the system . . .

The Fed caused our current inflation spike by monetizing much of the federal debt, and the consequences of that decision will play out regardless of what the central bank may say or do over the near term. When reality finally sets in, the only policy that can begin to slow inflation will be some kind of repeat of what Volcker did in the 1980s. It will not be a pretty picture, and it will be made uglier still by the amount of debt that the U.S. has racked up. For now, though, forget about the Fed and focus on the rising interest rates ahead of the U.S. economy. They are pretty much baked in the cake.

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