With a soaring dollar, plunging deficits, and surging services consumption, this inflationary surge seems likely to follow an entirely different trajectory.
As the economic circumstances surrounding inflation change, keep an eye on the housing market.
T he inflation that has marked our emergence from the pandemic began with a plunging dollar, soaring government deficits, and surging goods consumption. Now, with a soaring dollar, plunging deficits, and surging services consumption, this inflationary surge seems likely to follow an entirely different trajectory.
Based on the strong relationship between the dollar’s foreign-exchange value and inflation, shown in the chart below, an inflation uptick was predictable in mid-2021. The dollar initially climbed against foreign alternatives in a flight to safety at the pandemic’s onset but began sliding as the Fed flooded markets with surplus dollars.
Inflation soared well past what was indicated by the dollar’s weakness, though, and hasn’t yet normalized with the dollar’s recent strength. Yawning federal deficits drove inflation beyond the foreign-exchange effect.
While textbook economics suggests that government deficits boost demand and thus prices, historical statistics seem not to support the theoretical relationship. Government deficits are closely linked to trade deficits, so, while a government deficit increases demand, it can boost the trade deficit, which increases supply, offsetting the price effect. Including both deficits reveals their inflation impact. The chart below compares the net of government and trade deficits to the Fed’s preferred inflation measure based upon PCE (personal consumption expenditures).
The relationship between inflation and the twin deficits is especially strong following the Great Financial Crisis when monetary policy was jammed at a wide-open setting. The unprecedented size of the pandemic stimulus also heightened the fiscal effect on inflation. Now, a shrinking government deficit, along with a steady trade imbalance, indicates potential sharp inflation declines.
Fiscal stimulus affects prices by boosting consumption. It also may reduce investment, including inventories. The ratio between consumption of goods and inventories closely tracks changes of inflation, illustrated in the chart below.
The indicator ratio of goods consumption to inventories has been influenced both by the government deficit’s boost to consumption, about a third of the indicator change, and by the shift during the pandemic towards goods consumption, accounting for the remaining two-thirds. Both federal stimulus and an autonomous shift in consumption are significantly responsible for today’s high rates.
The three preceding graphs explain today’s inflation as a function of the dollar’s foreign-exchange value, government-and-trade-deficit effects on demand and supply, and shifting goods consumption. Noteworthy is that in the last few months each of these factors has turned decisively toward significantly lower future inflation.
Monetary policy figures importantly in inflation analysis, too. The strongest relationship between money and inflation occurs over long periods of time, a decade or more. The chart below depicts the connection between long-term averages of money supply and inflation.
The Great Inflation coincides closely with preceding long-term money growth, but, since the mid 1990s, the correlation is reduced. There is an upsurge of both money and inflation in the bubble preceding the Great Financial Crisis, as well as in the current spike, but, overall, the connection is much looser. From 1960 to 1995, money growth averaged three percentage points more than inflation, corresponding to real GDP growth in that era. Since then, despite slower real growth, money has grown annually over five percentage points faster than inflation, facilitating the current era’s propensity for financial bubbles.
The contrast between the Great Inflation and the pandemic era is evident in the initial trajectory of inflation. As shown in the following chart, each inflation began below 2 percent, then rose approaching double-digit levels.
From inflation below 2 percent at the beginning of 1966, it took about seven years of excessive monetary growth for inflation to reach 6.6 percent at the end of 1973. The pandemic inflation saw a similar jump in just 13 months.
If the current pandemic inflation has monetary causes at its origin, we may expect it to linger long-term. While money growth recently has been negative, it was so high, up to 25 percent, during the pandemic, that long-term averages remain elevated.
If, on the other hand, this inflation was caused by a unique confluence of dollar weakness, unprecedented deficits, and extraordinary consumption swings, the pandemic era will be viewed as an extraordinary detour on the long-term path of declining inflation below central-bank targets. One of the best measures of future long-term inflation, the Cleveland Fed’s measure of expected inflation, projects just that scenario over the next ten years.
If inflation is about to correct toward historical levels, it’s not certain how this will happen. While significant factors indicate lower future inflation, it is not yet registering in the overall numbers. CPI inflation around 9 percent attracted headlines, but the better measure of inflation, PCE prices, remains well above the Fed’s 2 percent inflation target.
Something must give, and the most likely candidate is the U.S. housing market, which has been responsible for many U.S. recessions. After the Fed’s incomprehensible policy of funneling funds into mortgages at the peak of a housing bubble, housing unaffordability has reached the level of the last crisis, as shown in the chart below comparing house prices to income.
In the last few months, even with recent mortgage-rate declines, year-over-year increases in mortgage payments for average new homes have risen at the fastest ever rate, with only the early 1980s severe recession as a point of comparison. Home sales peaked even before mortgage-rate increases, and, judging from the last crisis, prices soon will follow. House prices are over 20 percent above historical norms relative to incomes, and corrections generally bottom well below average, which would wipe out equity for the most recent generation of home buyers. Whatever happens with prices, home building already is plummeting. The National Association of Home Builders CEO states, “We’re heading into a housing recession.” In the first read of second-quarter 2022 GDP, the housing downturn accounts for virtually all the quarterly decline, and it’s just getting started. On top of China’s even larger housing slide, inflation may be in for a large negative shock.