We just passed 3% price inflation and nobody seems to notice. Wall Street is too busy honing in on Fed Chair Jay Powell's bullishness on the economy, drinking it up wholesale, to realize what is happening.
True, the price inflation I'm talking about isn't quite consumer price inflation, which is now at "only" 2.8% per year, but one step above that in producer prices. For one big reason I will explain below, we are headed quickly towards stagflation. And this time, unlike in the late 1970's, there will be no way out of it without the collapse of the dollar and the bond markets. The slide has begun and I don't think price inflation will tick down below 2% from here by the time the crisis becomes obvious. I do not know exact timing of course, but what I am more prepared to say is that I seriously doubt price inflation will trend down noticeably anymore like it did from 2012 to 2015. That's not happening again. All we'll get at most is an occasional minor month-to-month downtick, but the trend will clearly be higher price inflation from here.
Former Fed Chair Alan Greenspan, who arguably started this whole mess, agrees. While he has the reputation of a turncloak among the hard money crowd for being the fiat money king after nursing at Ayn Rand's objectivism philosophy, his knowledge of economics is still generally revered by hard money advocates. The term "objectivism" actually comes from hard money itself, from gold, which becomes the monetary backing of "Galt's Gultch" in Rand's novel Atlas Shrugged, where the world's businessmen hide out as society collapses around them. Gold has "objective value" she writes, and hence the name of her philosophy. (I do not consider myself an objectivist, though. I've only read the novel once.)
Anyway, Greenspan is speaking out now, and he's saying that the economy is heading towards stagflation, too. I agree. Whatever he did as Fed chair, I don't doubt his knowledge of monetary economics. Now here's why.
So the Producer Price Index rose 3.1% year over year as reported by the Bureau of Labor and Statistics yesterday, June 13. *Crickets*. The PPI is like the Consumer Price Index's less popular cousin. It gets little more than token acknowledgement, but it has always moved more or less in tandem with the CPI, which is just three tenths of a percent behind its peer. What happens when the CPI hits 3%? Here is what I believe happens, in broad strokes.
What will probably happen in the immediate aftermath of the CPI climbing to 3%, possibly even by next month's release but almost certainly within the 2018 time frame, is that the Fed will blow it off and look to the Personal Consumption Expenditures [PCE] index, its so-called "favored" measure of inflation. Once that overshoots the Fed's 2% target, and it is already at 2% on the dot as per the last release, the Fed still will not panic. They'll just move to the core PCE index that strips out food and energy, blaming oil volatility or climate change causing food prices to rise or something like that.
If core PCE overshoots, the Fed still will not panic. They will turn to the "symmetrical inflation" model where they believe a brief overshoot (whatever "brief" means) is healthy because it will average out the times when core PCE inflation was below 2%. At what point will they run out of excuses? Somewhere between 4% and 5% on the CPI is my guess, though I really don't know. Eventually though, they'll have to start chasing.
Then what? Here's where things get worse. They can try chasing, but it will backfire. The more they chase inflation, the higher inflation will go in my opinion, and the following is the ruling reason I see for the stagflation that is about to take center stage.
Global bond markets are distended to historic records, by any measure. Despite yesterday's 25 basis point rate hike, interest rates are still historically low, and rates are still negative in Switzerland, Denmark, Sweden and Japan for instance. There has never been more money locked up in bond markets as there is now. Sifma measures total Treasury debt at $14.933 trillion, up from $5.783 trillion since 2008. All that money is locked up in the Treasury market, with bond managers still counting their capital gains as bond prices have soared to record highs that don't even make logical sense. That's how you end up with negative yields.
If the Fed has to chase inflation, and it does this by selling bonds, what happens to the bond managers that are seeing their capital gains evaporate? They'll have to rotate out of bonds. But into what? Stocks? If the Fed is chasing inflation, stocks will go down, too. So what's left? The answer is commodities. If the Fed has to chase inflation and eat into bond prices in order to do it, a lot of the money that has been stored, pent up in the bond market since 2008, will start to pour out into the commodity markets and make price inflation even worse.
Why didn't this happen the last time stagflation struck? Because last time stagflation struck, the Fed had the tools to chase it, from the late 1970's until 1981. Back then, the Treasury market was anything but distended. In fact, just the opposite. Debt to GDP was at an all-time record low 31.7% in 1981. See the top paragraph at the link. This record low wasn't just a result of the dramatic interest rate hikes of that era to stave off double digit inflation, as one may want to believe. Debt markets were hovering around record lows in terms of debt to GDP for nearly 20 years surrounding this period, before stagflation was ever even considered so much as a theoretical possibility.
From 1968 all the way to 1985, the government debt to GDP ratio in the US was below 40%. There wasn't much money trapped in debt markets that would have threatened to exacerbate price inflation at the time, so chasing inflation with aggressive rate hikes eventually worked, saving the dollar from total collapse. This time, as they say, it really is different.
This time, if the Fed chases inflation with more aggressive rate hikes, it could actually exacerbate the price inflation. Yes, at some theoretical point, raising rates would quell it, but last time the Fed had to take the overnight rate to 20% in order to finally beat it. How high will it have to go this time? It's best not to think about.
Alan Greenspan is right. Stagflation is coming. The Fed beat it back successfully in 1980 with 20% interest rates. This time, there is nothing they can do. This time, stagflation could win. Commodities and real assets, in my view, are the only safe place to be.
Disclosure: I am/we are long GLD, GDX, GDXJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long various commodity stocks.