In early 2021, Larry Summers was in the minority when he predicted that the $1.9 trillion American Rescue Plan (ARP) would cause significant inflation. Late last year, other economists began to come around to his point of view.
In early November, it became clear that Joe Biden would nominate Jerome Powell for another term as Fed Chair. Investors concluded that he would be the point person for raising interest rates and making other moves aimed at fighting inflation which sent shares of fast-growing tech stocks heading towards the basement.
Since then the Fed has made it clear that it will raise rates. So far its actions have not been working particularly well. In March the consumer price index rose 8.5% —the highest since 1981.
Now, Summers is predicting a 66% chance of a recession in the next two years, according to the Boston Globe.
This raises many questions (and here’s what I think about them):
- What’s causing the current bout of inflation? Many causes — most notably that at the beginning of the pandemic, orders for goods fell right before demand for them spiked. Spread of Covid-19 limited the supply of workers to meet the demand — sending prices up.
- How is this year’s inflation different from 1981’s? 1981’s inflation was due largely to rises in energy prices which were a larger part of the economy and after nearly a decade of inflation, long-term inflationary expectations were high.
- What will tame this year’s inflation? Given that wages and prices are rising— which could create a longer-term wage-price spiral — the cure could be a surge in supply, a recession that causes high unemployment, or both.
- Is a recession inevitable? It’s not inevitable — especially if core inflation — excluding volatile energy and food prices — remains as low as it was in March. That might influence the Fed to raise interest rates less than anticipated — thus reducing the odds of a recession.
- What should investors do? If you can wait for a decade to cash in your investments, keep buying into a stock index fund and stay away from bonds because their prices will fall if interest rates rise.
What’s Causing Inflation Now?
What's causing this inflation? As I told Metro West Daily News, inflation has been building up since March 2020. That’s when production for consumer goods like computers cars and furniture dropped amid an anticipated decline in demand.
That forecast was very wrong — demand actually increased during the pandemic. For example, the global PC market soared 55% in the first quarter of 2021 as the number of people working and learning from home increased.
The limited ability to satisfy that demand enabled producers to raise prices. Prices for some durable goods soared — used car prices were up 55% over January 2020 levels, furniture and bedding prices rose 19% and laundry equipment prices spiked 33%, according to the Times.
Russia’s invasion of Ukraine further stoked inflation by reducing Russian oil supplies and intensifying supply chain issues, particularly for energy, wheat and other commodities shipped out of that region, according to USA TODAY.
What’s more the recent Covid lockdowns in China are inhibiting the operations of its factories — adding to the supply deficit.
A tight labor market and low unemployment rate also helped embed inflation into the system as companies pay employees more and, in turn, raise prices to make up for higher costs.
How This Year’s Inflation Compares to 1981’s
This year’s inflation differs from 1981’s in at least one important respect — for the moment, long-term inflationary expectations are far lower than they were 41 years ago.
In 1981 — the last time inflation was at 8.5%, the Fed raised interest rates to record levels causing a sharp and painful recession. As I wrote in February Fed Chair Paul Volcker raised interest rates to nearly 22% — prompted by high long-term inflationary expectations.
Volcker’s harsh steps in the early 1980s were prompted by a decade’s worth of “persistent, spiraling, inflation that bedeviled the U.S. economy throughout the 1970s.” according to the Washington Post.
Simply put, people expected high inflation to continue for the long term and he used his power to break the back of those expectations. To do that, he raised the prime interest rate from an already record high of 11.75% to 21.5%.
This caused the worst downturn since the Great Depression. How bad was Volcker’s recession? The nearly 11% unemployment rate reached late in 1982 remained “the apex of the post-World War II era,” according to a 2013 Federal Reserve History. [Unemployment has since surpassed that level — reaching 14.7% in 2020, noted to the Journal].
What is different about the current inflation is that it has not been around long enough to make people think inflation will be high for the long term. As I wrote on April 1, even Summers conceded that long-term inflationary expectations remain low.
As Summers told the Times, “right now people are forecasting way accelerated inflation for this year. The market forecast is close to 6% [with the $25 to $30 a barrel oil price increase contributing 1% to 1.5% to that rate] but they’re still forecasting more limited inflation beyond.”
What Actions Will Tame Inflation?
I think there is merit in trying to keep long-term inflationary expectations from getting as high as they were back in 1981. Without action, I am concerned that we could be in the early stages of a wage-price spiral (WPS) that could make people expect higher inflation in the long run.
Such a WPS can become a perpetual motion machine. Energized by the demand spike that caught the supply chain by surprise, producers raise prices because customers seem willing to pay them. To catch up with the demand, those producers struggle to attract and keep workers.
Due to the low unemployment, producers raise worker pay to keep the ones they have and to add more of them. If the labor market remains tight, consumers have money coming in and are willing and able to pay higher prices. So producers keep raising prices - thus keeping inflation high and boosting workers’ expectations for bigger raises.
The only tool the Fed has to keep this WPS from raising long-term inflationary expectations is to raise short-term interest rates way above long-term rates. That creates a so-called inverted yield curve which is often a good predictor of recessions.
How good of a predictor depends on which data you choose. According to Barron’s, in the first week of April, the yield curve inverted slightly with the two-year treasury yield at 2.42% — 20 basis points more than the 10-year yield of 2.40%.
Such a gap has been a good predictor of recessions. A BCA Research report “found that the gap between 2- and 10-year yields has inverted before seven of the past eight recessions, with no false signals. The gap between 3-month and 10-year yields has a better record, calling all 8 recessions without a false signal,” wrote Barron’s.
Summers told the Globe that the Fed will have to raise rates considerably to cause a recession. The median estimate of central bank policy makers is that the Fed Funds rate will end 2023 at 2.8% — considerably higher than the current 0.5% level.
However, to get the inflation under control, Summers thinks that the fed funds rate must be higher than the rate of inflation. To get there, he sees the fed funds rate rising to 5% — a level that would make the price of borrowing so high that it would “cool off the economy,” according to the Globe.
If a recession happened would it tame inflation? I think the answer largely depends on how many people lose their jobs. At the moment, the unemployment rate is 3.6% — but if rising interest rates put a crimp in new borrowing and cause a spike in bankruptcies, companies would abruptly cut staff and the unemployment rate could top 10%.
Unemployed workers would buy less and would be more eager to get a job — even one which paid less than the one they had before. The resulting lower demand could send that WPS into reverse — causing producers to lower their prices, pressuring them to cut costs by reducing staff and lowering wages, which would in turn reduce demand.
Another way to reduce inflation would be to increase supply above the level of demand. The Times reports that higher wages are easing the labor shortages that have crimped the supply of goods and services.
Perhaps the Fed won’t need to raise rates as much as Summers expects. Morgan Stanley Investment Management managing director Andrew Slimmon said that “freight costs and shipping backlogs have been dropping, which may predict that the [consumer price index] will be substantially lower six months from now.”
Is Recession Inevitable?
Summers is more pessimistic than his peers. A Reuters poll of over 100 economists conducted early this April found that they estimate a 40% chance of a recession by 2023.
Underlying Summers’ pessimism is the Fed’s incomplete control over interest rates. He is tracking the housing market as an early warning indicator. With the 30-year fixed mortgage reaching 5% for the first time in the last 11 years, he sees the “housing market could be the canary in the coal mine for whether higher rates lead to a soft or hard landing for the economy.”
I see one of two outcomes: inflation will eventually tame itself over the next couple of years as supply catches up with demand, or the Fed will raise interest rates enough that a recession will rein in inflation.
What Should Investors Do?
Every investor is different. However, if you have a decade before you need to withdraw your funds, I think it makes sense to keep making monthly contributions into a stock index fund. Over the long run, stocks generate a return of about 7%.
If I had known in November 2021 what I know now, I probably would have sold a considerable amount of my technology stock holdings at the beginning of that month. But let’s get real — I do not know (nor does anyone else) when a market top or a market bottom is reached.
If there is any reason why buying now is good, it could be that there is so much bad news out there and in theory it is now reflected in stock prices. But I doubt the market reflects, say, the effects of Russia launching nuclear missiles at major Western population centers.
Meanwhile, if history is any guide, if Summers is right and a recession is heading our way, the recession will not last more than 18 months and the stock market will surpass its previous high once the recession ends. In recessions since 1980, it has taken the S&P 500 anywhere between seven and 76 months to surpass the pre-recession high.
How so? According to the balance, below are the six recessions since 1980, how long they lasted, and my estimate of how long it took for the S&P 500 to surpass its previous high after it fell during that recession:
- 1980. Six months recession and seven months for S&P 500 to reach pre-recession high of 422 reached in January 1980
- 1981 to 1982. 16 month recession and 27 months for S&P 500 to reach pre-recession high of 452 reached in December 1980
- 1990 to 1991. Nine month recession and 12 months for S&P 500 to reach pre-recession high of 804 in May 1990
- 2001. Eight month recession and 69 months for S&P 500 to reach pre-recession high of 2,525 reached in August 2000
- 2008 to 2009. Six month recession, 76 months for S&P 500 to reach pre-recession high of 2,117 reached in May 2007
- 2020. Six month recession, seven months for S&P 500 to reach pre-recession high of 3,593 reached in January 2000
So unless the recession that Summers predicts is more severe than the previous six, patient investing in a stock index fund will likely work out for you.
