Victor M. Cossel
July 20, 2022 – Charleston, SC, USA
INFLATION IS ALWAYS AND EVERYWHERE A MONETARY PHENOMENON…MOST OF THE TIME.
Financial markets keenly sense the ebbs and flows of monetary policy adjusting asset prices accordingly. Importantly it is the rate of change in monetary flows that most asset prices are particularly sensitive to. For instance, while monetary stimulus levels remain near all-time highs, equity and bond prices have been falling swiftly for the last six months in anticipation of the Federal Reserve’s contractionary monetary policy. Such market weakness is understandable considering markets themselves serve as the direct mechanism for central banks’ monetary policy which transmits from the markets to the broader economy indirectly with a lagged effect. Thus, most extrapolate today’s market weakness from tightening as tomorrow’s economic slowdown. The sequencing and recurrences of this process support the economic axiom “inflation is always and everywhere a monetary phenomenon.” As such, most attribute today’s near record inflation to record monetary stimulus exacerbated by massive fiscal pandemic stimulus spending – both of which are fading.
Yet upside inflation surprises persist walloping financial assets pushing interest rates higher at a time when recessions fears should be pressuring interest rates lower as the business cycle slows. Sure, prior monetary stimulus lingers but most of the fiscal has been spent and the business cycle peaked more than a year ago which should anchor rates. Given fading monetary and fiscal supports, we have to ask, “Why is inflation running higher than expected?” Our sense is that the government’s tax and regulatory uncertainties coupled with combative rhetoric are resulting in underinvestment which threatens productivity enhancements and supply responses to tame inflation. Today’s high energy prices serve as a case in point demonstrating that government policies and signals undermine capacity investment which usually follows a period of high commodity prices.
In short, there is simply a disincentive to invest leaving a supply shortfall relative to demand in the energy sector which is foundational to the entire energy-consuming economy which bears inflationary input costs. Remarkably hawkish commentary from the Federal Reserve is shaking corporate confidence further exacerbating the disincentive to invest as the Federal Reserve drives demand destruction while raising borrowing costs. While late to curb inflation, the central bank is doing what it needs to do addressing the monetary phenomenon of inflation. However, and more concerning is the legislative and executive branches outright disregard for counter cyclical measures to stimulate capital expenditures for a supply response. Government is not alone in undermining supply responses from the energy industry – many parts of society have joined the anti-carbon campaign too combatting hydrocarbon providers at a time of few meaningful alternatives. Ideological campaigns furthering an energy transition ignore the harsh realities of current cost curves of alternative energy sources so the resulting inflation is not a monetary phenomenon but a political one.
Such an energy shock may prove more enduring than any one since the 1970s. As such, investor considerations in the asset markets need to adjust for stubbornly higher interest rates and higher risk premiums for financial assets. While the process is underway, it is by no means complete. Ultimately the first constructive step toward friendlier energy policies may come this fall should the Congressional midterm welcome a legislature which could mitigate the executive branch’s hostility to capital expenditure broadly and to hydrocarbon based energy specifically. Time will tell.