We’ve had the highest inflation since the 1970’s. It’s come down some, but what happens next? The conventional wisdom is that inflation is on its way down and that we’ll have a soft landing, the fed will pivot soon and start cutting interest rates, inflation will drop back to 2%, and the economy will rally from here,
But I’m not so sure. Even if the conventional wisdom that inflation is going down and the Fed is ready to start cutting interest rates is true, it likely means that deflationary factors are starting to dominate, which isn’t necessarily good. We won’t automatically go back to low inflation and a booming economy, it might be a sluggish economy or even a recession.
Here are the dueling factors I see:
Things that are inflationary
Government
- Payments made by the government to businesses and consumers puts more money in circulation, which tends to drive up prices.
- If the government is “printing money” to pay its bills, it is increasing the amount of money in circulation, which tends to drive up prices.
- If the Fed is “easing”, they are getting putting more money in circulation, which is inflationary.
Credit
- Low interest rates make it easy to borrow and spend, and that tends to drive up prices.
- Lots of banks that are willing to loan, and lots of other sources of loans (SoFi, etc), make it easy to borrow and spend, which tends to drive up prices.
- In general, easy credit is inflationary.
Hot war in Ukraine
- The war has led to the loss of a significant supply of wheat and other food to the rest of the world, and shortages drive prices up.
- The war has caused extensive damage to infrastructure that will have to be rebuilt, which will drive up the cost of the materials needed to do so.
- There has been massive destruction of metals used in tanks and bombs, which won’t be available for better uses like green energy.
- Massive spending on building new weapons and war machinery is inflationary, as all spending is.
Cold war in Russia and China
- Doing less business with China means the loss of very cheap manufacturing, which will be replaced with more expensive products built in friendlier locations. Cheap Chinese products and materials are pervasive throughout everything we consume.
- Russia has significant stores of fossil fuels that are less available, which puts upward pressure on fuel prices.
- China and Russia have significant stores of metals needed for green energy that are now less available and more expensive.
Demographics
- Fewer young people and more old people in most developed countries means fewer workers and more consumers, which will drive up wages and prices in general.
Immigration
- More restrictions on immigration means fewer workers available, which usually drives up wages.
Green Energy
- With fossil fuels, you pay for the cost of drilling and processing the fuel over time, as it gets used. With green energy you pay most of the cost up front, like the high cost of an electric car, or solar panels, or a windmill, then pay much less as it is used. This big initial expense will be inflationary.
- Green energy requires lots of metals for batteries, the electric grid, charging stations, and other infrastructure. Many of the mines for these metals are in unfriendly locations that may be inaccessible or expensive to access.
- It’s going to be expensive to mine for these metals even in friendly locations because nobody wants the mines near them.
- The electric grid is key to every kind of green energy, so some big investment in the electric grid infrastructure will be required.
Things that are deflationary
Government
- If the government increases taxes to businesses and consumers to pay its bills, that money is unavailable for other spending, which should drive down prices.
- If government spending is reduced in general, that should reduce the amount of money in circulation and drive down prices.
- If the Fed is “tightening”, they are taking money out of circulation, which is deflationary.
Credit
- High interest rates suppress spending, which leads to lower prices.
- Any stress on banks will probably make it harder to get loans.
- If businesses and consumers find it difficult or impossible to get loans, they have to cut back spending, which is deflationary.
Demographics
- A growing percentage of the population will be spending their savings and selling their investments in retirement, which could drive down the value of investments.
- Pension funds, which are often underfunded, will have to make good on their promises as a large percentage of the population retires. Some of them will require bailouts from the government, and the liquidation of their investments could drive down investment values in general.
- The US has significant obligations for Social Security, Medicare, and Medicaid payments which are primarily funded by payroll taxes coming from a shrinking percentage of younger people. We may have to increase payroll taxes and reduce benefits to keep it viable, and both are deflationary.
Artificial intelligence
- AI seems likely to eliminate jobs in general, there may or may not be equivalent new jobs created.
- This is a once in a lifetime paradigm change, it’s impossible to know what the final impact will be since everyone will change their businesses and behaviors to adapt to it in ways we can’t predict.
Recession/Depression
- Layoffs and fewer jobs available generally lead to reduced wages and more unemployment.
- Severe recessions cause spirals of reduced consumption, which leads to reduced production and layoffs, which leads to even less consumption.
Conclusion
Some inflationary and deflationary factors offset each other. And some of these factors are temporary and others are more permanent. The war in Ukraine will end some day, hopefully not too far in the future. A recession, if it comes will last a year or two, based on history, and then lead to recovery. Government programs will come and go based on who is in power. Demographic changes are long term, if not permanent.
It’s not clear to me yet what will play out. I’m just keeping an eye out so I can react if it becomes more clear.