Pro Perspectives 5/12/20

May 12, 2020

We've talked quite a bit in that past couple of weeks about the recipe for a return of inflation. 

Remember, we have deluge of money flooding the world from global policymakers, and pent-up demand that will be chasing supply that has been disrupted and will take some time to rebuild.  Add to that, the wage bar has been reset higher — from the impact of wage increases that have been given to essential workers to the impact of federally subsidized unemployment pay (exceeding that of median income).   

That said, as we've discussed, what will become a wave of possibly very hot inflation, first looks like deflation, in this environment.  After all, when you put money in the hands of people but tell them they have to stay home (with little visibility on an endpoint), it's safe to say that consumption (aside from necessities) is going to be crushed in the lockdown phase.

With that, there was a big deal made of the inflation data this morning. 

Here's a look at the chart of core CPI … 

And with this chart, we heard a lot of commentary about the prospects of negative interest rates, and fears of a deflationary spiral. 

But we have a very important catalyst at work that can turn this dynamic on its head.  The reopening of economies.  

This is a "light switch" effect for demand – not a return to pre-health crisis demand by any means, but it's the "rate of change" in demand (from virtually non-existent) that should put pressure on businesses to go from “opening the doors” to ramping up operating capacity (including staff and supply).  And again, this is where the supply disruption should be exposed and price pressures should appear.  We shall see in the coming weeks. 

Another very important spot to watch on the inflation front, as demand comes back into the economy:  On March 26th, as part of the Fed's policy response, they cut the reserve requirement ratio at banks to zero (from 10%). This was an incredible move – another explicit devaluation of money.  Banks no longer have to keep reserves to make good on your demand for your deposits.  If you need your money, the Fed will pass it through (the banks) to you. 

This move to "zero" incentivizes, if not mandates, banks to make loans (an infinite amount of loans).  What  does this do to the supply of money?  At a zero reserve requirement ratio, the stock of money could increase infinitely.