David Rosenberg: Some effects of the pandemic may linger, but inflation isn’t one of them

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My newest theme this year is contrarian versus consensus, and I am sure that’s to no bewilderment from the crowd since trying to find holes in the consensus forecast is how I make my living. I’m especially positioned against the consensus view when it comes to inflation.

I find myself in United States Federal Reserve chair Jay Powell’s camp that because the pandemic caused a temporary deflationary condition, due to the initial shock hitting demand greater than supply, the combination of the fiscal juice and reopenings are creating the exact opposite condition, where demand is outstripping supply. But it’s a tad disingenuous to believe that supply won’t catch up, and when it does, demand growth will subside since so much of it is artificial in nature and the conditions for disinflation will come back into vogue.

I actually expect to see this happen before the end of the year. And this is not the same economy of the 1970s any more than the 1870s, so comparisons here are completely off base. But I find most market pundits don’t really understand what inflation is, and that it is a sequence of price increases, not a one-off shift in the price level to protect profit margins from a short-term dislocation between demand and supply, which so very clearly reflects the residual impacts from the pandemic.

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Powell is right: the inflation everyone is talking about will be almost as transitory as deflation was a year ago when we saw the front-month contract on WTI go negative for a day and we had three straight months of negative readings on the CPI. The worst thing to do back then was extrapolate, and that holds today as well. With a tip of the hat to Cosmo Castorini in Moonstruck, everything is temporary.

There’s really no sense debating that the U.S. economy is in a boom right now. But the real question is why a U.S.-inspired boom would come as a surprise to anyone, given the massive, if not unprecedented volume of policy stimulus in the system. The vaccinations are an obvious plus, but with 80 per cent of the U.S. economy now open, that thrust is heading into its latter phase with only 62 per cent of the pandemic job loss having been recouped, even as GDP is in the throes of reclaiming a new peak.

The hole in the U.S. labour market is still so big that it is short 8.4 million jobs from where it was before the pandemic, and more like 12 million when you account for where it would be, had the pandemic never occurred. But output is probably, as of this quarter, back to an all-time high in real terms and is already back there in nominal terms.

Productivity had its best year in a decade, rising 2.5% even as the economy as a whole had its worst year since 1946

That, in turn, tells me that productivity is still chugging along at a very strong pace. I am very bullish on productivity, and one of the big structural factors that emerged in 2020 is that even with the economy contracting 3.5 per cent last year, business spending on automation actually rose six per cent in volume terms. Productivity had its best year in a decade, rising 2.5 per cent even as the economy as a whole had its worst year since 1946. What makes this current era not the 1970s is that the trend in productivity is inversely correlated with inflation, because of the implications for unit labour costs, which is the mother’s milk for inflation. The principal cause of the inflation we had in the 1970s and into the early 1980s was that we had practically no productivity growth and the proliferation of cost-of-living-adjustment (COLA) clauses caused wages to far exceed productivity. That’s why I think this incessant inflation chatter we continue to hear because of transitory supply shortages is complete nonsense.

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The truth is that there has been nothing quite like the disruption caused by the pandemic. It may take some time to sort out, as Jay Powell told us last week. For all the bond bears and inflation-phobes out there, who extrapolate the present into the future and gaze at the various purchasing manager surveys, the statement that resonated the most was that nobody should claim they have a more extensive network of business contacts than the Fed has at its disposal.

U.S. President Joe Biden and his band of fiscal adventurers may think they have a mandate to use the pandemic as a means to have government infiltrate the economy, but the 2022 midterms will have a say in how long this lasts, just as Bill Clinton found out the hard way in 1994, Barack Obama in 2010 and Donald Trump in 2016.

It is certainly true that the pandemic has triggered supply chain disruptions and COVID-19’s lingering effects have restricted the supply of some key materials and labour — though there is a more than ample supply of idle workers waiting in the wings, whether in manufacturing, construction, resources or consumer cyclical services. This is also the case with food, though inclement weather conditions (in Brazil but also in key growing parts of the U.S.) have played a role in terms of pricing, not to mention the traders in the futures and options pits trying to make a quick buck as the net speculative long positions in corn, wheat and soybeans have been soaring to the moon.

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But with a lag, the basic laws of economics will reassert themselves: the vaccination success will help ease whatever shortages seem to exist in the jobs market; and on the demand side, one can reasonably expect the end of the stimulus checks and uber-generous unemployment benefits in the third quarter to exert a sharp dampening influence. As for further fiscal stimulus from the Biden team, including infrastructure, these latest proposals are already being met with some resistance in Congress, including some factions within the Democratic Party. Post-summer, expect production to expand, demand growth to recede, and for all this price inflation chatter to quiet down. The case for a bull-flattener in the Treasury market will be very strong in that environment, all the more so since vibrant growth, accelerating inflation and an early return to Fed tightening has already been priced in.

One very important element in all this is where the new equilibrium personal savings rate levels off once all the distortions play out. It goes without saying that it isn’t going to sit at 27.6 per cent. It is only there because government transfers have boomed 148 per cent in the past year. Real incomes, excluding these fiscal giveaways, are running barely above one per cent on a year-over-year basis. We now have a situation where consumer cyclical expenditures have recouped 70 per cent of the huge loss, but are still 20 per cent below pre-pandemic peaks. Much of this spending is lost forever, since there are only so many visits to restaurants, bars, salons, sporting events and movies that we can take in a given week, month or year, not to mention how many vacations we can really afford to take.

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There is also this other little matter, which has accentuated the shortages of materials, concerning the unprecedented consumer spending on durable goods during this crisis: soaring 44 per cent in the year to March and well more than 20 per cent above the pre-COVID peak. Keep in mind that this segment of personal consumption expenditure is more than double the areas of services that are primed for a post-pandemic recovery. That so-called pent-down demand, since nobody is building another deck in the back yard or fitting a second table in the dining room, may well provide a huge offset to the service-sector rebound. We then end up with the government deficit bumping against massive surplus savings in the household sector, which then splashes a lot of cold water on the hawkish inflation and bearish interest views that have dominated the market narrative for much of this year.

Join me on Webcast with Dave on May 19 when I will be hosting my long-time mentor and legendary market strategist Don Coxe. Learn more on my website.