Watching for Inflation

The current cover of The Economist asks Will Inflation Return? There is reason to believe the answer is yes.

Like interest rates, inflation is not something that I generally claim to be able to predict. Back in 2013 I posted some words, however, saying that I didn’t consider there to be much room for lower interest rates, and that bonds would be poor investments for a while. (And then I stopped posting in this blog for six years.) Since then rates moved up until about 2018.  Recently interest rates have plummeted in response to COVID-19 shutdowns. At this time U.S interest rates are again at unsustainable levels, and the most likely future path for them is increased yields.

Part of the case for inflation is that few Americans have much life experience with inflation anymore, so they are not expecting it. Central banks in many developed countries have been fighting deflation for more than 10 years. They too are not prepared for inflation. Globalization and exportation of manufacturing jobs has gone on for so long that low inflation expectations have become unusually ingrained into the expectations of anyone who buys manufactured goods from abroad. In short, there is an unusually pernicious consensus that is ripe for puncture.

Two categories of goods that have escaped price competition are higher education and healthcare, which have experienced severe price gains in past decades. I recently replied to an article posted on LessWrong titled Considerations On Cost Disease by Scott Alexander, and the resulting combination is worth reporting on here. My response to his article, in short, is that the monopolistic constituencies of higher education and healthcare are intact, and continue to be capable of extracting rent. General inflation would be increased by continued high inflation in both of these sectors.

There is one possible countervailing force that could temporarily halt tuition price gains at leading universities. The “woke consensus” of preaching social justice instead of discourse and objective truth presents some reputational risk to the leading universities. The Foundation for Individual Rights in Education (FIRE) maintains a list of universities that have agreed, at least in theory, to adopt or endorse the Chicago Statement. Many prominent universities (e.g. Harvard, MIT, UPenn, Dartmouth, Cornell, Northwest, Brown) are absent from this list. Some that are on the list have adopted other guidance statements or exhibited behavior that directly conflict with these principles (e.g. Smith). The risk to such institutions is clear: if the perception builds that students and faculty proclaim dogma over reason and these institutions are tagged as being “woke”, then these institutions could lose ground to universities that maintain the liberal tradition. The effect would be slow and subtle, but once started, would be difficult to reverse. 

As for healthcare, a new Executive Branch Administration may find it worthwhile to pursue Medicare for all, expanding the healthcare sector further, while continuing to separate the service providers from the true payors (patients and taxpayers). Additional Government involvement would then increase medical inflation further.

What would be the trigger? The current economy may be underproducing, and awash in money. If the suppression of economic activity due to COVID-19 is suddenly removed, too much stimulus money could be chasing too few goods. Part of the COVID-19 response has been to greatly increase the money supply as measured by M1. (I have Michael Burry to thank for pointing this out.) Look at the recent increase in M1:

So far this has shown up primarily in price gains of equities, especially in Internet stocks (AAPL, AMZN, FB, GOOG, MSFT, NFLX) and TSLA, at levels that no longer make economic sense with respect to the current and future earning power of these companies. Naturally, a surge in inflation would be accompanied by an increase in interest rates and increases in the implied discount rates used to value stocks.