We don’t really care if June marked the inflation peak or not. Yesterday’s revelation that wholesale (PPI) commodity prices rose by 23.4% on a Y/Y basis in June is the far more important data point.
As it happens, that was the highest gain since the 28.9% Y/Y increase posted 75-years ago (June 1947) as the US economy was coming out from under wartime price controls and rationing!
It far overshadowed previous cyclical peaks including a reading of 17.4% in July 2008, 16.0% in February 1980, and 18.4% during the peak of the Korean War inflation in March 1950. The only competitor during the past three-quarters century was the very same 23.4% Y/Y gain registered in November 1974 on the heels of the Arab oil embargo and the Fed’s money-pumping spree during Nixon’s last years in office.
So the question is not whether June 2022 was the inflation peak for this cycle, but how in the world did the massive monetary policy error, which enabled this red hot spike, actually occur?
And make no mistake, the underlying cause of an 23.4% Y/Y rise in PPI commodity index is egregious money-printing by the Fed and other central banks, not just the recent supply-side disruptions owing to Ukraine and the misbegotten Washington/NATO Sanctions War on Russia, the world’s second largest commodity producer.
As we once learned way back in the 1970s during the 1973-1974 and 1979-1980 commodity surges, if central banks have not pumped the global economy full of excess liquidity, a sharp supply-side driven rise in oil and wheat prices would cause an off-setting deflation in other prices. Under an honest monetary regime, there would have been no material change to the overall inflation index.
To paraphrase Milton Friedman, everywhere and always deflationary commodity outages and shortfalls are turned into general price inflation by the foolish monetary “accommodation” policies of the central banks. And the present pot-boiler inflation is no exception.
Y/Y Change in PPI for All Commodities, 1947-2022
There is actually no mystery as to how central banks got so far off the deep-end. In fact, it was Milton Friedman and his chief disciple, Ben Bernanke, who paved the way. It was they who instilled the wrong-headed fear of deflation among central bankers, culminating in the “lowflation” group-think that, in turn, fostered the rabid money-printing of the past decade, especially.
The fact is, when the cold war ended in 1991 and the Soviet Union was consigned to the dustbin of history, an unprecedented opportunity for a virtuous deflation was triggered. That is, vast swaths of mankind economically impaled in the former Soviet bloc and Red China were freed from the albatross of Marxist economics, thereby opening the door to a massive inflow of cheap labor into the globally traded economy—a secular shift that had the potential to substantially reverse the West’s great inflation of the 1970s.
Goodness knows that a thorough-going deflation was more than overdue as the 1990s opened. And that’s when Mr. Deng of China in particular saw the opportunity to end communist autarky, join world trade and mobilize the vast labor resources that had been trapped in China’s rice paddies for centuries and its Maoist-afflicted industrial economy in more recent times.
The implications for inflation policy were momentous. Thus, during the heyday of American prosperity between 1953 and 1968, the general price level (CPI) rose by just 1.43% per annum and unit labor costs by 1.31%. Those figures don’t represent perfect price stability, but they provide a reasonable approximation in today’s world.
But after Nixon pulled the plug on the dollar’s link to gold in August 1971, it was off to the inflationary races. During the 24 years through early-1995, the CPI rose by 276%or 5.7% per annum, causing unit labor costs to soar by 187% or 4.5% per year.
Stated differently, the embedded rate of inflation rose by 4.0X at the CPI level and 3.4X in terms of labor costs. That’s an acceleration of inflation with a vengeance.
CPI And Unit Labor Cost Indices, 1953-1995
By the mid-1990s, therefore, the US economy was a sitting duck for low-wage competition because its cost and wage structure had been inflated to a farthewell by a central bank which mistakenly believed that inflation would be absorbed domestically and that industrial production would stay at home.
This was a drastic miscalculation which dramatizes the folly of the Fed’s inflation targeting regime—an insidious policy first pursued informally during the 1990s through January 2012 and then formalized with the adoption of the 2.00% target thereafter.
What was actually required by the overhang of high domestic wages and costs depicted above was an extended period of domestic deflation. That would have purged the inflationary excesses of 1971-1995 and narrowed the dollar cost gap between the newly mobilized economies of China and its emerging supply chain and those of Pittsburgh, Detroit, Chicago and the lesser nodes of US industrial production.
But, of course, Alan Greenspan, who desperately desired to be the toast of the town in Washington and New York, was not about to shut down the Fed’s printing presses and permit domestic wages, prices and costs to deflate. And thereafter Bernanke actually became hysterically opposed to the needed deflationary curative owing to his slavish adherence to Milton Friedman’s fundamentally flawed argument that insufficient money-pumping by the Fed during 1930-1933 had caused the Great Depression.
The result was one of the worst Faustian bargains in history. The Fed (along with other central banks) inflated wildly, with its balance sheet (brown line) rising from $470 billion to $8.8 trillion during the 26 years after 1995. That’s an 18.7X gain or an out-of-this world 12% growth per annum, when the Fed balance sheet should have increased hard at all during the period. The counterpart result was a massive off-shoring of the US industrial economy. The monthly trade deficit in goods (purple line) rose from $13.6 billion in 1995 to $100.5 billion in 2021.
That is to say, the Fed’s stupid 2.00% inflation targeting policy caused a further 56%rise in domestic unit labor costs during that quarter-century period, thereby inflating, rather than deflating, the dollar cost of production gap between the US and the China-based supply chains.
Fed Balance Sheet Versus Monthly Deficit in Goods, 1995-2021
Not only did this vast off-shoring of the US industrial economy eliminate millions of high paying jobs, but, even more importantly, it fostered the delusion that there was no inflationary consequence to the Fed’s madcap money-printing, and that the US economy was actually suffering from a new form of monetary disability that was totally new under the sun: Namely, “lowflation” defined as a persistent shortfall from the now sacred 2.00% target.
But lowflation was never a steady-state reality—just the one-time consequence of off-shoring and an artifact of the phasing of the global commodity cycle.
As to the former, the chart below is dispositive. If we are to believe the BLS, the PCE deflator for durable goods plunged by 39% between 1995 and 2019. That’s a -2.0% annualized decline for one-quarter a century running.
PCE Deflator For Durable Goods, 1995-2022
We don’t believe it, at least in its entirety. We think there is a good amount of dubious “hedonic adjustments” in the reported numbers. But even if you set that aside, it is self-evident that the globalization of the supply chain during that period caused a one-time deflation of durable goods prices, as the China labor arbitrage became fully effective.
Actually, the proof is in the pudding when you look at the eras before Mr. Deng built his massive new export factories in China. To wit, during the heyday of American non-inflationary prosperity between 1953 and 1968, the PCE deflator for durable goods rose by just 0.7%per annum. But after the dollar was ripped from its anchor to gold at Camp David in August 1971, the durables deflator accelerated by 4.1X to 3.3% per annum through Q1 1995.
That is to say, there is nothing inherently deflationary about durable goods. What happened between 1995 and 2019 was a giant labor and cost arbitrage which is now over and done. The central banks should never have attributed that to insufficient monetary stimulus as they did for most of the past quarter century.
Likewise, the cycle for the commodities which drives the PCE deflator for nondurables was simply ignored by the central banks when it became convenient to do so after the adoption of inflation-targeting in January 2012. In this case, there was a huge wave of nondurables inflation between 1995 and 2008 as the China supply chain rapidly cranked up its demands on global commodities, but also a low-interest rate driven surfeit of investment thereafter which brought prices back down to earth after 2012.
Specifically, during the 13-year run-up to the $150 per barrel oil price peak in July 2008, the PCE deflator for nondurables rose by 2.6% per annum, which is hardly low inflation. After Q1 2012, however, the nondurables deflator remained flat as a board through the end of 2019 before surging at a 4.23% rate through Q1 2022.
Nevertheless, the central bankers jabbered endlessly about low inflation during the flat period of the cycle, with not so much as a nod to the timing of the commodities cycle. Nor have they ever acknowledged the fact that nondurable goods prices have not been remotely low inflationary over the past 27 years, having risen by 63% or nearly 2% per annum during that span.
Moreover, the story is the same for the period before the global supply chain took off after 1995. To wit, during the two aforementioned periods, the PCE deflator posted right in line with the underlying inflationary environment. That is, barely 1% in the former period and pushing 5% per annum in the latter.
Per Annum Change In PCE Deflator for Nondurable Goods:
- Noninflationary Heyday, 1953-1968: +1.3%;
- Post Camp David Inflation, 1971-1995: +4.6%
In any event, the chart makes clear there was no low inflation stemming from commodities and nondurables after 2012—just a temporary flat-zone of the cycle.
PCE Deflator For Durable Goods, 1995-2022
Finally, the largely domestically-driven PCE deflator for services showed an altogether different pattern. Namely, high inflation post-Camp David, but no deflation or even low inflation thereafter during the post-1995 off-shoring period.
In fact, after inflation targeting was adopted in 2012, the one component of the PCE deflator that the Fed can more directly influence—the services component—has exceeded the Fed targets year-in and year-out.
Per Annum Increase, PCE Deflator For Services:
- 1971-1995: 5.6%;
- 1995-2012: 2.7%;
- 2012-2019: 2.4%;
- 2019-2022: 3.2%
Y/Y Change in PCE Deflator for Services, 1971-2022
As we will show in Part 2, these divergent trends created an utterly false “lowflation” reading after 2012 and reinforced the Fed’s giant anti-deflation error that began in the 1990s.