Inflation Will Be More Persistent Than Expected

Semi-trucks pull into a TA Travel Center to fill up with diesel in Jessup, Md., on May 2, 2022. Jim Watson/AFP via Getty Images

Commentary

The most important economic question to date is still the old one: whether inflation has peaked or still has some months to go. The U.S. official tone on inflation has always been on the supply side such as the logistic blockage due to Covid-19 lockdowns or the Ukraine-Russian war. The demand side of ridiculous monetary easing causing inflation has never been addressed, albeit the real boosting effect has been emphasised repeatedly. Tracing the source of inflation is crucial because the supply side factors are fading out, but this is not yet the case on the demand side.

For over two quarters, lockdown is no longer practiced except in dictatorship countries. The Russian invasion can no longer push commodity prices beyond their March peaks. Hence, supply side advocators are now asserting inflation has peaked and will come down very soon. However, the fading out of these two factors happened in the second half of 2021 (H2) and the second quarter of 2022 (Q2) respectively, while inflation has continued to rise in the period. More importantly, core inflation excluding food and energy show a similar uptrend, suggesting demand factors might be in play.

Such a mistake is likely a result of the observability of the two sides: supply factors are mostly observable while demand factors are not. The former group is often attributed to the cause. Demand factors are generally inferred from some observables such as monetary boosting in the context here. Nevertheless, it is well documented in literature that the monetary channel takes quite long time to show an effect (it may take up to a few quarters), which must be taken into account in such analysis. In the accompanying chart, the growth rates of money, credit and prices are plotted together.

US monetary, credit and prices YoY growth rate. Courtesy of Law Ka-chung

Monetary base is the narrowest measure of money directly created by the central bank. After repeated deposit creations in the banking system, it is “multiplied” to broad money (M2) which constitutes the basics for inflation. Money growth does not automatically imply price growth (i.e., inflation) as a stock pile of money without flowing is meaningless. Only when money moves, which means credit, will inflation be generated. This process takes time, which is usually a year or two from empirical experience. In our chart the time gap between them is 1.5 years.

Tightening means monetary base begins contraction, but whether broad money will follow suit depends more on the market than on central banks. Broad money is generally less responsive than the narrow one. As money is withdrawn, credit will slow down but with quite a long-time lag. Based on the empirical 1.5 years’ time lag shown in the chart, credit growth and hence inflation are projected to stay high for some months before coming down materially. In other words, inflation is unlikely to go below 5 percent by the end of 2022.

This means the Fed cannot step back from a periodic of 50 basis point (bps) hikes to 25 bps, in each Federal Open Market Committee (FOMC) meeting, probably until early 2023, so there is likely to be five to six 50 bps hikes in due course. By then the Fed funds rate could reach a level of 3.5 to 4.0 percent!

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.