Expert Commentary

CP High! Price Inflation can lead to Debt Deflation.

Talking about talking about a policy mistake.

This week’s release of U.S. consumer price inflation for May showed that headline inflation is running at 5% per annum and core-inflation (excluding food and energy) at 3.8% per annum. A lot of the increase is a mathematical base effect from such a low number 12-months ago, but with both releases coming in above economists’ forecasts, it is opening the door to the chance that price rises are proving to be sticky.

The Fed wants average consumer price inflation to be 2% over the long run and so its “strategy” to watch it run above 2% for the time being before tightening monetary policy. The Fed is very confident that it has the “tools” to rein in consumer price inflation if if gets too hot.

That is the really incredible aspect of what is going on because this is the same Fed which, for the past decade, has been struggling with the fact that no matter what it did to encourage consumer price inflation higher, it stubbornly went lower. So, why on earth does the Fed think that it will be able to stop runaway inflation? More to the point, why does the market believe the Fed?

The answer lies in social mood. It is this peak-positive social mood that makes the Fed believe that it can control the economy and also makes the market believe that the Fed can.

This has possibly come about because of the ultra-cosy relationship between the markets and the Fed. The Fed is terrified of another “taper tantrum” in the bond market, so it has invented the phrase “talking about talking about tapering” as a means to placate the market. This is akin to saying to your 6-year old child that “we’ll talk about talking about your bedtime at some point this evening.” Before you know it, it’s way past bedtime and you have to assert authority. The tantrum is ten-times worse than it would have been two hours earlier.

If consumer price inflation does continue to accelerate, the Fed will eventually have to resort to a Volcker-esque tightening of Fed Funds. A 21.5% Effective Federal Funds rate seems completely bonkers to anyone under the age of 50, but that is what it reached in 1981 as Fed Chairman Paul Volcker decided enough was enough and tried to put rampant consumer price inflation to bed. The bond market had already anticipated the tightening of course and yields started to rise before Volcker’s Blitzkrieg spilling over into asset price and debt deflation. The same lead action will happen now, which is why we’re keeping a really close eye on the bond market, particularly the 5-year real yield. The decline in the 5-year real yield has coincided with the incredible rally in stocks over the past year. Should it rise above minus 1.65% now, though, a double bottom will be confirmed - a significant reversal pattern.

Like a child’s eyes welling up with tears, it will be a sign that all hell is about to break loose.


US Treasury Real 5-Year Yield- June 2021