From the Desk of Christopher Thornberg

The pandemic-driven business cycle ended in the last half of 2021, when levels of aggregate consumption reached long run trend and unemployment dropped below 4% in the United States—all in less than two years (comparatively, the Great Recession took a full nine years from beginning to end). As Beacon Economics anticipated near the beginning of the crisis, it was a ‘V-shaped’ cycle, a deep decline followed by a rapid recovery. And that cycle is now complete.

Still, as far as business cycles go, this was truly unique—the recessionary decline was the deepest in U.S. history, and the shortest. The recovery was amazingly fast, with some of the fastest declines in unemployment ever experienced. Why so different? This recession was supply-shock driven, without the typical longer-term consequences that come from, for example, an asset bubble collapse that drives a demand shock, which is what powered the Great Recession. Rather than forcing an economy to reshape itself after years of subprime driven mal-growth, this downturn simply saw a portion of the economy temporarily closed off as the world waited out COVID-19. Moreover, much of the rest of the economy benefitted from the shift in spending away from services affected by the restrictions to other things.

Of course, monetary and fiscal stimulus also played a role in the strong recovery, both in guiding the nation through the first few weeks of (clearly unwarranted) financial panic, as well as supporting businesses and workers who were truly hard hit. But the scale of the intervention in the economy was vastly more than what was needed under the circumstances. This is evident by the simple fact that other developed nations have followed similar V-shaped recoveries despite thrusting significantly less stimulus into their economies. Economic growth has now slowed, but most countries had larger economies at the end of 2021 than they did in pre-pandemic 2019, and those that didn’t were typically facing issues going into the pandemic. Despite the massive amount of Federal government stimulus, the United States doesn’t stand out globally in its rapid V-shaped bounce.

This is because much of the excess stimulus passed straight through the consumer sector and went right into the financial sector. This happened in part because the pandemic’s restrictions on activity hampered households’ ability to spend the funds they received. If you can’t spend it, invest it. A major share of this savings glut poured right into the financial markets. Checking account balances have soared, as have cash reserves in the business sector. The desire to earn returns on this excess cash is driving a bubble – from the stock market to real estate to venture capital to cryptocurrencies. The fundamentals, ranging from cap-rates to P/E ratios to the sheer quantity of VC funding, simply don’t make sense.

And all this financial froth is paying rich dividends to U.S. households. According to data from the Federal Reserve’s Flow of Funds, U.S. households were $30 trillion richer at the end of 2021 than they were just two short years earlier. The buildup in wealth would typically drive even greater increases in spending, but these wealth gains are being stymied by supply chain problems and labor shortages. Money that isn’t spent is being pushed right back into the financial markets causing asset prices to grow even more. Pent-up consumer demand is at the core of the highest pace of inflation seen in 40 years, currently 7% and likely to climb even higher in the coming months.

In the meantime, the nation’s Federal debt is piling up at a shocking pace—growing to over $8.4 trillion in the last five years, $5.5 trillion in just the last two. This is a 60% increase in Federal debt in only five years. At the same time, the debt-to-GDP ratio in the United States has increased from 94% to almost 120%. This rate of expansion would panic debt holders and lead to credit downgrades if it were a private company. And with even more spending increases in recent pending Federal budget acts, coupled with no moves to increase taxes, the nation’s structural deficit is likely to approach or exceed $1.2 trillion next year. With the current account deficit already at $1 trillion, the so-called twin deficits come to 4% of GDP, which is a big warning sign for an economy. The only other time the United States ran deficits at this level or higher was during the runup to the Great Recession.

While supply chain issues are being blamed for inflation, it’s likely that the trade deficit would be that much larger if these issues weren’t hampering the pace of imports. But supply follows demand, and Beacon Economics has little doubt that the manufacturers of the world will catch up, implying that consumer spending will continue to grow at an excessive pace throughout most of 2022—fueling an overall economic growth surge. This will feel good in the short term, but eventually consumption will have to fall back in line with output.

Indeed, the standard reaction to news about inflation in the United States has been to worry about the harm being caused to U.S. consumers. In reality, it is excessive consumer demand that is driving inflationary pressures. This doesn’t mean that there aren’t individuals and families who are being hurt by inflation, there are, but in the reporting of these stories, we need to also explain that while this is true for a small fraction of American households, the average U.S. household is clearly on a spending binge. That demand is evident in the strong growth in overall consumer spending, which has been growing faster than U.S. GDP for 5 years running—with no slowing in sight. Looking at the history of periods when consumer spending grew faster than output, such as before the downturn in the stagflation 1970’s and in the lead up to the Great Recession, it’s clear that these episodes have always had ugly endings.

Amazingly, despite all the signals, historic inflation, and a massive increase in public debt, the bond markets seem shockingly unconcerned. Inflation expectations have risen by only a modest amount, and it was only after the Fed signaled a rate hike did interest rates start to inch up. With inflation at 7%, a buyer of a 1-year treasury is clearly going to see a negative real rate of return, yet U.S. treasury auctions are regularly selling out.

None of these trends are sustainable. It’s only a matter of time before the markets fully recognize this, and when that happens, there will have to be a painful adjustment—how painful depends on just how warped the fundamentals become in the months, and maybe even years, ahead. For now, private sector debt growth remains steady and credit quality high, bank lending and most bond markets seem similarly restrained (outside of their pricing), and levels of real investment have yet to start growing at a worrisome pace. This market frenzy is being driven by cash, albeit cash created through massive Federal borrowing and a dramatic increase in the money supply.

Still, even without debt, it’s clear that the financial world appears to be “frothy” a term Alan Greenspan used in the late 1990’s. The P/E ratio of the stock market has been trending ever closer to its 2000 peak and is much higher than it was in 1929. There are stories of crowd sourcing money being used to fund deals in the blood-sport known as commercial real estate, where cap rates continue to fall. The ratio of home prices to asking rents is growing at the same pace seen prior to the Great Recession. The Ponzi scheme referred to as cryptocurrency was saved from its demise as values soared – and even with the big tumble it’s taken in recent month is still overvalued by 100% (in our humble opinion). Although these appear to be narrow areas of concern, history has shown how such issues can quickly spread, infecting many corners of the world and potentially leading to a downturn on par with the Great Recession or worse.

Beacon Economics believes public policy discussions must quickly focus on this looming crisis. What the next expansion looks like critically depends on what course of action policymakers choose. The more rapidly the Federal government moves to close fiscal deficits and reduce the money supply, the less harm this brewing financial bubble and excessive consumer spending can ultimately cause to the economy.

Unfortunately, the conversation in both parties in Washington DC and in most state capitals and city halls continues to be dominated by populist rhetoric rather that economic realities. This means that most political conversations about the economy today are devoted to finding any sort of flaw, real or perceived, that can be blamed on the other party. This detrimental partisanship is, frustratingly, fueled by much of the media. If feels like the old adage “if it bleeds it leads” has gone to an extreme in this echo chamber world we live in. In terms of the economy, news stories seem to try to explain away any and all signs of prosperity. The crucial conversation we should be having about an overheated economy and the desperate need for fiscal and monetary responsibility by the Federal government, seems far from front and center.

In such an environment there is no room for political discussion about reducing the stimulus that is overheating the U.S. economy—particularly in the runup to what will be another contentious election and the growing global crisis surrounding Russia and its invasion of Ukraine. The longer the bubble is allowed to grow, the worse the crash will be.

As if all this uncertainty wasn’t enough, Russia’s decision to invade Ukraine has sent shock waves through global markets. From an economic perspective, it’s hard to see how Russia will come out ahead from this unprovoked attack on a sovereign nation and the horrors being inflicted on a civilian population. But then the actions of political leaders—particularly autocrats—are driven by any number of considerations, only one of which is economic. As such we’ll leave the geopolitical analysis to the Henry Kissinger’s of the world.

What does this invasion mean for the U.S. economy? The short answer is not that much. While home to over 44 million residents, Ukraine is a small economy still trying to emerge from the shadow of communism. Its exports flow mainly to other European nations and are largely low tech manufactures that can easily be purchased from other countries. Russia is, of course, more formidable with the sixth largest economy in the world on a PPP basis, but it is not a highly developed economy. Its per capita output is just half of Germany’s, and it plays little role in global supply chains. Its exports are dominated by resource exports, oil and gas being the largest, and again, the United States is not a major buyer.

To date, the biggest economic impact of the invasion has been on global energy markets where oil prices have shot up to close to $100 per barrel. This may be one reason why Vladimir Putin feels his nation can weather being an international pariah—after all Russia stands to gain at some level from the surge in energy prices that his actions have caused. Moreover, Europe’s dependence on natural gas has led to the bizarre situation where heavy sanctions are being leveled on most parts of the Russian economy, except this critical export. It remains to be seen if the West will eventually cut off this vital source of foreign currency despite the impact it could have on the energy dependent EU states.

The increase in global energy prices, and the potential inflationary impact that could have on U.S. consumers, is the primary economic concern within the United States with regard to the attack. But such concerns are largely misplaced in the aggregate. First, the price of gasoline, the most direct impact on consumers, is not that high today once we account for overall inflation. A real price index of gasoline through January 2022 shows prices were still 30% lower than they were throughout all of 2012.

Second, and more importantly, many consumers in the United States are far less sensitive to the price of gasoline than they used to be due to the broad range of fuel-efficient vehicles, the ability to easily have products delivered, and the current trend among many workers of working from home, which has reduced the costs of commuting. Energy prices are not the real issue. Inflation is affecting a wide variety of consumer spending categories. Unfortunately, blaming inflation on commodity markets is an effective way to distract consumers from the real sources of the problem.

How sustained will inflation be in the United States? The Federal Reserve seems to be suggesting that a few rate hikes and the unsnarling of supply chains will quickly reduce the rate of price growth, and so far, the bond markets appear to be buying it. But a careful empirical analysis of the history of prices suggests that other factors play an important role, including the Federal deficit, wage growth, and of course, the money supply, which lies at the heart of monetary theory. Given the current tightness of U.S. labor markets, the complete lack of conversation about closing the Federal deficit points to continued inflationary pressure. Even more dismaying is the Fed’s decision to engage in $4 trillion in quantitative easing, which has expanded the money supply at a pace not seen since the high inflation 1970’s.

One good metric of inflationary pressures in the United States is the Unit Money Supply, a concept as simple as M2 divided by nominal GDP or, basically, available cash per unit of economic transaction. If we consider the 1970’s, it’s clear that the rapid growth in money supply at that time kept prices growing rapidly, and the Unit Money Supply stayed steady. This time, the dramatic increase in money supply has happened faster than prices have been able to keep up with, and the Unit Money Supply has jumped over 25% since the start of the pandemic. If we are to believe that the Unit Money Supply will converge back to its long run trend, then one of two things has to happen: either the Fed reverses its policy of quantitative easing to pull excess cash out of the economy, or price levels jump an additional 20% to 25% over the next few years. Elected officials are dodging the political bullet called ‘interest rate hikes’, which would occur under option one, hence, right now, path two seems more likely.

With so much potential inflation in the system, it’s difficult to understand why the bond markets remain so placid. One issue is that these markets are made up of people who are likely to buy into social narratives given their lack of personal experience with inflation. In other words, they are accepting the, frankly, pollyannish view being put forward by the Fed and its Chair Jerome Powell. For those who don’t believe that financial markets can possibly indulge in such delusional group think, consider the almost complete lack of insight surrounding the risks associated with the sub-prime lending bubble less than two decades ago, and the ‘new economy’ nonsense that preceded that by less than a decade. Market realities will eventually rip off the mask of self-delusion, and when that happens, interest rates will have to rise.

In short, rates have nowhere to go but up. The trillion-dollar question is when and how painful will the increase be. The sooner the better is the only logical answer to the first half of that question. Unfortunately, it’s the last thing on most policymakers’ minds.