In 2020, for a few months, it seemed like the world would end. Millions died, and spending and stock values plummeted. But we can now characterize 2020 and 2021 as nothing short of boom years. This is because legislatures and central banks rose to the challenge.
In the U.S., trillions in congressional support during the pandemic, coupled with lower interest rates and help from the Federal Reserve, propelled stock and real estate prices to record highs. Though the GDP was down slightly in 2020, this congressional support meant 2021’s GDP was back to where it would have been without the pandemic.
After first collapsing 21% in the spring of 2020, the stock market rebounded to an all-time high of 254% of GDP at its peak in 2021. This was more remarkable since it had been at its all-time high of 180% of GDP in 2019, just before the pandemic. And that was a level already considered by many to be overvalued.
But early 2022 brought a quartet of bad news.
Bad News All Around
First, it seemed that the legislative fiscal generosity had dried up. Along with this, the Federal Reserve was beginning to withdraw its support for debt markets and remove deposits from the system with a policy of “reverse Q.E.” or “quantitative tightening” (Q.T.). This move left households on their own for the first time since early 2020. Most of the payment forbearance granted to apartment renters, mortgage holders, and student loan borrowers had ended.
Second, the price inflation accelerated in 2022. The worldwide absence of workers from manufacturing and distribution businesses due to the pandemic depleted the supply chain. This lack of workers led to shortages, and these shortages led to higher prices. As a result, the U.S. and other large, developed countries contended with high inflation for the first time in 40 years.
But then, Russia invaded Ukraine. Russia is the number one exporter of wheat to the world and the number one exporter of oil and natural gas to Europe. Ukraine is the number five exporter of wheat to the world, so this war had global price implications. When the invasion happened in February of 2022, Europe and the U.S. responded with aggressive sanctions against Russia that further blocked supply and further drove up prices. An estimated one-third of the inflation reported for mid-2022 is related to this war.
Fourth, the Federal Reserve raised interest rates even though it was unclear how high-interest rates could hasten the end of the Ukraine War or resolve supply-chain issues by any other mechanism. Higher interest rates increase the cost of borrowing to buy a home or stocks, and thus they began to exert downward pressure on home sales and stock prices.
A Rocky Road For Households
Financial markets tumbled, a gut-punch to households whose wages in the twelve months ending in June 2022 had increased far less than inflation. And now, the economy was faced with an absence of government support, a continued pandemic, higher prices, and higher interest rates.
Household net income shrunk because of reduced government spending. The government deficit was $390 billion through the first six months of 2022, compared to a deficit of $2.71 trillion during the entire year of 2021. Therefore, household net income was a mere $240 billion for the first six months of 2022, a steep decline from the $1.85 trillion level for the entire year of 2021.
However, private sector debt increased sharply during this period, from $931 billion to $1.478 billion, and government debt growth, including state and local debt, continued at the 2021 run rate. Therefore, overall nominal household revenue and GDP held up.
Net Worth Also Falters
On the net worth side, trends were unfavorable. By June 2022, stocks had tumbled in value, yet real estate prices continued to rise. Household net worth was down by 4.4%, from $150.3 trillion to $143.7 trillion. But these values were still well above 2019 levels.
As of late 2022, the U.S. was simultaneously experiencing a recession, inflation, and low unemployment. An unusual combination, to be sure, but not a baffling one, given the equally unusual circumstances of 2022.
It’s Not Debt’s Fault
Government debt and spending did not cause inflation. However, during the summer of 2022, inflation reached 9%, decimating family budgets. First, inflation in U.S. economic history has been infrequent and usually receded quickly once the underlying cause was addressed, without the need for high-interest rates. Second, our current inflation is primarily a result of the pandemic and the Ukraine War and will resolve once we come to grips with these two causes or when they pass.
Third, inflation is not a monetary phenomenon; in other words, it’s not a function, or artifact, of the Fed “printing” copious amounts of money. Fourth and finally, although raising rates will help tame inflation, it will do so only in the bluntest and most painful way. High U.S. inflation has usually been resolved without using high-interest rates since the real solution is to resolve its underlying causes.
Today’s solution to lower inflation is the same as it always has been: to tame inflation, we need to address the underlying cause, which means the restoration of COVID-impaired supplies and distribution, a resolution of the Ukraine War, and new couplings to offset the decoupling with China and Russia.
Helpfully, since 1997, the Federal Reserve has published the Global Supply Chain Pressure Index (GSCPI), which integrates transportation cost data and manufacturing indicators to gauge global supply chain conditions. Changes in the GSCPI are associated with goods and producer price inflation. The index calculates standard deviations from average value, with zero meaning the supply chain is operating at a normal level. The index catapulted from that zero point to 3.15 in the spring of 2020, and recorded 4.31 standard deviations, its highest value ever, in December 2021.
In September 2022, it had fallen back to 1.07, which suggests that supply chains are about two-thirds of the way back to normal, but still high by historical standards. Unfortunately, the Ukraine war may be an intractable problem for years. These wild cards make it difficult to predict the duration and path of inflation, nevertheless, as we resolve or at least mitigate them, inflation will return to lower levels.
This blog is adapted from The Paradox of Debt: A New Path to Prosperity Without Crisis by Richard Vague.
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