Inflation — Will It Stop Soon?

Introduction

According to Truflation, a blockchain tracker of inflation updated daily, inflation was up 12% year over year as of today, April 28, 2022. That is truly a mind boggling number. In the paragraphs to follow I’m going to make a case as to why inflation may soon evaporate and become a distant memory.

Mortgage Rates

Something worth looking at is mortgage rates. On March 9th, 2022, the Fed stopped interfering with the mortgage markets. Up to that point they were buying $40 billion a month of mortgage backed securities. This was creating artificial demand for the mortgage bonds, lowering the interest rate for mortgages.

You can see a super dramatic move as the market both anticipated the Fed stopping its MBS (mortgage backed security) purchase program and then actually following through. The “free market” price of mortgages may be around 5% to 5.25%, indeed close to what rates were before the Fed started artificially creating MBS purchase demand to stimulate the economy.

The Fed is threatening to now start selling $95 billion of MBS per month. If they follow through prepare to see a massive swing upwards in mortgage rates, probably to around 7% for the 30 year. Personally, I don’t believe the Fed will do it. If they sell at all, it will be at a slower pace.

What I want you to note is how quickly market forces reacted to new information and inputs. The Fed stopped buying MBS, and rates went back to normal over a period of several months.

Energy — The Pendulum Has Swung the Other Way

The gains in energy prices are an exaggerated over-response to under production and pandemic dampened demand. Demand stopped so hard and so fast that oil companies couldn’t even find tanker ships to place oil on. For a brief while futures for oil futures fell below $0 because oil companies had to pay to place their oil somewhere.

This destroyed oil exploration projects and drove many oil producers out of business. When demand came roaring back, there were less oil producers in business, exploration projects had been canceled, the balance sheets of oil companies were hurting, and banks didn’t want to make new loans to oil companies for more exploration. Banks were scared of losing more money on bad oil company loans.

Look at the Baker Hughes rig count to see how US oil exploration has come roaring back now that prices have reached $90+ a barrel.

From 438 drilling rigs a year ago to 695 today. That is a 58.7% increase in drilling rigs since one year ago! Oil exploration is going to boom at these prices. That exploration will turn into production. That production will put a lid on oil price expansion and eventually drive prices lower.

Energy — A Hidden Cost of Everything

Oil based products are heavily used in food production and transportation. Whether you are planting with a tractor, fertilizing or spraying pesticides, you are consuming an oil based product. Then you have to ship the product to the grocery store using gasoline or diesel.

When the price of oil spikes, food will normally follow because farmers now have to cover the increased cost of their gasoline, diesel, fertilizer, pesticides and transportation to ship food to market. A good bit of food price increase comes directly from oil price increases.

If the price oil level offs, or starts to drop, it will have that a deflationary effect on food prices.

New and Used Automobiles — The Chip Shortage is Over

While there is some pent-up demand to work through, I expect that new and used car prices may start to fall as suppliers start to have normal amounts of inventory to sell now that the chip shortage is mostly over. Worst case scenario is prices hold at these levels for a year. Automobiles are a big component of the metrics used to calculate inflation. If auto prices stop climbing, this will have a significant effect on inflation metrics.

Housing

Mortgage rates rising is going to have a big effect on housing prices and on rents. Housing prices drive rent prices over the long term, so we should focus on housing prices. With mortgage rates being so high, mortgage payments for home buyers will be higher as well. This means buyers can only afford a cheaper house price as mortgage rates go up. That diminished buying power is going to have a negative effect on housing prices.

Will diminished buying power from mortgage rate hikes overcome the market forces of years of underbuilding and people looking for larger “work from home” paradises? I don’t know, but it is certainly going to slow home price growth. If the Fed starts selling MBS and the 30 year mortgage rate goes to 7%, look out below. Home prices will flat out fall.

Cash Out Economy Coming Crashing Down

There is another thing to consider. Refinancing of mortgages is driving to a halt. All that cash that was flowing into the economy from homeowners pulling out equity at record low mortgage rates — that cash won’t be seen again for some time. That cash was used to renovate and buy goods and services. Less demand for those items is going to put downward pressure on prices — it is deflationary.

The Stimulus Party is Over

Most of the middle and lower class benefited from stimulus and/or child tax credit expansion. That was money that went to buy furniture and vehicles, pay off debt, or keep someone at home who would have been producing goods and services. Removing people from the labor force with stimulus has increased the cost of labor, and as a result the price of labor intensive products such as restaurant food has gone up.

But that party is over. The stimulus is done, and with it the artificial demand caused by increased amount of cash floating around has diminished. As people run out of money they will return to work, lowering pressure on the price of labor and all goods and services using labor.

Food — The Wildcard

Much remains to be seen with food. While in the Ukraine some farmers are doing wartime planting of their fields, it remains to be seen what effect the war will have on wheat production and other crops. If war and drought punish crop yields, for sure we get inflation. On the other hand if the war isn’t stopping farmers in the Ukraine from planting and harvesting wheat, we could see a downward push on wheat prices that have the worst news built in.

If energy prices and labor prices level off or subside, it could bring down food prices as well.

Summary

In short, I feel the case for deflation over the next 18 months is better than the case for inflation. The main case for inflation would be a circular feedback loop where labor costs drive goods and services costs, and then inflation of goods and services costs force labor costs to rise to keep pace. I believe it is fear of this circular feedback loop that is driving the Federal Reserve to act very decisively to raise rates and stop pushing liquidity into the system through asset purchases. The Federal Reserve is in the driver’s seat here, and they are promising continued aggressive action to crush inflation.