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  • Writer's pictureThomas Hayes

Was Inflation Transitory After All?

Going into 2022, there was consensus on Wall Street that the Fed had it wrong, inflation hadn’t been transitory, and they had caused things to spiral out of control with their low rate policy.  The Fed finally relented in early 2022, and raised interest rates at the fastest pace in history to try and slow the pace of inflation.  With the November 2023 CPI reading at 3.1% over the last 12 months, it seems as though the Fed has won the fight. But were low interest rates from the Fed really to blame for inflation in the first place?


While I would concede that the Fed did in fact keep rates too low in the face of a clear economic recovery, I think they may have been right about the nature of the inflationary spike. The Fed initially pushed the idea that inflation was transitory, meaning it was a temporary spike, and inflation was unlikely to remain elevated for a significant period of time.  Now that inflation has come back down to reasonable levels, it looks like they may have been more right about that assumption than most people on wall street would like to give them credit for. 



The idea that the Fed was responsible for inflation because of low interest rate policy flies in the face of a decade low rate policy. The Fed had maintained that low interest rates for a decade prior to the pandemic, with inflation remaining tame. In fact, from 2010-2020 when rates were at their lowest levels, inflation not only did not spike, but remained lower than it was over the prior decade when interest rates were more elevated.



This seems counterintuitive from an economic perspective. Shouldn’t lower rates make borrowing cheaper, and therefore drive inflation?  I think the issue lies with velocity.  The stimulus produced by low Fed interest rates had no velocity, it didn’t move through the economy.  Although rates were low, banks did not increase lending, and so the money simply sat on deposit at the Fed. U.S. bank excess reserves held on deposit at the Fed had historically been $2 billion or less prior to 2008, but by late 2014, $2.6 trillion in excess reserves had accumulated. The stimulus had no velocity.[3]


So if low interest rates didn’t cause a spike in inflation, then what did?  I would argue a combination of factors, driven by the pandemic, led to a spike in inflation that ultimately did turn out to be transitory.  During the pandemic, lockdowns forced consumers to stop all discretionary spending on services for an extended period of time, leaving consumers with an excess of savings.  Even as lockdowns subsided, restrictions on travel, dining out, and other activities, remained in place causing consumers to continue to accumulate savings.  This, coupled with massive fiscal stimulus, caused a spike in consumer bank account balances of 120% as of March 2021, vs what they had been two years prior.[4] 


The pandemic also caused supply chains to break down, leading to a shortage of durable goods at a time when consumer spending was forced to shift away from services.  The decrease in supply of durable goods, and spike in demand driven by a shift away from services, coupled with these higher bank account balances, led to a huge spike in durable goods inflation.



As the economy reopened, inflation shifted away from durable goods, and back to services. Services businesses struggled with the sudden spike in demand as the pandemic led many to close down entirely, or drastically cut their workforce, and so demand once again immediately outstripped supply.  These changes in demand at the retail level for durable goods and then for services, caused even greater changes at the wholesale level in what was known as a bullwhip effect. 


As we come to the close of 2023, and inflation looks to be returning to normal levels, the consensus still seems to be that the Fed had it wrong, and that their low-rate policy caused inflation to spiral out of control. A few individuals who share my view deserve credit for sticking to their guns, namely Tom Lee of Fundstrat, and Ben Carlson of Ritholtz Wealth Management, who have continued to reinforce the idea that inflation may not have been caused by the Fed, and perhaps was in fact transitory. While the Fed may have been slow to react, I think their initial assessment of the inflation spike was accurate.




Disclaimer: The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

 

 


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