Pre-Mortem: How US Inflation Shot to 15%

Since April, I have argued the Fed must raise the FFR to near 8%. This argument assumed inflation would neither increase nor decrease much from April’s level. Indeed, since then, core CPI inflation has remained around 6%. In fact, it has slowed somewhat, and the Fed and markets hope it will keep slowing. But what if it does not? What if core CPI accelerates to 15% by the middle of next year? That is this week’s pre-mortem.

As Bilal explained last week, a pre-mortem is a useful framing device that assumes a future outcome and works backward to figure out how it could happen. It contrasts a post-mortem, which takes a deceased patient and tries to work out what went wrong – and which is of little benefit to the patient!

A pre-mortem helps us explore outcomes we might otherwise ignore because they do not readily fit our worldview. By examining a wider range of outcomes, we can come up with a stronger rationale for our core views and realize faster if we are wrong.

Back to the Future

It is mid-2023. Heatwaves, wildfires and hurricanes have already started, and inflation is 15%.   The entire Federal Reserve Board of Governors has offered its resignation. Congress has convened a bipartisan enquiry commission. Few had predicted the move, but in hindsight the causes were clear. 

The Kindling and the Spark

The growth scare of mid-2022 turned out to be just that in the end, a scare. With still-loose monetary and fiscal policies, and the dollar stabilizing, growth roared back in Q4.   

Meanwhile, the US went through an autumn of discontent. Workers went on strike in numbers unseen since the 1970s or simply did not return to work. Employers, confident they could recoup higher wage costs through higher prices, eventually granted the wage increases needed to fill their numerous vacancies.    

So when Russian President Vladimir Putin decided to stop oil and gas sales to the US and its allies, it was the spark that ignited the bountiful inflation kindling created by years of loose macro policies.

Signs of Exceptional Overheating Ignored

That the US economy was exceptionally overstretched was obvious – in retrospect. The most straightforward evidence was inflation. By mid-2022, it had hit 9%, the first time since the oil shocks of the 1970s (Chart 1). But, as is often the case, we ignored evidence that was staring us in the face.

Yet there were other signs of exceptional resource pressures. The current account deficit widened to its lowest level since 1960, except for the few years before the GFC (Chart 2).  Similarly, unemployment fell to the lowest in 40 years.

Had the extent of the overheating been acknowledged, a joint monetary and fiscal policy response could have been devised. Instead, the macro policy mix remained loose.

Loose Fiscal, Loose Money

Fiscal consolidation, which had brought the deficit from 12% to 4% of GDP in FY2022, ended there. The FY2023 budget deficit was roughly similar to FY2022, far too large considering the macro imbalances (Chart 3).

Monetary policy was no tighter. The Fed saw stable inflation expectations, falling commodities prices, and sliding core inflation. And it stuck with its plan to slow the pace of interest rate increases in the second half of 2022, even though the FFR was still well below the Taylor rule FFR (Chart 4).

With such loose policy settings, growth roared back in Q4, helped by a plateauing dollar and a strong acceleration of credit growth (Chart 5). Households, which had spent the past decade deleveraging, had ample room to re-lever. Corporate businesses also piled on debt.

The Autumn of Discontent

With real wages eroded by inflation, workers started to flex their market power in autumn.  Sporadic strikes became more frequent, especially in critical sectors such as transportation.  Workers also expressed their displeasure with falling real wages by refusing to return to work (Chart 6). And the back-to-school season saw participation drop as a lack of childcare forced parents to stay home – by mid-2022, employment in childcare services was still 10% below pre-pandemic levels.

Faced with worker demands and unwilling to lose the business opportunities strong growth afforded, employers relented. They granted the wage increases required to fill their multiple openings (Chart 7). 

Employers paid higher wages believing the strong demand for their products would allow them to pass on the higher costs to their customers. Despite the deepest recession since the 1930s, profit margins were at a historical high, partly reflecting the high concentration of the US economy (Chart 8).

The feedback loop between wages and prices that had taken root in Q2 2021 strengthened.

Russia Shuts Off the Taps

For a long time, Putin’s intentions towards energy exports to the US and its allies were unclear. Gas supplies to Europe were lowered and raised unexpectedly, for various reasons, technical and other. In November 2022, however, his intentions became clear: Russia shut off 80% of gas exports to Europe and cut its oil exports to the US and allies by 50%. With Russia accounting for 10% of world exports of oil, prices doubled to $200/barrel.

Like lightning, the increase transmitted instantly to US consumer energy prices. Headline inflation jumped. With the tight labour market, employers raised wages to compensate and retain their workers. Meanwhile, employers raised their own prices to offset the higher wage costs.

The result was devastating: the increase in headline inflation passed through to core, and both core and headline CPI rose to near 15% (Chart 9).

The End Game

The last time inflation came close to 15% was during the second oil shock. Then, as now, inflation had stabilized at a high level before the shock hit. The Fed was only able to lower inflation through the deepest recession since the 1930s. Time will tell if the coming recession will be as painful.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)