The Producer Price Index (PPI) came out hot again. Higher prices for producers may or may not be passed onto consumers. For businesses that can pass on the costs, that implies higher inflation. (They raise their prices and the consumer accepts prices going up). For businesses that cannot pass on the cost, that implies lower margins. (Their costs go up and they have to absorb those costs). Either way, it’s going to put pressure on the job market.

Let’s say it’s the former, and the costs are just passed on. The Fed is going to look at the inflationary impact and make a decision about rates, or possibly liquidity. They will try to prevent an inflationary spiral, where those cost increases accelerate. I’m beginning to suspect that the current rates are near “r*” or the neutral rate. Where lower rates are stimulative, higher rates are restrictive, but these rates are close to neutral. And there is no absolute r*, it’s just what makes sense for that economy.

The Fed will be combating deficit spending, which stimulates demand. We take out a lot less in taxes than we inject in spending and that is goosing the economy. And there are plans to increase that spending by a 45% increase in DoD spending. We’ve had deficit spending, and at high levels, for so long I’m certain we’d fall into a recession if we just reduced deficits to a more sustainable 2% of GDP. Rates would go up to slow economic activity and account for the additional stimulus that would come from more deficit spending. So far Jerome Powell and the FOMC has done what I thought was impossible, reduce inflation without sending unemployment to 8 or 10 percent. The next round may not go as well.

Next, let’s look at what happens when margins shrink. Margins are the difference between revenue and expenses. As expenses go up, margins (and profit) shrink. Firms generally react by reducing costs. The first thing that go are travel and perks. But those are normally not a big part of the budget (or shouldn’t be). Next, speculative projects are cut or sold off, such as the AI team hired to bring chat bots to your lawn care business. Once sales start to fall off, because all other businesses are reducing their spending, you don’t need as many workers. Now it’s time for the large-scale layoffs.

Of course, many businesses are aware of the pattern and want to get ahead of it. Their very clever staff economists know that business will fall off in a few months as other businesses are spending less. The try to front-load some of the layoffs to coast on what will be accumulating inventory to try to avoid larger layoffs later. And all layoffs lead to morale problems. If many companies do this, it’s a self fulfilling prophecy, right? We all expect a recession in three months, so we all lay of 10% of our staff now, to avoid firing 15% or 20% later. Guess what happens? We guarantee a recession.

What do I expect from Warsh when he takes over? First, the Federal Open Market Committee chairman does not set policy. It’s a vote of the board. But I don’t know what Warsh is going to do or how he’ll throw the decision making into disarray at the behest of Trump. So we might get a degree of chaos we won’t need. But let’s say he push policy toward lower rates and we get inflation. I suspect that may not be unwelcome among Trump and the rest of the leadership, along with the oligarchs who back him.

Higher inflation is a back-door default on the US debt. A default normally means non-payment of interest or principal. (Which is something I would not put past the administration – with regards to not paying interest to foreign bond holders). There inflation adjusted bonds, but the bulk of the market just takes inflation into account when they’re calculating an acceptable price for the bond. That’s based on a stable inflation rate of around 2%. I have 10 year bonds yielding 4.9 to 5% and that’s fine in a 2% inflation regime. I get 5%, the government takes about 1.5%, inflation takes 2%, leaving me a 1.5% real return at zero risk every year for 10 years. If inflation shoots up to 5% and stays there, now the math is ugly. The government still takes its 1.5%, Inflation now takes 5%, and I’m left with a real return of -1.5%. What would I do if I saw this as a possibility? Move away from long-dated bonds. That means selling long duration bonds (as the market is currently doing) and driving the interest rate up.

But the real damage to the bond is the principal of the bond drops in real value much faster. The price of the bond includes the principle to be returned in 10 years. After 10 years of 2% inflation, 1,000 USD is not worth about 817 dollars in real terms. That’s accounted for in the price of the bond, along with the stream of payments and the expected inflation rate. That doesn’t mean I get 817 dollars in 10 years. I still get 1,000, but it has the spending power for 1,000 today. And that’s the difference between nominal and real. If the economy just treads water (little real growth but it’s growing at least as fast as inflation), inflation will shrink the value of the bonds relative to GDP. If the nominal GDP goes from 30 trillion to 60 trillion in 20 years because of 3.6%, but no real growth, then you are no better off than you are today. However, any assets that have a fixed denomination, like cash an bonds, are worth half as much.

We currently have debt at about 120% of GDP. If we inflate the dollar at 3.6%, and we don’t add to the debt, that debt will be 60% of GDP in 20 years¹. Of course we’ll add to the debt, so we won’t cut it in half. But we make interest on the debt a smaller and smaller part of the budget in real terms. Nominally, the amount of interest will still increase, but the nominal size of the budget and the economy will increase faster. It’s as if we decided to reduce the interest paid on the bonds. But, if we actually just paid less interest, that’s a default.

Nothing is guaranteed and it could be that Warsh and the oligarchs backing Trump decide money is important and keep the system functioning in good order. We get inflation, interest rates go up (maybe not as much as I think they should, but enough). Inflation calms down and we lower rates to get people working again. (And jack up the price of assets like land, housing, and stocks – something the oligarchs love even more than statutory rape). And I sell my long bond positions for nothing. But, with inflation at about 2.5% to 2.7%, as we’re currently seeing, my real return on those bonds is cut in half or basically gone. A money market or long bond is basically keeping pace with inflation at this point, until we see inflation drop to 2%. And even “good Warsh” won’t want to irk his boss by pushing for that.

1. There’s a rule of 72 which say that if you multiply the interest by time, and it’s 72, you double in value. So an investment returning 7.2% for 10 years doubles in value. Or the US GDP growing at 3.6% for 20 years, doubles in size. ↩︎