Inflation Models Matter


ederal Reserve Chairman Powell may prove to be the first Fed Chairman in history to run the US economy off the cliff in both directions. We have had Fed Chairmen who were too easy and produced inflation. We have had Fed Chairmen who were two tight and produced recessions/depressions. We have never had a Fed Chairman who has managed to do both. Powell could be the first. 

Equity markets have been falling consistently since Fed Chairman Powell’s speech at Jackson Hole. Investors understandably get nervous when the most powerful economic policy maker in the US says things like:

“Reducing inflation is likely to require a sustained period of below-trend growth ...  While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”

Chairman Powell’s Jackson Hole speech essentially said that his recipe for defeating our current inflation problem is for a lot of Americans to lose their jobs. This gloomy outlook is a product of Powell’s “Cost/Push” model of inflation. Under Cost/Push assumptions, Fed tightening thus far has accomplished relatively little. unemployment remains far too low and the job market far too healthy for inflation to come down. Powell dismisses the “Monetarist” model of inflation, despite the success of this model in finally beating the persistent inflation of the 1970s. Dismissing the Monetarist view of inflation has important implications for Fed policy, because the Monetarist model suggests that Fed tightening to date has gone a long way toward easing inflationary pressures and we may be past the worst of the inflation problem. 

This report will explain the two competing models of inflation and provide historical evidence for each. Determining the best investment strategy for the next year or two critically depends upon which economic model best predicts where inflation is headed. If the Fed’s Cost/Push model is correct, then cash is king. Equities, bonds, and commodities should suffer as the Fed increases rates until the economy suffers a recession that creates a big increase in unemployment and relieves inflationary pressures. However, if the Monetarist model is correct (and we think it is), then 20-year treasuries yielding close to 4.0% are going to be a good investment over the next 12-18 months. Equities are probably in trouble no matter which model is correct because the Fed is on a path to over tighten and drive the economy into recession.

The Cost/Push Model of Inflation

Chairman Powell’s comments about labor costs and labor markets suggest that he adheres to the “Cost/Push” model of inflation. Cost/Push asserts that inflation is primarily caused by rising wages. Businesses react to rising wages by increasing prices, which causes workers to demand still higher pay, which business must pass on through additional price increases. This process repeats again and again in what is known as a “wage cost spiral”, as shown on the diagram below.

 Higher unemployment is supposed to fix a wage cost spiral because it reduces the ability of workers to demand higher wages. Since higher unemployment is the key to controlling inflation, a low and healthy unemployment rate signals to the Fed that more rate increases are needed. As Chairman Powell asserted in his Jackson Hole speech: 

“The labor market is … clearly out of balance, with demand for workers substantially exceeding the supply of available workers.”

We should note that the Fed is not so simplistic as to think that wages alone determine inflation. Chairman Powell understands that continued COVID shutdowns in China, Russia’s invasion of Ukraine, and drought conditions across most of the world’s grain producing areas also contribute to our inflation problem. However, the Fed cannot fix global supply chains, bring peace to Ukraine, or make it rain in Nebraska. The Fed can drive up the unemployment rate, and that is the apparent focus of their current policies.

The Evidence for Cost/Push

Chairman Powell’s belief in Cost/Push is explained by the chart below. The chart clearly shows a tight link between labor costs and inflation. As labor costs rise, inflation consistently starts to rise as well about 12 months later. 

We agree that labor costs have a powerful influence on inflation. Our disagreement with Powell and the Cost/Push model is less the diagnosis and more the proposed cure. Powell has promoted the notion that slowing the economy and driving up unemployment will eliminate labor cost pressures and therefore eliminate inflation. Although that chain of events sounds reasonable and appeals to common sense, there is no historical evidence for rising unemployment driving down labor costs. 

The chart below plots the unemployment rate against unit labor costs from 1970 to 2022. Over that period, the relationship between unemployment and unit labor costs was statistically zero. That is why the blue regression line in the chart is completely flat, and remains flat no matter what leads or lags between unemployment and labor costs are built into the analysis. The word “stagflation” was coined specifically to describe periods in which the economy is weak and unemployment high, yet unit labor costs and inflation remains stubbornly high as well.

The ability of labor costs and inflation to stay high despite rising unemployment seems counterintuitive but is relatively easy to understand. Companies usually follow a “last hired, first fired” policy when letting workers go. Holding on to longer tenured, more experienced workers ensures that the company will have the skilled workers required to ramp production back up when the economy recovers. However, these experienced workers tend to earn higher wages than the newer hires who are being laid off. That means that even as companies reduce their workforce, unit labor costs can increase. The Fed has the power to drive up the unemployment rate by continuing to raise interest rates. That does not mean that this strategy will reduce inflation. 

The Monetarist Model of Inflation

Ancient Origins

The Monetarist model of inflation has been around since money was invented about 5000 years ago. When money consisted of gold and silver coins, inflation occurred when rulers minted more coins by decreasing the percentage of gold or silver in each coin. By debasing the currency in this way, more coins could be put in circulation and the value of each coin declined. When the value of money goes down, the cost of everything purchased with money goes up (inflation). 

Under the old gold and silver based monetary systems, inflation resulted whenever too much money was minted (or printed after the invention of paper money) relative to the amount of gold or silver backing that currency.  This connection between the supply of money and rising prices was so well understood that the original meaning of inflation was creating too much money. The fact that prices would rise after too much money was minted or printed was automatically assumed. 

This model of inflation began to breakdown during the Industrial Revolution. Massive gold discoveries in California and South Africa (and later Australia and Alaska) dramatically increased the amount of money that could be minted or printed and yet still be backed by a consistent amount of gold. Money supply soared. Even so, prices went down through much of the 1800s as factories and farms became mechanized and more efficient. The monetary model of inflation fell out of favor.

A Modern Revival

The monetary model of inflation was resurrected in 1971 by a pair of economists named Anna Swartz and Milton Freidman. Their book, A Monetary History of the United States, used the history of US inflation and money supply growth to argue that the old-fashioned monetary theory of inflation still applied. 

Swartz and Freidman updated the monetary model for the modern economy by focusing not on the amount of money printed relative to gold, but rather the amount of money printed relative to economic output. They argued that the connection between the supply of gold and inflation broke down in the 1800s because the industrial revolution made it possible for economies to produce more goods each year. Inflation, according to Swartz and Freidman, results only when the money supply grows faster than the ability to produce more goods. As Friedman famously put it:

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

This “Monetarist” view of inflation gained traction throughout the 1970s because the Fed, using the Cost/Push model, spent that decade struggling to contain inflation and soaring unit labor costs. As shown in the chart below, during the 1970s the Fed allowed money supply growth to repeatedly top 13%. Each time it did, about 12 to 18 months later unit labor costs and inflation spiked in response to the money supply. 

President Carter appointed Paul Volker as Fed Chairman in 1979. For the next decade, the Fed explicitly embraced a monetarist approach to inflation. Under Volker’s leadership, money supply growth was relentlessly driven below the economy’s growth rate (red arrow on the graph). Unit labor costs and inflation dropped to an average of about 2% for the next 30 years. 

Chairman Powell stated in Congressional testimony that “the growth of M2 . . . doesn’t really have important implications for the economic outlook.” He, and others at the Fed, believe that the 2008-2013 financial crises proved that money printing by the Fed no longer causes inflation. During that period, the Fed printed trillions of dollars yet unit labor costs and inflation remained steady at about 2%.

We believe this view ignores the fact that there are two money printing machines in the US economy, the Fed and private sector banks. The Fed prints money by putting more money in its own checking account. Banks print money by putting more money in customer checking accounts every time they make a loan.  The 2008 financial crisis was caused because banks had made trillions of dollars in bad loans. For every dollar the Fed printed after 2008, private sector banks unprinted a dollar by foreclosing on or refusing to renew existing loans. You can clearly see this “one step forward, one step back” process in the money supply figures during 2008-2013 (the blue line in the chart above).

Contrast that with the behavior of money supply during 2020-2021. The Fed primed the pump by printing about $6.5 trillion during that period. By 2020, banks had recovered from the 2008 financial crises and were eager to lend. That eagerness became a lending frenzy once the US government guaranteed many of those loans through the PPP and other COVID stimulus programs. With both the Fed and banks printing money at a frenetic pace, money supply growth hit an unprecedented 25%. Explosive money supply growth sent interest rates to all-time lows, stimulating demand for homes, autos, and nearly every type of manufactured good. These labor-intensive industries were forced to offer higher and higher pay to attract skilled workers. Labor costs and then inflation soared along with money supply after the typical 12 to 18 month lag. 


If the Federal Reserve cost/push model of inflation is correct, then the Fed has made alarmingly little progress toward containing inflation pressures. Unemployment is the same as it was when they first began tightening 6 months ago. Based on cost/push, unit labor costs and inflationary pressures will continue to rise until the Fed takes interest rates and thereby unemployment significantly higher.

By contrast, a monetarist view of inflation finds encouragement in  the collapse in money supply from about 25% to less than 5% since the Fed began tightening. That does not mean that the Fed job is done. Using the 1970s as a guide, the Fed will need to drive money supply growth negative to fully contain unit labor cost and inflationary pressures. However, unlike the cost/push model, the monetarist model suggests that the Fed has made great progress toward containing inflation. A couple more rate hikes might get the job done. This view of inflation is supported by commodity prices. Despite extremely grim geopolitical and weather developments, most commodity prices are down 30% to 40% since the Fed’s first tightening moves.

Investors can gauge which inflation model is most accurate by watching unit labor cost and inflation data over the coming months. If cost/push is correct, inflation should continue to rise for the foreseeable future. If the monetarist view is correct, unit labor costs should start to decline in the next several months and be markedly lower by next summer. Inflation should show the same behavior a few months after unit labor costs.

For followers of cost/push, the only investment option is cash. Many more rate hikes will be forthcoming if cost/push is correct. Bond yields will rise, pushing bond and equity prices into an even deeper bear market. Over tightening into a recession is a distinct risk, creating further downside for stocks.

If the monetarist view is correct, then inflation should be noticeably rolling over and starting to decelerate in the next 6 or so months. That will probably not impact the Fed’s relentless tightening focus, because unemployment is unlikely to have risen enough to reassure followers of cost/push. However, peaking inflation and continued downward pressure on commodities could make bonds a better investment than cash under this scenario. 

Unfortunately, equity investors are probably in for more downside no matter which model proves correct. Throughout the summer, investors reacted to crashing money supply and commodity prices by buying equities in anticipation of falling inflation. In recent weeks, Powell’s Jackson Hole speech and bad news on backward looking Core CPI inflation put an end to this market rally. 

Chairman Powell bluntly reminded investors in Jackson Hole that falling money supply and commodity prices only matter if the Fed thinks they do. Powell has explicitly stated that he is ignoring money supply and commodities and is focused on unemployment and backward looking measures of inflation like Core-CPI. So long as this is the case, the equity market will suffer as rates continue to rise. With equity investors now “once bitten/twice shy”, the next bull market may not begin until investors are convinced that the Fed is ready to start cutting rates. That could be a long wait.

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