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What If Inflation goes to 6%?


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What If Inflation goes to 6%? 

What do you think this does to the economy, interest rates, fed policy, fiscal policy, etc?

 

The chance of inflation going up significantly is far from zero in the future. 

 

 

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Why do you think were going to 6%?

 

Check out historical inflation, consumer prices for the United States here:

https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

 

Inflation has been steady for the last 10, 20 if not 30 years. Going forward, things can change, but why?

 

But to answer your question if inflation goes to 6%, rates will rise, and will ultimately lead to an economic recession.

 

 

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Why do you think were going to 6%?

 

Check out historical inflation, consumer prices for the United States here:

https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

 

Inflation has been steady for the last 10, 20 if not 30 years. Going forward, things can change, but why?

 

But to answer your question if inflation goes to 6%, rates will rise, and will ultimately lead to an economic recession.

 

I think it is in the realm of possibilities.  M2 Money growth has been very high with crazy high government spending.

https://fred.stlouisfed.org/series/M2SL     

 

I actually don't want to debate whether it's likely - just the effects.

 

If inflation goes up significantly I think interest rates go way up and:

1.  Housing demand decreases

2.  Car demand declines (especially more expensive cars) as people can afford less.

3.  More bankruptcies of highly levered companies.

4.  Huge long term bond losses of whoever owns them.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Why do you think were going to 6%?

 

Check out historical inflation, consumer prices for the United States here:

https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

 

Inflation has been steady for the last 10, 20 if not 30 years. Going forward, things can change, but why?

 

But to answer your question if inflation goes to 6%, rates will rise, and will ultimately lead to an economic recession.

 

I think it is in the realm of possibilities.  M2 Money growth has been very high with crazy high government spending.

https://fred.stlouisfed.org/series/M2SL     

 

I actually don't want to debate whether it's likely - just the effects.

 

If inflation goes up significantly I think interest rates go way up and:

1.  Housing demand decreases

2.  Car demand declines (especially more expensive cars) as people can afford less.

3.  More bankruptcies of highly levered companies.

4.  Huge long term bond losses of whoever owns them.

 

LongHaul, I agree with you. 

  • Stocks: High probability that stock investors will finally start doing their valuations using much higher interest rates.  This will very likely cause drop in S&P 500 PE from 39.12 today and S&P 500 Shiller PE from 34.79 today.
  • CRE: Investors with short-term loans will have to renew at higher interest rates, causing some to foreclose.  CRE investors looking to acquire will have to acquire at higher interest rates.  This will cause CRE cap rates to lift up by amounts not expected by a lot of CRE investors today.
  • Pricing Power:Companies with pricing power and price-insensitive customers will raise prices.  However, because it takes 12 years to double prices at 6% inflation, the effect on earnings, borrowing costs, discount rate for valuation, and stock price will vary even across companies with such power.
  • Higher inflation:  Unlike 1970s, this time, there is also a possibility that Fed may not want to raise Federal funds rate and might continue to try to buy treasuries to try to keep rates lower, causing more inflation.  I understand some have the perspective that buying treasuries can't cause inflation because money is locked inside Federal reserve.  I disagree with that perspective because even if banks in total have to keep extra money at Federal Reserve, banks can still use those reserves to enable transactions at higher prices.  Yes, they cannot create new loans with that money, but they can still use money parked with Federal Reserve to enable transactions at higher prices.

 

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How do you have strong inflation and weak demand at the same time?

 

You can have strong demand and inflation in things that are not financed, while higher interest rates can result in lower prices in things that are financed.

 

Imagine telling buyers who were ok with paying half of their monthly income for a mortgage that they have to now pay a mortgage of more than their monthly income.  Buyers would be willing to buy if the price of the asset is dropped enough for them to be able to keep the monthly payment affordable given their increased wages (6% higher than before).  If the interest rate on a new mortgage goes up from 3% to 6%, how much do you think the asset price has to drop to keep the monthly payment only 6% higher than before?

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It doesn't work like that.

 

Thanks rb for your perspective.  To understand deeper what you mean, what do you mean by "it"?

Demand dynamics and inflation. What you've described in your posts: housing, autos, finance, investment is a huge part of the economy. You can't have weakness in a huge part of the economy and a raging economic orgy in another. Weakness in housing, autos, finance and investment equates to a really bad recession (think 2008) which is not an inflationary event.

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It doesn't work like that.

 

Thanks rb for your perspective.  To understand deeper what you mean, what do you mean by "it"?

Demand dynamics and inflation. What you've described in your posts: housing, autos, finance, investment is a huge part of the economy. You can't have weakness in a huge part of the economy and a raging economic orgy in another. Weakness in housing, autos, finance and investment equates to a really bad recession (think 2008) which is not an inflationary event.

 

I think you might be mixing up mine and LongHaul's posts.

 

Are you saying we cannot have a 1970s style inflation-triggered stagflation, where inflation leads to higher interest rates and in-turn lower stock prices?

 

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I kind feel moderate inflation is going to be yet another positive for stocks especially as with financial repression (Fed keeping interest rates low) it will be impossible to hold cash. And kinda agree with Powell that you don't just go from 1-2% to 6% overnight. Inflationary pressures tend to build slowly over time although agree could be some short lived effects due to supply shortages/pent up demand etc which might push it to 3-4% this year. Also different economy from the 1970s. Far less manufacturing based so high input prices aren't going to have the same kinda impact. Remember commodity prices were super high in 2008 and inflation was still moderate.

 

Learning Machine. Guessing the PE of 39 you are using is 2020 which is obviously trough earnings. If the strong growth everyone is expecting comes through that multiple could come way down. Also for the S&P 500 not sure how relevant CAPE is given a lot of S&P constituents are fast growing so average earnings are less relevant than future earnings and a lot of the cyclicals could enjoy very strong future earnings compared to the stagnant economy post GFC if all the stimulus juices the economy.

 

I think the Fed hiking rates and the bond market hiking rates are very different in effect. The former leads to tighter financial conditions. The latter not so much and it will be a while before bonds become credible alternatives to stocks.

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It doesn't work like that.

 

Thanks rb for your perspective.  To understand deeper what you mean, what do you mean by "it"?

Demand dynamics and inflation. What you've described in your posts: housing, autos, finance, investment is a huge part of the economy. You can't have weakness in a huge part of the economy and a raging economic orgy in another. Weakness in housing, autos, finance and investment equates to a really bad recession (think 2008) which is not an inflationary event.

 

I think you might be mixing up mine and LongHaul's posts.

 

Are you saying we cannot have a 1970s style inflation-triggered stagflation, where inflation leads to higher interest rates and in-turn lower stock prices?

You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.

 

Yes, I'm also saying that you can't have a 70s style stagflation. That was driven by supply side inflation which led to a wage-price spiral. Higher rates were the cure. Now we're talking about demand side inflation which is a completely different animal. You can't have demand side inflation with weakness in demand. It's also very unlikely you'll have high inflation and high interest rates. But you could have a burst of higher inflation that leads to a higher rate environment and normal inflation. Think a 4-5% 10 year yield and 2% inflation or such kinda what we had during the 2000s.

 

Economically speaking that's kinda where you want to be. (I am personally a fan of a somewhat higher normalized inflation). But that will of course not be good for stocks if they're currently pricing in a 2% 10 year yield till kingdom come.

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I kind feel moderate inflation is going to be yet another positive for stocks especially as with financial repression (Fed keeping interest rates low) it will be impossible to hold cash. And kinda agree with Powell that you don't just go from 1-2% to 6% overnight. Inflationary pressures tend to build slowly over time although agree could be some short lived effects due to supply shortages/pent up demand etc which might push it to 3-4% this year. Also different economy from the 1970s. Far less manufacturing based so high input prices aren't going to have the same kinda impact. Remember commodity prices were super high in 2008 and inflation was still moderate.

 

Learning Machine. Guessing the PE of 39 you are using is 2020 which is obviously trough earnings. If the strong growth everyone is expecting comes through that multiple could come way down. Also for the S&P 500 not sure how relevant CAPE is given a lot of S&P constituents are fast growing so average earnings are less relevant than future earnings and a lot of the cyclicals could enjoy very strong future earnings compared to the stagnant economy post GFC if all the stimulus juices the economy.

 

I think the Fed hiking rates and the bond market hiking rates are very different in effect. The former leads to tighter financial conditions. The latter not so much and it will be a while before bonds become credible alternatives to stocks.

Mattee, I don't know where you get to the fact that the S&P constituents are fast growing. S&P earnings peaked in 2007 at 85 and then peaked again in 2019 at 140. That's a growth rate of 4.2% per year nominal. That's actually somewhat better than one might have expected but it's certainly not outside the bounds of what would be a standard model. Certainly not something you would call fast growing.

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I find it hard to understand why people think inflation -> higher rates -> lower housing prices.

Real hard assets are supposed to go up in a real inflation scenario, isn't it? Same for stocks. Check Venezala's stock market for example. Inflation through the roof. Stock index through the roof. Same happened in 1948 in China.

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But that will of course not be good for stocks if they're currently pricing in a 2% 10 year yield till kingdom come.

 

rb, I agree with you on this!

Yeah. That's what I'm more concerned of. I don't think we see any nightmare scenario in the near future in terms of inflation. But we may get to higher rates. Again, nothing earth shattering. But given that everything seems priced to perfection these days i would say that implies a lot of risk for equities that something will not go according to plan. I mean look how you get a bit of a freakout because the 10 year moved by 50 bps.

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I find it hard to understand why people think inflation -> higher rates -> lower housing prices.

Real hard assets are supposed to go up in a real inflation scenario, isn't it? Same for stocks. Check Venezala's stock market for example. Inflation through the roof. Stock index through the roof. Same happened in 1948 in China.

Cause that's not's really gonna happen. You're not gonna have a real inflation scenario. You won't get Venezuela, or Argentina, or 48 China. If it comes to pass you'll have demand boost->a mild and boring inflation spike->higher rates->inflation subsides->a higher rate plateau->lower asset prices.

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You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.
 
I said lower price for financed assets not necessarily lower demand.
 
Also, the difference is in timing:
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Inflation hurting RE is one of the biggest widespread, false narratives I consistently see people peddling. It is my belief, especially in certain areas(Sunbelt) that we're entering a phase not unsimilar in parallels to the mid 2000's. It will also mirror the tech bubble part one(late 90s) and tech bubble part 2(2015-now) in terms of how it plays out. First go around was warranted excitement but also ahead of itself, second go around is all that but with fundamentals to support it, and let it run longer and larger. And during housing bubble part 1.....mortgages where 5-8%......

 

EDIT: to clarify, I wouldn't exactly want to be a highly levered owner of certain RE assets, especially with a lot of short/mid term maturities. But otherwise, most of the higher rates = RE is fucked narrative, is crap.

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You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.
 
I said lower price for financed assets not necessarily lower demand.
 
Also, the difference is in timing:

  1. First, demand goes back to normal, while minimum wage goes up and stimulus money shows up in people's bank accounts. 
    This causes more dollars to chase limited goods. 
    ]That causes inflation to finally show up. 
    ]That causes market to raise longer-term interest rates, or Mr. Market starts to predict it, and starts raising longer-term interest rates earlier. 
    Fed continues to keep low Fed rate and continues to buy treasuries to try to lower longer-term interest rates.  That causes monetary supply to increase further.  I hear what some say that banks have to hold extra reserves as a result of Fed buying treasuries, but that doesn't stop banks from using those reserves to enable transactions at higher prices. 
    The rise in interest rates causes price of financed assets, i.e. stocks, CRE, etc. to go down, or Mr. Market starts to predict and some financed and effectively-internally-financed assets like stocks start to go down sooner.

Prices don't react to interest rates prices react to demand. Rates are the catalyst. So whenever you say lower price you say lower demand.

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Inflation hurting RE is one of the biggest widespread, false narratives I consistently see people peddling. It is my belief, especially in certain areas(Sunbelt) that we're entering a phase not unsimilar in parallels to the mid 2000's. It will also mirror the tech bubble part one(late 90s) and tech bubble part 2(2015-now) in terms of how it plays out. First go around was warranted excitement but also ahead of itself, second go around is all that but with fundamentals to support it, and let it run longer and larger. And during housing bubble part 1.....mortgages where 5-8%......

 

EDIT: to clarify, I wouldn't exactly want to be a highly levered owner of certain RE assets, especially with a lot of short/mid term maturities. But otherwise, most of the higher rates = RE is fucked narrative, is crap.

I don't think we're talking about an environment where you have sustained inflation. What we're talking about realistically is an environment with more inflationary pressure where you basically have low inflation, higher rates. I agree that in a sustained inflation environment RE assets will go up nominally. On a real basis that's more of a mixed bag. But it's hard for me to picture a scenario where you basically have lower rates lead to higher RE asset valuations, higher rates don't affect RE asset valuations.

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You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.
 
I said lower price for financed assets not necessarily lower demand.
 
Also, the difference is in timing:

  1. First, demand goes back to normal, while minimum wage goes up and stimulus money shows up in people's bank accounts. 
    This causes more dollars to chase limited goods. 
    ]That causes inflation to finally show up. 
    ]That causes market to raise longer-term interest rates, or Mr. Market starts to predict it, and starts raising longer-term interest rates earlier. 
    Fed continues to keep low Fed rate and continues to buy treasuries to try to lower longer-term interest rates.  That causes monetary supply to increase further.  I hear what some say that banks have to hold extra reserves as a result of Fed buying treasuries, but that doesn't stop banks from using those reserves to enable transactions at higher prices. 
    The rise in interest rates causes price of financed assets, i.e. stocks, CRE, etc. to go down, or Mr. Market starts to predict and some financed and effectively-internally-financed assets like stocks start to go down sooner.

Prices don't react to interest rates prices react to demand. Rates are the catalyst. So whenever you say lower price you say lower demand.

 

Are you saying you disagree with the numbered points above?  If so, which # do you disagree with so that I can understand your perspective better?

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- inflation is not about assets not going up, it is about them not going up enough in relation to the general background costs of living. Therefore, like Einstein's theory of relativity, you are going up a down escalator.

 

- from what I've seen, inflation occurs from a high base - after a reflation of wages and assets. It is hard to get inflation when everything is scraping the bottom of the barrel. That is why an argument can be made that it takes some time before these forces are unleashed. It could be a year or two or three or a decade.

 

- lots of debt is already higher than the fed rate. corporations are borrowing at 2/3-7% depending on credit quality. So inflation would have to start going up to a point where re-rolling future debt will be discounted at a higher rate and affect those asset prices. Plus the market would also assess the revenue side of the equation in valuations.

 

 

 

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You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.
 
I said lower price for financed assets not necessarily lower demand.
 
Also, the difference is in timing:

  1. First, demand goes back to normal, while minimum wage goes up and stimulus money shows up in people's bank accounts. 
    This causes more dollars to chase limited goods. 
    ]That causes inflation to finally show up. 
    ]That causes market to raise longer-term interest rates, or Mr. Market starts to predict it, and starts raising longer-term interest rates earlier. 
    Fed continues to keep low Fed rate and continues to buy treasuries to try to lower longer-term interest rates.  That causes monetary supply to increase further.  I hear what some say that banks have to hold extra reserves as a result of Fed buying treasuries, but that doesn't stop banks from using those reserves to enable transactions at higher prices. 
    The rise in interest rates causes price of financed assets, i.e. stocks, CRE, etc. to go down, or Mr. Market starts to predict and some financed and effectively-internally-financed assets like stocks start to go down sooner.

Prices don't react to interest rates prices react to demand. Rates are the catalyst. So whenever you say lower price you say lower demand.

 

Are you saying you disagree with the numbered points above?  If so, which # do you disagree with so that I can understand your perspective better?

Specifically 5 and 6. If you see sustained inflationary pressure the FED WILL raise rates. In fact the higher LT yields represent an anticipation of this raise down the road. Higher rates of course affect prices of financed assets by influencing demand for them. Higher rates->Lower Demand->Lower prices.

 

An environment where you have 6% inflation without financed assets participating in that is frankly maybe possible in one iteration of a simulation but not one that is plausible.

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