The "Everything" Inflation Cycle

The Fed faces a unique inflation cycle. It's the "Everything" inflation cycle since inflation is present everywhere; in consumer goods and services, producer finished goods and materials, transportation costs for freight, housing, and equities. It is rare to see simultaneous rapid price increases in the conventional price measures, like the CPI and PPI, and real estate and financial assets prices.

Inflation cycles end when policymakers tighten monetary policy. Policymakers usually focus on the consumer price inflation cycle when they decide to raise official rates. But monetary policy is a blunt instrument, and it cannot target a specific type or area of inflation.

The US has never experienced an "Everything" inflation cycle, so the critical question is when policymakers lift official rates, which inflation cycle ends first and falls the hardest. The inflation cycles most vulnerable are the ones that have experienced a significant increase far beyond what fundamentals warrant. I bet it's the asset price cycles that drop first and the hardest.

The "Everything" Inflation Cycle

Typically, consumer prices define the inflation cycle. Yet, while consumer prices are running the fastest in thirty years, the inflation cycle is much bigger and broader than what's going on with consumer prices.

Consumer prices have increased 6.2% in the past year, the most significant increase since the early 1990s. Consumer price measures no longer include house prices. If they did, consumer prices would roughly match the double-digit record readings of the 1970s and the early 1980s.

Producer prices for finished goods, a series that dates back to the 1950s, are up 12.5%. Only two years (1974 and 1980) have posted more significant increases in the past 60 years, and each one was associated with a spike in oil prices. Excluding energy prices, producer prices are up 6.5%, the highest increase since 1981.

Meanwhile, producer prices for intermediate materials and supplies, excluding food and energy, a leading indicator for finished products inflation, are up 22%. That's the second-highest increase since the series started in 1975. Also, prices for truck transportation of freight have jumped a record 16.3% over the past twelve months, while rail transportation has increased 7.3%.

Asset prices have posted even more significant increases. For example, according to the Case-Shiller Home Price Index, house prices have increased roughly 20% in the past year. And at the end of October, the S&P 500 equity index was up 40%.

Against the backdrop of rapid increases in CPI and PPI inflation, rapid increases in asset prices are rare. But, easy money has created the "Everything' inflation cycle, resulting in rapid price increases in traditional measures and excessive valuations in the asset markets.

At mid-year 2021, the ratio of the market value of domestic companies to GDP stands at a record 2.5x times, exceeding the tech-bubble peak by one-third. During the high inflation cycle of the 1970s, that ratio was a post-war low of .5. The residential real estate market value to GDP stands at 1.5x times, not far from the housing bubble peak of 1.7x times. In the 1970s, that ratio was half the size.

What happens when inflation cycles end? Reversals in inflation cycles end badly (i.e., recessions). It does not matter if it's a CPI/PPI cycle (the 1970s and 1980s), a commercial real estate bust (1990), a tech-equity bubble (2000), or the housing inflation cycle (2008).

In 2021, it's an "Everything" inflation cycle. There is no precedent on what will happen to the various price cycles when policymakers lift official rates. Policymakers, in a way, will be acting blindly but will base their rate decisions on the rise in consumer prices. Yet, policymakers have no control over where higher official rates bite. I bet that higher official rates will impact the area or segments of the economy and finance where easy money has inflated prices far beyond what underlying fundamentals warrant. Real estate and financial assets are the most vulnerable.