Deflating Demand

America’s bifurcated economy faces a long-dormant specter: inflation. The challenge for investors is determining whether this nefarious outcome is a temporary or permanent feature of the post-pandemic landscape. The answer lies in assessing its root cause. The Pandemic’s onset brought a health policy-induced retrenchment of service demand. With the consumption of services off the table, consumers transferred spending to goods. The fiscal response amplified this decision by increasing incomes broadly. The reality of just-in-time supply chains is that they depend upon stable demand. The resultant supply bottlenecks delivered inflation. Adaptation will occur over time, providing a higher supply, while incomes will be lower due to fading stimulus payments. As business adapts, this too will pass.

An abrupt switch in consumption baskets during the Pandemic conspired with slow-moving supply chains to deliver goods inflation. This temporary event is already fading.

A demanding policy. The government delivered monetary and fiscal stimulus in the face of a cataclysmic economic retreat brought on by health policies enacted to prevent an eye-watering death toll. The challenge of all macro policies is their lack of precision, which leads to unintended consequences. A demand gap in services was a forgone conclusion as the pandemic permeated the economy. The policy response delivered savings surpluses that enabled an unprecedented expansion of goods to offset the services gap. As is always the case with too much money chasing too few goods, prices rose. The follow-on problem that the U.S. economy faces from its Pandemic policies is inflation, and whether it is structural or transitory.

The boom in consumption also led to an expanding trade deficit, as imports increased faster than exports (Exhibit 1). With hindsight, these events are obvious, yet they were not contemporaneously evident. Hawks spoke of government deficits, not export deficits, and lower demand as the government crowded out private spending, not higher demand. While global supply changes are dynamic, the increased demand overwhelmed them. This economic outlier is a unique event. As the current quarter shows, goods consumption brought forward future demand and will ensure future goods demand lowers.

Exhibit 1. GDP Contribution by Component

Source: Federal Reserve Economic Database, CRM Calculations.

Up, Up, and Away. That inflation is occurring in the economy is unquestioned (Exhibit 2). Its durability is uncertain, even as it reaches rates unseen in 30 years. The duration of inflation is a function of its root cause, which is the convergence of excess demand resulting from temporary policy decisions with modestly constrained supply. The former is transitory, whereas the latter involves dynamic global supply chains that are not designed for sudden jumps in demand. There is little debate that demand will fade as stimulus checks are no longer available and monetary stimulus recedes. The economy will endure the drag of this loss of consumption over the next few years, which is, on its face, disinflationary.

Exhibit 2. U.S. Consumer Price Index (Annual Change, %)

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations.

The supply constraints appear burdensome as ships litter American harbors and containers stack up in their ports. Yet, this hides the fact that goods consumption is materially above the prior trend. This situation is critical to understanding the current inflationary pressures. Supply chains are dynamic and global. This situation requires operational planning with lead times that can stretch to a year to deliver goods from one place to another. The accelerated goods demand overwhelmed the supply chain, as evident from the dramatically higher level of goods consumption. Thus, goods inflation should not be surprising.

Do not touch. As the Pandemic spread across the world, the economy shuddered as consumers retreated. While trite, it is evident that consumers would not spend money on services that involve contact with other people. The expectation was for losses in leisure activities, hotels, and dining. A surprise at the time was the fall of medical services during a pandemic. In hindsight, people avoiding discretionary health services where the virus is likely is rational. The data is clear on these outcomes: commodity prices (e.g., goods) rose, while services and shelter moderated (Exhibit 3). The law of supply and demand remained intact.

Exhibit 3. U.S. Consumer Price Index Major Components (Annual Change, %)

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations.

While unemployment rose sharply in the affected sectors, rebates and other support helped fill the income gap. Yet, most remained fully employed and possessed disposable income from rebates, mortgage refinancing, and their service spending void. Demand rapidly moved to a goods supply chain that was unable to adapt quickly by design. As the polemic in Washington centers around the failures of the supply chain, the root cause was the increased demand meeting an inflexible supply. The supply chain was the symptom, not the cause, while goods inflation was the follow-on outcome.

Boom and Bust. The divergent economy is evident in the difference in consumption since the onset of the Pandemic (Exhibit 4). Durables and non-durables goods have exceeded their prior trends by a cumulative amount of nearly $700 billion. In comparison, services fell by over $1 trillion below previous trends. Herein lies the challenge for the future. The goods sector is pulling workers from the languishing services sector with the enticement of higher wages. Yet, it is doubtful a worker would switch into a sector where the job may disappear as the transitory demand fades without a material incentive. This action brings current wage inflation at the cost of future wage deflation.

Exhibit 4. U.S. Consumption Surplus/Deficit by Component (Billions, $)

Source: U.S. Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis. Cumulative difference from prior trend, 2020Q2 to 2021Q3.

The wage outcome should be evident. Higher wages entice an employee to the goods sector from the services sector. The employee is a price-maker. When the tide turns and the employee is terminated, they return to an overflowing employment market. The service economy is now the price-maker on its primary input, labor. They need not deliver the inflated goods wages, particularly when further stimulus policies are limited. Thus, both sides of the consumption bucket deflate as demand wanes and supply expands in this environment. Inflation becomes deflation.

Drawdown. As the economy exceeds its prior heights with frantic goods consumption, inventories continue to drawdown and reflect recessionary behavior (Exhibit 5). This perplexing artifact does not foreordain a deflationary spiral. As goods demand fades, the sector will need to restock its drawn-down inventories. This outcome provides a means to moderate the blow from the dearth of demand that will arrive. Yet, it is likely not sufficient as the demand increase was about four times the inventory drawdown. While the extent is uncertain, this arithmetic suggests that goods inflation will return to more deliberate rates.

Exhibit 5. U.S. Inventories Change ($, Billions)

Source: U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis

Moderation of steroidal goods demand evinced by the economy will deliver material short-term implications, which may have already begun to arrive. This force may reach its nadir in the first quarter next year. As the holiday season and its annual highs in consumption pass, goods companies will hold late-arriving merchandise that will require liquidation. This prospect suggests the new year could start on a depressed note as seasonal factors conspire with supply chain disruptions to deliver the confluence of excess supply and receding demand. This situation portends further pressure on goods to deflate.

Unbalanced. There is no more evident sign of the evolution of the U.S. to a services-based economy than the trade deficit, which has plummeted during the Pandemic (Exhibit 6). The surge of spending on goods drove imports upward while feeble global demand constrained exports. The result was an expansion of over 25% in the net trade deficit to about $1.3 trillion. This outcome would usually signal a decline in the U.S. dollar. Yet its level remains consistent with the pre-Pandemic level. This outcome moderates the inflationary impact of increased import goods purchases.

Exhibit 6. U.S. Net Exports

Source: U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis.

The other perplexing outcome is the rise of commodity prices with no offsetting decline in the U.S. dollar. Commodities are priced in U.S. dollars globally; thus, price increases usually result in a drop in the U.S. dollar. Disentangling the drivers of these outcomes is complex, yet there is one clear implication: U.S. dollar demand is high.[1] This situation highlights a material inflation threat for U.S. policymakers.

Dollar Divergence. The driver for currency levels is a combination of growth and inflation differentials, which reflect the nominal interest rate. Higher levels in one country entice investors to buy the currency and lead to currency appreciation.[2] This relationship would suggest support for the U.S. dollar as domestic inflation accelerates faster than its foreign counterpart, a situation that is now occurring. Thus, there is a theoretical and fundamental argument for the strong U.S. dollar despite the rise in commodity prices.

Exhibit 7. U.S. Real Trade Weighted Dollar & Ratio of Export/Import Price Indices

Source: Board of Governors of the Federal Reserve System, retrieved from FRED. The ratio is Export & Import Price Indices of Commodities (End Use). CRM Calculations.

Another anomaly further supports a higher U.S. dollar: export prices are rising materially faster than import prices (Exhibit 7). After nearly six years of no movement in the ratio of the price indices, export prices are ten percent higher than import prices. Yet, the real trade-weighted dollar is effectively unchanged. This situation presents two outcomes: U.S. disinflation as the U.S. Dollar appreciates or inflation as export prices fade. Caveat emptor.

Diminished Demand. The goods demand boom that accompanied the fiscal stimulus is waning and portends a future demand drought. A rebound of services could overcome this pullback. Yet it must also contend with low vaccination rates that moderate its rebound. As the recent GDP numbers show, this outcome is beginning to show up sooner than anticipated. Herein lies the problem for the world and the U.S.: future growth will require more stimulus because of the Pandemic policy response. If not, higher debt with lower interest rates and growth is the outcome.

Exhibit 8. Forecast for US GDP Growth

Source: CRM estimates. Amounts are annualized rates. The shaded area is the forecast. For 2021, growth will approach 6.0% (with 1.3% from the stimulus) and achieve a rate not seen in forty years (Exhibit 8). Two key risks remain: exports do not rebound due to continued uncertainty from the Pandemic, and investment declines rather than slows. Both risks are probable outcomes and could lower annual growth 0.3-0.5%. Our inflation expectation is a revised 5.6% rate (year/year). With inflation running well ahead of expectations, fiscal policy is the antidote to help cure the nearly four million unemployed people. The risk is 1970s stagflation, rather than 1940s demand-pull inflation and growth.

[1] This relationship is the International Fisher Effect, and there is a debate on its validity.

[2] This is occurring despite no material change in foreign holdings of U.S. Treasuries over the last year. https://ticdata.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt