There are few things more preposterous in this old world than the Fed’s claim that it can reliably goose inflation to its 2.00% target, and to the second decimal place at that. The very pretension of it is mind-boggling, as proven by the chart below.
The one thing the Fed surely can’t levitate is the inflation rate of manufactured goods. That’s because the latter are overwhelmingly imported, meaning that the inflation rate of manufactures is driven by global markets, international financial conditions and labor costs, exchange rates and the mercantilist export policies of China and other low-wage economies.
As it has happened, the CPI index for durable goods (brown bars) has been heading deeply southward for more than a quarter century and by 2020 it stood 17.4% below its 1995 level. That’s goods deflation with a vengeance, but it wasn’t a consequence—at least directly—of the machinations of the inflation-targeting geniuses domiciled in the Eccles Building.
Instead, it represented the one-time migration of durable goods production from high-cost unionized US and European plants to Chinese sweat shops and their low-cost supply chains in East Asia. From the vantage point of the American consumer this was an eminently good deflation, yet it was virtually the sole basis for the Fed’s endless whining since Bernanke joined the Board in 2002 that the general inflation rate was too low, and it therefore needed to pump trillions of fiat credits into the US economy to insure achievement of its 2.00% target.
Needless to say, this was a case of not fit for purpose, if there ever was one. In theory, of course, trashing the dollar in this manner should have depreciated the USD exchange rate, thereby causing the landed price of imports to rise and domestic inflation to be boosted via the round about channel of imported goods inflation.
Alas, the red capitalists of Beijing were not about to play by rules they didn’t invent and didn’t understand. So the faster the Fed pumped out dollars, the faster the People’s Bank of China pumped out new RMB with which to sop them up. In turn, this kept the exchange rate of the “export yuan” from appreciating, thereby denying America’s monetary central planners the imported inflation, which they perversely sought.
At the same time, the inflation rate of domestic services excluding energy services (i.e. gas and electric utilities) exhibited no timidity whatsoever. During that same 25-year period, domestic services inflation averaged 2.78% per annum. And it did so virtually like clockwork, posting between 2% and 3% every year save for the slight shortfall during the Great Recession.
Accordingly, the juxtaposition of the purple and brown bars below tells you all you need to know. The Fed’s relentless money pumping over-stimulated the sector it could actually influence—domestic services—while leaving untouched the actual cause–durable goods deflation—of the topline shortfall from its misbegotten 2.00% inflation target.
Even with the help of this virulent, albeit temporary, goods deflation from China, the overall CPI rose by 2.14% per annum during the quarter century between 1995 and 2020. The only basis for the entire long-running “lowflation” narrative, in fact, was the Fed’s groundless insistence that the core PCE deflator, which rose by 1.70% per annum during the same 25-year period, was the sole valid measure of inflation.
Then again, without the drag of durable goods deflation imported from China, even the core PCE deflator would have readily exceeded the Fed’s 2.00% target during that entire period.
Nevertheless, more often than not the reason for the Fed’s rabid money-pumping has been the “lowflation” claim. Combating that illusory threat accounts for much of the massive growth in the Fed’s balance sheet—from $450 billion in 1995 to exactly $8.0 trillion as of June 9th.
That is to say, the Fed has inflated the most virulent financial asset bubble in recorded history foolishly attempting to neutralize China’s deflationary gift. There are few cases of more perverse public policy action in all of American history.
YoY Change in CPI for Services Versus Durables, 1995-2020
This refutation of the “lowflation” myth is crucial because it is the implicit foundation for the current “transitory” inflation debate. The truth is, we have had robust domestic inflation all along—a condition only thinly veiled by the outright deflation of global goods prices as shown above.
Moreover, now that the era of China exporting deflation has come to a close, the underlying 2-3% inflation that was always there will likely reassert itself in the official topline inflation number during the quarters and years ahead. Indeed, here is the same chart, but on a monthly YoY basis for the five years since May 2016.
There are few things in the incoming data as stable as the purple bars, meaning that domestic services—which account for 59% of the CPI—have been cranking out 2.5% per annum inflation like clockwork, even in recent months when the Fed heads were virtually drooling over the alleged inflation shortfall.
But what is also happening to durable goods can’t be gainsaid. After years in the sub-basement of deflation, it has flipped into rapidly ascending inflation.
Nor are the rising brown bars on the right side of the graph some kind of transient “base effect”. As we have been insisting, the CAGR (compound annual growth rate) for the two-years stack is essentially a proxy for a world in which the very temporary Covid-lockdown deflation didn’t happen. These computations start with 2019 and late 2018—a time when the US economy, according to the Donald and Wall Street economists alike, was hitting on all cylinders.
Accordingly, the two-year stack for CPI durables leaves nothing to the imagination. Upwards of 25 years of goods deflation is over, and inflation is again rapidly accelerating.
CPI Durables, CAGR for Two-Year Stack:
- November 2020: 1.61%;
- December 2020: 1.64%;
- January 2021: 1.31%;
- February 2021: 1.35%;
- March 2021: 1.54%;
- April 2021: 3.28%;
- May 2021: 5.02%.
YoY Change in CPI for Services Versus Durables, May 2016-May 2021
For want of doubt, here is the 25-year run of Chinese goods imports to the US. From a monthly level of $3.8 billion in 1995 ($45 billion annualized) the tide swelled to a $337 billion annual rate by 2008 and peaked at a $538 billion annual rate in 2018. And it was that tsunami of cheap goods that brought the red deflation rushing into America’s main street economy.
To be sure, the communist suzerains of Beijing ended-up burying themselves in debt to accomplish this 12X rise in exports to the USA between 1995 and 2018, boosting total pubic and private debt outstanding from about $1 trillion to $50 trillion during this 23 year period. And they also ended up swapping the labor of their people for upwards of $4 trillion of Uncle Sam’s debt emissions, which pay relatively meager and have nowhere to go except lower in value.
Still, the era of China’s deflationary exports to the US and its implicit foreign aid gift to American consumers is now over. Thanks to the Donald’s blunderbuss tariffs and China’s exhaustion of its peasant labor pool, its exports to the US have already fallen by $100 billion annually and business is resourcing away from China to the remaining pods of low labor costs in the world (Vietnam, India, Bangladesh, Mexico).
But here’s the thing. Manufactured goods are likely to remain somewhat cheaper than would be the case with 100% manufacture in high cost plants in the US. But the watch word here is subdued inflation, not outright deflation.
That’s actually the skunk in the woodpile. The great 25-year era of goods deflation was a one-time capture of the cheap labor latent in China’s peasant economy and the wreckage left by the Great Helmsman through the 1970s. And that’s over and done.
Indeed, in the aftermath of the Wuhan Virus and the growing protectionist barriers being thrown up against Chinese exports and technology acquisition in both the US and Europe alike, it is evident that Beijing is heading for a full bore version of the state-driven autarky that fueled its rise as the factory floor of the world.
That is to say, exports and imports will become a rapidly diminishing part of it GDP, paving the way for a much higher labor-cost homegrown economy. The deflationary exports of the last 25 years will soon become a thing of the past.
China Goods Exports To The US, 1995-2020
Needless to say, we have pivoted this analysis around the year 1995 for a very crucial reason. That marks the shift of Chinese policy under Mr. Deng to full bore export mercantilism. The previous year, in fact, China had radically depreciated its currency—from 5.8 RMB to the USD to 8.7 RMB to the USD—to promote that very objective; and for most of the next two decades it did not waver, depreciating the yuan step-for-step with the Fed’s own trashing of the USD, as we will amplify in Part 3.
For want of doubt, here is the same chart as the first one above, but for the earlier 25-year period from 1970 to 1995. We have called this the initial fiat dollar era because through the 1970s and well into the 1980s there was no global alternative to the high labor cost of US and European factories.
Accordingly, during the great inflation of this period, the CPI for durables rose nearly as fast as the CPI for domestic services. There was not yet any Fed whining about “lowflation” because China had not yet begun its one-time capture of global manufacturing and its ferocious export of goods deflation to the rest of the world.
Per Annum Inflation, 1970-1995:
- CPI durables: 4.36%;
- PPI commodities: 5.00%;
- CPI nondurables: 5.04%;
- CPI domestic services: 6.49%;
- Topline CPI: 5.62%
We doubt whether general inflation will return to these levels for reasons we will amplify in Part 3. But the tide of red deflation is rapidly receding, meaning that the Fed’s fig leaf of justification for its insane money-pumping will become transparent right soon.
And then both ends of the Acela Corridor will be stranded high and dry.
YoY Change in CPI for Services Versus Durables, 1970-1995