Is Inflation About to Get Much Worse

The S&P 500 is currently sitting near an all-time high. Equity traders seem to have decided that a war in the Middle East, one that has effectively closed the world's most critical energy choke point, is simply a great opportunity to buy the dip. And buying the dip has become such a winning strategy in recent years that dips don't really happen much anymore. The average consumer is a bit less convinced. US consumer sentiment has recently fallen to a 74-year low. To put that in perspective, those 74 years included the assassination of JFK, the 1973 oil embargo, September 11th, the global financial crisis and a global pandemic. People are more miserable now than they were during any of those times. That is not a great number if you're an incumbent politician running for office. The immediate cause of this collapse in sentiment is the closure of the Strait of Hormuz. Though, as we'll see, the problems run much deeper than that. In late February, an assault on Iran shut down the transit of roughly 20 million barrels of oil a day, about a fifth of the global supply. Martin Wolf, writing in the Financial Times, points out that the Strait is a vital artery of the world economy, a place in which one starts a war only after careful consideration of goals, means and risks. He goes on to say, that's not what happened. Brent crude has, as of the time of this recording, been pushed above $125 a barrel. As I mentioned in last week's video, oil prices feed directly into the cost of food, fertilizer and shipping, so that increase is rapidly working its way into everything you buy. Politicians would very much like to blame our current cost of living problems entirely on this geopolitical bad luck. And while the energy shock has certainly acted as a massive accelerant, several highly credible economists had been warning that a surge in inflation was sitting in the pipeline long before the first missile was fired. The war merely exposed the problem. According to a new book by Manoj Pradhan and Charles Goodhart, for three decades central bankers have been taking credit for a structural decline in global prices that had almost nothing to do with their policy decisions. They had the wind at their backs and mistook it for the power of their own legs. Now that the wind has changed direction, the job of central banker has become one of the most difficult and politically dangerous roles in public life. Pradhan and Goodhart argue that from about 1990 until recently, the global economy was coasting on what economists call a demographic sweet spot. The baby boomer generation had entered the workforce, female labor participation rose sharply and China and Eastern Europe joined the global trading system. This essentially amounted to a once in history doubling of the effective global labor force, which is a very reliable way to keep wages and prices from going up. Central bankers looked at this massive structural gift of cheap labor and cheap goods and concluded that their success was down to their own financial genius. To understand why this matters, we need to talk about something called the Phillips curve. It's one of the most important relationships in economics and for years people thought that it was broken. The Phillips curve is the idea, dating back to 1958, that when unemployment is low and workers are scarce, wages go up and prices follow. When there's lots of spare labor, prices stay flat. Simple enough. But for the last two decades, central bankers kept interest rates at rock bottom, unemployment fell to historic lows in several countries and inflation barely moved. Economists started writing papers about the death of the Phillips curve. Central bankers took credit for having conquered inflation through sheer competence. Pratt and Goodhart argue that the Phillips curve wasn't dead. China had just put it in a coma. Before we dig into that, let me tell you about this week's video sponsor Odoo. If you're running a business, you know the pain of juggling a dozen different tools. One for accounting, one for inventory, one for sales and none of them talk to each other. That's the problem that Odoo solves. Odoo is an all-in-one management platform that brings everything under one roof. Sales, CRM, accounting, inventory, e-commerce, website builder, all of it. And because it's all on one platform, everything is actually connected. Make a sale and your inventory updates, your accounting reflects it and you get a real-time picture of your entire business. No more copy-pasting between five different tabs. The interface is modern and intuitive. This isn't clunky enterprise software from 2005. Your team can get onboarded without a week-long training session. It also scales with you. Start with one app, add more as you grow and your first app is free. Free forever with unlimited hosting and support. Want access to all of their apps? Plan start at just $24.90 a month. For a full ERP suite, that's kind of insane. It even auto-configures based on your country. Taxes, currencies, local regulations all handled. Check out Odoo at the link in the description. They've got a free 15-day trial that you can play with to see it for yourself or you can even book a demo with an expert to evaluate your project. So, back to inflation. The author's insight is that we shouldn't be looking at inflation as one big number. There are two separate inflation dynamics running at the same time. The first is a domestic services curve. Your hairdresser, your plumber, your lawyer, the people who have to physically be where you are, their prices are driven by your local labor market. When workers are scarce, those prices go up. That relationship never broke down. The second is a goods curve and for the last 30 years, this one was essentially made in China. When you offshore most of your manufacturing to a country where labor is cheaper, the price of physical goods falls relentlessly and that goods deflation was so powerful that it masked the fact that services inflation, the domestic part, was ticking along quite normally the whole time. What this meant in practice was that central banks in the US and Europe were essentially outsourcing their inflation targets to Chinese factories. Politicians got to enjoy solid economic growth with low borrowing costs. Workers in the services sector got steady pay rises and nobody had to make any difficult decisions because cheap televisions and cheap clothing from China were pulling the average down. It was a great arrangement for everyone. The workers who lost those factory jobs didn't vanish. Most of them ended up in the services sector which is one of the reasons services inflation never actually went away. But that era is now coming to an end. The world's population is aging rapidly and the global labor force is beginning to shrink. China is still flooding certain sectors with cheap goods. European car manufacturers can tell you all about that. But the structural force that kept global prices falling for 30 years is running out of road. China's own population is aging faster than almost any major economy. Its workers are moving out of export-driven manufacturing and into domestic services. And on top of that tariffs and trade barriers are now actively blocking whatever cheap goods China does produce from reaching western consumers at the old prices. The structural tailwind that made central banking look easy for 30 years hasn't just faded. It's being erased by demographics, by geopolitics and by deliberate policy. And if you're a central banker operating without that tailwind in an economy where workers are scarce, where services inflation is persistent and where your government is running enormous deficits that it has no realistic plan to pay for, the job starts to look very different. If you think this structural shift sounds like an abstract long-term problem for future generations to worry about, it's not. The bill is already coming due. Back in January, before the Strait of Hormuz was closed, before Brent hit 125, Adam Poston, the president of the Peterson Institute for International Economics, and Peter Orszag, the CEO of Lazard, published a piece arguing that US inflation could hit 4% by the end of this year. That is double the Federal Reserve's target and their argument had nothing to do with an energy shock. They were warning that the ingredients for a resurgence in inflation were already in place. The war has simply thrown gasoline on a fire that was already burning. Their case rests on several reinforcing pressures. The first is the lagged pass-through of tariffs. When a government announces a massive new tariff, businesses don't raise their prices the next morning. They work through their existing inventory, they watch what their competitors do, and they wait to see if the policy gets reversed. But eventually, the old inventory runs out. Poston and Orszag note that businesses have now depleted the stockpiles they built up ahead of the tariffs, and they're beginning to pass those costs on to consumers in smaller increments, which means the inflationary effect is still building, not fading. Then there's the labor market, which is tightening. When any economy loses workers, whether through aging, emigration, or policy changes, the same thing happens. Labor is an input, just like energy or materials. When it becomes scarcer, wages rise, and those costs get passed on to consumers. Several Federal Reserve banks now estimate that the break-even employment level – the number of jobs the economy needs to add each month to keep unemployment stable – has roughly halved since early 2024. The labor market is considerably tighter than the headline numbers suggest. You might reasonably ask whether automation and AI could fill the gap, and over time, they possibly will in some sectors. As Poston has argued, the history of technological disruption suggests that the productivity gains tend to arrive before the disflationary effects do. In the near term, scarce workers mean higher wages. And higher wages in the services sector means higher prices at the dentist, the care home, and the mechanic. On top of that, fiscal policy remains remarkably loose. The US government is expected to run a deficit exceeding 7% of GDP this year, which is the sort of number you usually only see during a war or a major recession, not during a period of full employment. And financial conditions are much more accommodating than the Federal Reserve's headline interest rate would suggest. Credit spreads are tight, household wealth is at record levels, and private credit markets are supplying nearly $2 trillion of alternative financing that sits completely outside the traditional banking system. As Poston put it on the Odd Lots podcast a few months ago, the Fed has tightened, but the economy hasn't really noticed. Finally, and this may be the most important piece, inflation expectations are beginning to drift. When people experience price increases on highly visible, frequent purchases, eggs, gasoline, home repairs, they start to expect higher prices in the future. They demand higher wages. Businesses raise prices in anticipation of higher costs. It becomes self-reinforcing. This is exactly what Paul Volcker warned about in 1979, when he said that inflation feeds in part on itself. The problem today is that after the pandemic surge, inflation never truly returned to 2%. We're entering this new energy shock with an economy that was already primed for higher prices, which is not an ideal starting position. This brings us to the question of who actually pays for all of this, because the inflation problem and the government spending problem are not separate issues. They are the same problem. To understand why government deficits are expanding at such a rapid pace, we have to look back to the 1960s, when an economist named William Baumol asked a fairly simple question. He wanted to understand why a string quartet playing Beethoven should be paid any more today than they were a hundred years earlier. The instruments, he argued, are exactly the same. The sheet music is the same, the number of people required to play the piece hasn't changed, and the musician's productivity has not improved at all. The answer, it turns out, is that the rest of the economy had become more productive, and in such an environment, if you didn't pay musicians a higher wage, they would simply give up the violin and go work somewhere else. So, to keep the quartet playing, the concert venue has to pay them more, and ticket prices have to go up. This concept is known as Baumol's cost disease, and while it's very useful for explaining why concert tickets are expensive, it also explains the structural nightmare currently facing global government budgets. I should clarify that when economists talk about a lack of productivity in certain jobs, they aren't insulting anyone's work ethic. In economics, productivity just means output per hour. A factory worker with a new machine can build 10 times as many cars today as they could 50 years ago, but a nurse, no matter how hard they work, can still only care for one patient at a time. This type of work is strictly constrained by the linear nature of time, which economists generally find quite frustrating. As Pradhan and Goodhart point out, the classic examples of Baumol's cost disease are education and healthcare. They are highly labor-intensive services that are provided in person and are thus famously resistant to productivity gains. And while an aging population might not need much in the way of primary schooling, they do require an exponential increase in medical care. As the proportion of elderly people rises, so does the incidence of neurodegenerative diseases and the complex comorbidities that come with living longer. And despite what our tech elites might like to tell us, your grandparents are highly unlikely to be satisfied with a robot visiting them in the care home. Japan has actually been trying that approach for years, spending billions on healthcare robotics and only 2% of its caregivers regularly use them. The elderly require human carers and because those carers have the option of working in other increasingly productive sectors of the economy, you have to pay them steadily higher wages to maintain the exact same level of care. You are essentially paying more and more for the string quartet, except the quartet is your entire healthcare system and the audience is getting older by the day. This all brings us to the fiscal problem. Because healthcare spending is structurally locked in to rise much faster than GDP, governments are staring down the barrel of massive structural deficits that have very little to do with which party happens to be in power. In the United States, the non-partisan Committee for a Responsible Federal Budget estimates that the One Big Beautiful Bill Act passed by the current administration will add roughly $4 trillion to the national debt over the next decade. And there's also the well known social security cliff approaching in 2033 when the trust fund that pays retirees is expected to run dry. Pratt and Goodhart believe, and I think most honest observers would agree, that when that moment arrives, the politicians of the day will bail the system out rather than impose a 24% cut in benefits on the most reliable voting bloc in America. If you ask a politician how they plan to pay for all of this, they'll invariably point to a spreadsheet showing that their policies will generate a massive boom in GDP growth. This boom will supposedly lead to huge primary surpluses at some vaguely defined point in the future. This sounds great, except that these promised future surpluses almost never actually materialize. They serve as a convenient accounting fiction, allowing the current administrations to spend money today while leaving the bill for whoever happens to be sitting in office a decade from now. The result is a slow grinding structural deterioration in the public finances of almost every major economy, and when governments can't or won't fix their fiscal problems through spending cuts or tax increases, the pressure inevitably lands on the one institution that can still print money. If governments are unwilling to cut spending or raise taxes, they have to find more creative ways to manage the debt. In the United States, Treasury Secretary Scott Besant has chosen a actively shifting the government's borrowing towards the short end of the yield curve, issuing more treasury bills and fewer long-dated bonds. There's a certain irony in this. During the previous administration, Besant was among the most vocal critics of Janet Yellen for doing essentially the exact same thing. His argument was a serious one, that the treasury market derives its special status precisely from not being managed for short-term convenience. The United States government can borrow more cheaply than almost any other entity on earth because the treasury market is the deepest, most liquid and most stable asset market in the world. Investors accept lower yields in exchange for that reliability. When you start gaming the maturity structure for political advantage, you erode the very thing that makes US debt special and that tends to show up eventually in higher borrowing costs. It was a compelling critique at the time and it remains a compelling critique today, which makes it all the more remarkable that the man who made it is now doing precisely what he warned against. The logic behind the strategy is straightforward. Short-term rates are lower, so borrowing short saves money today. And if you believe that rates will fall significantly in the future, you avoid locking in today's higher long-term yields. The problem is the other side of that bed. When you borrow short, you have to keep rolling the debt over. And if rates don't fall, you find yourself refinancing at whatever rate the market is charging at the time. Given everything that we've just discussed, structural inflation, aging demographics, persistent fiscal deficits, there's no obvious macroeconomic reason to expect a dramatic decline in interest rates. The strategy makes sense if you believe that the pandemic era interest rate environment was normal and will return. Most of the evidence suggests that it was not and that it will not. There is one component of the inflation picture that both the treasury and most traditional macroeconomic models tend to quietly set aside and that is housing. Shelter costs make up more than a third of the consumer price index, the single largest component of any category. If you read the research predicting a return to low inflation, you'll notice that housing is almost entirely absent from the analysis. That is quite an omission. In the year to March, US shelter costs rose by 3%, already above the Federal Reserve's 2% target, while overall inflation came in at 3.3%. And critically, the official CPI measure actually understates the real-time pressure because it captures rents across all existing leases rather than what new tenants and new buyers are actually paying today. Anyone currently looking for somewhere to live knows that the number on the ground feels considerably worse than 3%. The reasons are structural. Tariffs have driven up the cost of construction materials. The contraction in the labour force has tightened the supply of construction workers and mortgage rates above 6% have created what economists call the lock-in effect. Existing homeowners refuse to sell because moving would mean surrendering the cheap fixed rate that they locked in years ago. The result is a market with almost no supply, rising costs of new construction and no obvious relief mechanism inside. New household formation still happens, people still fall in love and want somewhere to live, but increasingly that requires building a new home at precisely the moment when building one has never been more expensive. And as I've discussed in previous videos, the broader story of housing affordability across the developed world where house prices have risen far faster than wages for three decades is now creating a self-reinforcing intergenerational problem that no government seems willing or able to solve. Older homeowners vote in large numbers and have direct financial interest in keeping prices high. Politicians who propose serious measures to increase supply are essentially asking their most reliable constituency to accept a fall in their net worth, which is one of the reasons that the problem has persisted for as long as it has. For the purposes of this video though, the key point is simpler. Housing inflation is structural, it's understated in the official data and it's not going away, which means that the single largest component of the inflation basket is working against anyone who's hoping for a return to 2%. If you look at all of these factors, the housing market, the tightening labor market, the trade barriers and the fiscal deficits, you might assume that the public is fully aware of the inflation risk building in the system. According to a recent NBE or working paper The researchers studied how ordinary people and businesses form their inflation expectations and they discovered a pattern they call the cycle of selective inattention. It turns out that when inflation is low and stable, people simply do not pay attention to monetary policy. They ignore the federal reserve, they don't know what the inflation target is and they go about their lives. This is entirely rational behavior. You don't tend to read the terms and conditions of your home insurance policy until water is already pouring through the ceiling. But when inflation surges, as it did after the pandemic, people suddenly start paying very close attention. They check the news, they learn about the Fed and they start tracking inflation data. The problem is that they're learning about monetary policy at the exact moment when the central bank appears to be failing, which means the only lesson they ever absorb is a negative one. I mentioned earlier that inflation expectations are beginning to drift. The new research helps explain why this is so dangerous. When people expect higher prices, they demand higher wages. Businesses raise prices in anticipation. It becomes self-reinforcing, which is precisely what happened in the 1970s. The paper points out that the recent trajectory of household inflation expectations looks almost identical to the lead up to the inflation surge of 1974, which is, generally speaking, a sub-optimal baseline for long-term price stability. This brings us to the political reality of central banking. If the Federal Reserve wants to bring inflation back down, it has to keep interest rates restrictive. But restrictive monetary policy makes government debt more expensive to service, slows the economy and makes politicians deeply uncomfortable, particularly politicians who are running for re-election. As Pradhan and Goodhart point out, in any lasting conflict between governments and banks, the central banks lose. This is not a partisan observation. It's been true under governments of every political stripe, in every country for as long as central banks have existed. When fiscal conditions deteriorate and the debt keeps rising, the political pressure to cut rates becomes overwhelming, regardless of what inflation is doing. We are already seeing this tension play out. The current US administration has offered some rather direct feedback to the Fed chair on social media, initiated a Department of Justice investigation into the central bank's office renovations and nominated Kevin Warsh to take over the institution. Warsh has called for what he describes as regime change at the Fed, which is an unusual choice of words when discussing monetary policy, but it would be a mistake to treat this as a uniquely American or uniquely partisan problem. The research on central bank independence suggests that amongst the strongest predictors of whether a central bank will lose control of inflation are frequent turnover of its leadership and being pressured to buy government debt directly. In Turkey and Argentina, we've seen what happens when politicians take full control of monetary policy. You get rapid turnover of central bank governors, the government forces the bank to buy its bonds and the currency loses its purchasing power. The advanced economies are obviously in a very different position. They have deeper capital markets, stronger institutions and the enormous advantage of borrowing in their own currencies, but the underlying mechanics of inflation do not change depending on the size of your economy. When a government runs persistent deficits and refuses to cut spending or raise taxes, the pressure to monetize that debt, to quietly print the difference, becomes very difficult for any central bank to resist indefinitely. It is, for all intents and purposes, a slow-motion tax on everyone holding the currency. And unlike an actual tax, no one has to vote for it. For the last 30 years, the world essentially operated as one massive optimized factory. If something was cheaper to build in Germany or China or Taiwan, that's where it was built and we relied on an open, peaceful ocean to deliver it. That system was extraordinarily efficient. It was also one of the great disinflationary forces of the modern era. But as the events in the Straits of Hormuz have demonstrated, an open and peaceful ocean is no longer a guaranteed feature of the global economy. The breakdown of international alliances and the return of geopolitical conflict means that countries are suddenly realizing that they cannot rely on their historical partners. This presents a rather practical problem for anyone who happens to rely on electricity, food or the internet. Adam Posen has pointed out that Canada recently discovered it has almost no internet infrastructure that operates independently of the United States. All of their cables and satellites run through their southern neighbor. For decades, this was perfectly fine. You don't worry about concentration risk when the relationship is stable. But in a world where the terms of any international relationship can shift rapidly, that kind of dependency starts to look like a vulnerability. And Canada is not unusual in this regard. Most countries have similar single points of failure that they never thought to worry about. So, you have to build redundancy. And redundancy is expensive. Europe is facing its biggest geopolitical challenge since the Second World War. Countries like Poland and the Baltic States are increasing their defense spending dramatically. Germany has launched new fiscal expansions to rebuild its military capacity. Across the globe, governments are being forced to duplicate supply chains, build redundant energy infrastructure and onshore manufacturing that they used to happily outsource. You are essentially taking money away from productive private investment and pouring it into government spending, just to ensure that the lights stay on and the internet keeps working when the next crisis hits. None of this adds to the productive capacity of the economy. All of it adds to the deficit. And this creates a cycle that's very difficult to break. More defense and infrastructure spending widens government deficits. Those deficits put pressure on the central bank to keep borrowing costs manageable. The central bank accommodates the politicians, as Pratt and Goodhart argue they eventually will, by keeping interest rates lower than they should be. That fuels inflation. The inflation erodes living standards, which fuels populism, which further undermines the credibility of the very institutions trying to manage the crisis. For three decades central bankers had the wind at their backs. Cheap labor, cheap goods, open trade routes and falling prices made the job look easy. Now the demographics have reversed. The trade routes are contested, the deficits are structural and the politicians are telling the central bank what to do. The wind hasn't just changed direction, it's blowing directly into their faces. Pratt and Goodhart call this the age of the unanchored central banker, an era in which the central bank can no longer single-mindedly pursue low and stable inflation. Not because central bankers have become less competent, but because the structural conditions that allowed them to At this point the data suggests that the only people left on earth whose inflation expectations remain perfectly anchored at 2% is the Federal Open Market Committee itself, which is nice for them. For anyone who wants the detailed macroeconomic argument behind today's video, I'd highly recommend Pratt and Goodhart's new book The Unanchored Central Banker. I recently sat down with Manoj Pratt to discuss it on my interviews channel and you should watch that conversation now. Don't forget to check out our sponsor Odoo using the link in the description. Have a great day and see you in the next video. Bye.