Inflation by Fiat

Jared Dillian | The 10th Man
August 27, 2020

There are a number of sources of inflation. People spend most of their time looking at monetary policy, but there’s a lot more driving this story.

You have probably heard of AB5, the California law that requires firms to treat independent contractors and freelancers as employees. As far as laws go, I give it zero stars.

The goal was to give “gig economy” workers the dignity of a job. But nearly all of them thought that jobs were undignified, and that making their own hours and directing their own destinies was much more dignified. Benefits would be nice, but it wasn’t worth giving up their freedom.

So, the law senselessly put thousands of people out of work. Many of them moved to Idaho.

You’ve probably also heard that the rideshare companies, Uber and Lyft, threatened to cease operations in California unless they could reach a compromise. The rideshare business model simply does not work if you treat drivers as employees. It makes it impossible for them to do business in California.

You probably also heard that Joe Biden thinks AB5 is a great idea. He wants to roll out some version of it nationwide. This is bad for Uber and Lyft, but we won’t get into security analysis here.

If Uber and Lyft are forced to comply with such a law, they will have to raise prices—possibly much higher. A $20 ride would become a $60 ride and turn into an unaffordable luxury.

This is also how you get inflation by fiat.

I first learned about inflation by fiat in a 1983 book called Is Inflation Ending: Are You Ready? Few investment books have been more right than this one. The authors, Kiril Sokoloff and Gary Shilling, correctly predicted the end of inflation.

I am predicting the beginning of inflation—and putting a lot of my own skin in the game on that prediction, as subscribers to The Daily Dirtnap know.

Inflation by fiat happens when laws and regulations increase the cost of compliance for firms, and they pass it along to consumers in the form of higher prices.

As we discussed a while ago, safety and fuel economy regulations have increased the price of cars. In 1984, you could buy a Honda CRX that got 52 miles per gallon, but it was essentially made of plastic. If you were T-boned by a tractor-trailer, you got squashed into a seal-a-meal.

Traffic deaths have gone down a lot since then. But now, nobody can afford a car without a seven-year loan. There are trade-offs in everything we do.

If Joe Biden is elected, it is safe to say we will revisit the hyperactive regulatory state of the Obama years—and then some. Which means that prices will go up on a lot of stuff—regardless of what the Fed does.

Take utilities, for example. Taxing carbon or requiring the use of renewable resources will increase utility bills a lot. We take cheap power for granted (unless you live in California). If prices go up enough, we’ll get progressive pricing on utilities—you heard it here first.

The Jackson Hole

Fed Chairman Jerome Powell will speak today at the Fed Symposium in Jackson Hole, Wyoming. He is likely to say that the Fed will tolerate higher levels of inflation.

Boy, will it ever.

Pretend the Consumer Price Index (CPI) goes to 4%, which is entirely likely. I don’t see the Fed tightening monetary policy, as there’s been a lot of discussion about how the Fed wants an inflation target that averages 2%.

Inflation stayed below 2% for a long time, so it’ll let it stay above 2% for a long time.

Then CPI will rise to 6%. This will start to make the Fed a bit nervous. But there won’t be enough political will to stop inflation, because the stock market will be climbing higher and wages will be rising.

It’s unlikely that the Fed will act until inflation gets to 8%–10%. And if it takes 10 years for that to happen, my prediction is that you won’t see tightening or an end to the liquidity programs until then.

Unhappy Places

The term “reaction function” is a bit overused, but we should spend some time thinking about the reaction function of the Fed.

The Fed, as an institution, is much more worried about deflation than inflation—still. It is worried that we’ll end up like Japan.

Candidly, I wouldn’t mind ending up like Japan. They seem happy. The places with lots and lots of inflation, like Argentina or Venezuela, do not seem very happy.

Over the past 10 years, it’s seemed as if the Fed is targeting stock prices. It is, and it isn’t. Really what it’s targeting is deflation—anytime the capital markets begin to project a fall in inflation (like during the pandemic scare), it acts swiftly.

It does not act swiftly when there are signs of inflation. It waits and sees how things develop.

This is the reaction function of the Fed. And it won’t change until people really begin to suffer under inflation, and there is some political will to do something about it.

Inflation will rise for years to come. I’m not sure how fast it will happen—but I am sure that you want to initiate your inflation trades now. If you until wait until inflation hits 4%... 6%... 8%... the opportunities will have passed.

Some of the recent data indicates that inflation could accelerate rather quickly. That would surprise people the most.

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Personally, I’m having a lot of fun with my inflation trades. So, I’m reopening my offer to give you another very brief chance to join The Daily Dirtnap.

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Jared Dillian

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