The discrepancy between raging inflation and soggy Treasury bond yields remains a cognitive dissonance in financial markets.
There’s a simple explanation (and “Inflation is transitory” is NOT a full credit answer): The Federal Reserve and the commercial banks that depend on the Fed are virtually the only buyers of US government debt.
As long as the Fed is willing (and the market allows it) to buy arbitrarily large amounts of government debt, the price of US government debt is whatever the Fed says it is. It’s like the pump part of a pump-and-dump scheme in the stock market, except without the benefit of an exit strategy.
This Ponzi game can continue until inflation rises to the point where investors flee the Treasury market, yields soar and the economy falls back into recession. If the Fed and Treasury are willing to stake the credit of the United States of America on this game, it can last for a while. No matter how big a player you are, though, no one will take your marker at the craps table forever.
Without exaggeration, the US federal debt market is the most manipulated market of importance in the world at this writing.
The US banking system is a captive auxiliary of the central bank. The Fed has flooded the banks with reserves and pays them 0.05% (5 basis points) to hold these reserves at the Federal Reserve’s repurchase facility.
At the end of 2021’s second quarter, banks had parked a trillion dollars at the Fed. The object is to drive the banks into the Treasury market, and it is succeeding.
The scissors that opened during the past year between banks’ business lending and purchases of government securities has no precedent. It is all the more remarkable in the context of an economic recovery.
This has real-world consequences. The cash-rich tech companies continue to invest in IT equipment, while orders for oil- and gas-mining equipment languish at about a third of the mid-2010s level. US oil production, as I’ve noted in the past, continues to fall, and oil prices continue to rise.
IT equipment investment gives more social media interaction, streaming video, gaming, cryptocurrency mining and so forth. But it has little impact on productivity in the broader economy.
The Fed and Treasury have created a tsunami of demand, and starved the US economy of supply, as in the glaring example of oil and gas. The result is a rise in the prices of goods and services across the board. Both the impulse of inflation and the consistency of high inflation across all major categories of the Consumer Price Index are at generational highs.
The chart below provides two quick and dirty gauges of how fast prices are rising and how consistent the price rise has been across the economy.
I examined seven important categories of “core” inflation (leaving aside energy and food prices): shelter, medical care, new cars, used cars, durable goods, nondurable goods, and urban transportation. The “breadth” index is simply the number of those indices where inflation is two standard deviations above the twenty-year mean, and the present score is six out of seven. The “surprise” index is the average of the standard deviation of each component relative to the mean: on average, year-on-year inflation of these components is four standard deviations above the mean. In other words, we have the highest and broadest-based inflation in twenty years.
There’s nothing transitory about this. On the contrary, inflation will get worse, as the bubble in home prices feeds into consumer inflation. The median US home price at sale rose 23% year-on-year as of May, according to the National Association of Realtors. The realtors’ organization also reports an uptick in the cost of rentals:
That will get worse because there aren’t enough apartments available to house the scores of millions of Americans who are now priced out of the home purchase market. The apartment vacancy rate stands at just 6%, the lowest level since the 1980s.
Shelter comprises nearly a third of the Consumer Price Index, and the combination of a home price bubble and a shortage of rental properties will push the shelter component up relentlessly for the next two years or more.