The Inflation Podcast

The Crisis

Sri Lanka has recently fell into default for the first time in history (since it’s independence in 1948) as the government is struggling to halt a full-scale economic meltdown. 22 Million people live in the Southeast Asian island nation officially known as the Democratic Socialist Republic of Sri Lanka.

The government recently missed a $78 million interest payment, even after the 30-day grace period. There is a $105 million payment to China that is also late and its grace period is approaching. They currently owe $25 billion to foreign creditors but cannot pay them. $7 billion is payable this year, and the rest, with interest, is due by 2026 under current terms.

They have recently announced that they are halting scheduled debt payments on a whole pile of foreign liabilities to preserve cash for essential goods like food and fuel. They currently have 5 days worth of fuel, and are waiting on a $500 million credit line for fuel from India. India has been a key supporter during this crisis, having poured in about $3B in assistance. The United Nations plans on pledging $48 million, which is will last Sri Lanka roughly 2 weeks according to their own estimates.

Announcing you’re not going to pay your debts usually doesn’t do wonders for your credit rating, or your cost of borrowing money. A year ago, Sri Lankan 10-year bonds were yielding 8.5%. Today they are at 21.3%. It’s getting harder and harder to borrow money for Sri Lanka, but they have few other options as they have spent through their reserves. At the end of 2019 they had $7.6B in reserves , declining to $5.7B by the end of 2020, $3.1B by the end of 2021 and $0.05B now, or $50 Million.

Besides India, Sri Lanka’s best option is the IMF. As of last week, Sri Lanka’s government is seeking $6 billion to keep the country afloat for the next six months. This was increased from the $5 billion the finance minister Mr. Wickremsinghe told parliament that he would be asking the IMF for:

$3.3 billion for fuel imports

$900 million for food

$600 million for Fertilizer

$250 million for cooking gas.

Inflation

Sri Lanka has recently experienced high inflation (33.8% officially for April), which is only increasing, —39.1% for May, and likely over 40% currently. Food prices in Colombo, it’s largest city, have raised by 57.4% in May.

The government has also increased their Value Added Tax (VAT) by 50%, from 8% to 12%. Their corporate taxes are also increasing from 24% to 30%.

The Rajapaksa Family

The Rajapaksa family has been a powerhouse in Sri Lanka for decades and they are being blamed for many of the policies that have led to this crisis. Mahinda Rajapaksa, the former Prime Minister, resigned last month, and his brother Basil just resigned yesterday.

A state-run power entity, the Ceylon (salon) Electricity Board (CEB) has been planning a strike soon that, if enacted, will create blackouts. They recently agreed with the president to temporarily call off the strike, but meanwhile the capitol has still been experiencing rolling blackouts.

How did it get this bad?

1. Fertilizer Ban

2. 2019 Terrorism and Covid reducing tourism

3. Poorly timed tax cuts

4. Unnecessary infrastructure projects

5. General corruption and mismanagement

Sources:

https://www.reuters.com/markets/commodities/fertiliser-ban-decimates-sri-lankan-crops-government-popularity-ebbs-2022-03-03/

https://www.business-standard.com/article/opinion/is-sri-lanka-the-next-argentina-122040401320_1.html

https://www.nytimes.com/2018/06/25/world/asia/china-sri-lanka-port.html

Ben Bernanke recently wrote a guest essay in the New York Times where he compared the current inflation situation to the 1960s and 1970s inflation episode, which he called "The Great Inflation". Mr. Bernanke explained what he saw as the differences and similarities to our current inflation, and how we are "almost certainly not" going to repeat that experience.

His argument seems to hinge on two facts:

1.) The Fed currently has much more policy independence than it had in the 1960s and 1970s, so they will be able to do their job more effectively without presidents or Congress trying to meddle with their mandate, and;

2.) The American public has more confidence in the Fed keeping long-term inflation rates down, which makes us less vulnerable to a wage-price spiral which would keep inflation higher for longer.

With regards to the Fed's independence, I think that the Fed hasn't seen pressure from the President or Congress lately because their policy has been historically accommodative. The Federal Funds rate is at an almost all-time low while inflation is at 40-year highs. Back in "The Great Inflation" as Bernanke is fond of calling it, the Federal Funds Rate was between 4% and 8% during the times when the Fed and other policymakers butted heads. As interest rates rise, and the economic stakes rise, I don't know if we can count on the better angels of the President and of Congress to continue to respect the Fed's mandate.

As far as a wage-price spiral, we have a very strong labor market, and those labor market participants aren't going to not ask for compensatory raises to offset inflation because they believe in a vague way that the Fed is going to reign in inflation. They are more concerned with paying their bills now -- and with two job openings for every job seeker right now, employees are in the catbird seat for compensation negotiations. Ask yourself: would you be happy with a 3% raise this year?

Links:

Op-Ed:

https://www.nytimes.com/2022/06/14/opinion/inflation-stagflation-economy.html

https://www.richmondfed.org/publications/research/econ_focus/2016/q3-4/federal_reserve

Graph of Federal Funds Rate:

https://www.macrotrends.net/2015/fed-funds-rate-historical-chart

US BLS Job Openings:

https://www.bls.gov/charts/job-openings-and-labor-turnover/unemp-per-job-opening.htm

The Balance, Fed Funds Rate History:

https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135

For this episode I'm reading selections of two reports -- The World Bank's June 2022 Economic Prospects Report and David Wilcox's "The case for a cautiously optimistic outlook for US inflation." Links to both reports are at the end of the show notes.

Economic Prospects Report

The global economy is in the midst of a sharp growth slowdown following the extraordinarily strong rebound last year. This slowdown coincides with a steep run-up in global inflation to multi-decade highs. Looking ahead, growth over the next decade is expected to be considerably weaker than over the past two decades. Although global inflation is for now projected to return close to its 2019 average by 2024, there is a growing risk that it may remain elevated as global supply disruptions persist and some structural drivers that depressed inflation over the past three decades dissipate.

These developments raise concerns about stagflation—a period of both weak growth and elevated inflation similar to what happened during the 1970s. The experience of the 1970s is a reminder of the damage this could cause to the global economy and, especially, to emerging market and developing economies (EMDEs). The stagflation of the 1970s ended with a global recession and a series of financial crises in EMDEs.

There has been considerable debate about current stagflation risks. Some researchers have warned that the recent surge in inflation around the world could mark a permanent ratcheting up of price pressures after two decades of low and stable inflation. Some have also noted parallels between the current episode and the stagflation of the 1970s, including similarly negative real interest rates in both periods and the possibility of a wage/price spiral set off by rapid wage growth (Blanchard 2022; Summers 2022). However, others have pointed to material differences from the 1970s, especially in the conduct of monetary policy, which may help prevent another bout of stagflation: the inflation-fighting credentials accumulated since the 1980s and recent evidence of broadly stable long-term inflation expectations (Wilcox 2022).

This edition of the Global Economic Prospects report offers the first systematic assessment of how current global economic conditions compare with the era of stagflation of the 1970s—with a particular emphasis on how stagflation could affect developing economies. The insights are sobering: the interest rate increases that were required to control inflation at the end of the 1970s were so steep that they touched off a global recession, along with a string of debt crises in developing economies, ushering in a “last decade” in some of them.

The danger of stagflation is considerable today. Between 2021 and 2024, global growth is projected to have slowed by 2.7 percentage points -- more than twice the deceleration between 1976 and 1979. Subdued growth will likely persist throughout the decade because of weak investment in most of the world.

Links:

World Bank Global Economic Prospects Report:

https://openknowledge.worldbank.org/bitstream/handle/10986/37224/9781464818431.pdf

David Wilcox's Report (Peterson Institute for International Economics), "The case for a cautiously optimistic outlook for US inflation"

https://www.piie.com/publications/policy-briefs/case-cautiously-optimistic-outlook-us-inflation

Cleveland Fed Inflation Expectations:

https://www.clevelandfed.org/our-research/indicators-and-data/inflation-expectations.aspx

My Twitter Thread with questions for David Wilcox:

https://twitter.com/InflationPod/status/1536072114742124545?s=20&t=G5-WlEU0xGYPQqXb9RqWKQ

Inflation was expected to “remain elevated” ahead of today’s announcement, but instead it roared ahead to a 40-year high to 8.6% from 8.3% last month.

Groceries are up 11.9% year-on-year, gas is up 48.7%.

For the last few months, we have March: 8.5%; April 8.3%, May: 8.6%.

Analysts were hoping that that the 8.5% in March was going to be the all-time high and we were going to taper from there, but it’s looking like we may not have even topped out yet.

Also, it’s worth noting that prior to 1980, the CPI was simply the cost of a basket of goods. Now we have substitutions, Owner’s Equivalent Rent, and adjustments for quality improvements which, in my mind, are questionable.

Trueflation is reporting just under 10.75% for the last 12 months (https://app.truflation.com/)

It’s going to be painful to reverse this inflation, because debt loads are higher than they were the last time we saw inflation this high in the 1970s and 1980s. Back then the rates for 10-year T bills had to be raised to 15% to finally tame inflation. Now we think that raising them to 3% is going to do the trick? I think people are in for a big surprise.

The next issue is that our Debt/GDP is much higher now than it was in the 1970s. Can you imagine the balance on your mortgage going up at the same time as your interest rate was increasing from 3% to, say, 9%? Another bitter pill.

In March 2022, total receipts for the government were $315 Billion and net interest was $43 Billion. That’s 13.6% of the taxes collected going to debt service. This is at a borrowing cost of ~1.6%. If the borrowing cost increases to 5%, nearly half of our national income will be going towards debt service. In order to snap out of this current inflation, we need to embrace some sort of austerity while simultaneously raising interest rates and slowing the economy down. This is a bitter pill to swallow, and I don’t think we’ll do it.

Global Sovereign Debt

https://www.cnbc.com/2022/04/06/global-government-debt-set-to-soar-to-record-71-trillion-this-year-research.html#:~:text=Global%20government%20debt%20jumped%207.8,1.6%25%2C%20the%20report%20said.

“Even if politicians were to attempt to take the pure austerity route and cut spending programs and let system-wide defaults happen, the economy gets more and more painful, and after a few years, people vote those politicians out of office in favor of politicians promising stimulus.”

Episode 2: Why are gas prices getting so high? Will we see $10 gasoline?

Gasoline is something that economists call a relatively inelastic product, meaning that changes in price have little influence on demand, at least in the short term. This makes sense, as much travel isn’t discretionary (commuting, etc.). In contrast, air travel is highly elastic, with a 10% increase in the price of air travel leading to an around 12% reduction in the demand for air travel. With car gasoline purchases it is closer to 3.4% reduction for a 10% increase. There has been some recent data suggesting it’s becoming more elastic, but now we’re getting into the weeds.

So, what this is all getting to is that when gas gets more expensive, people still have to buy it in the same quantities, for the most part.

How much more expensive has gas become?

As of recording, the average gas price in the USA is $4.85 cents per gallon for regular and $5.63 per gallon for diesel. The most expensive state is California at $6.33 per gallon.

A year ago, regular gasoline was $3.05 average in the nation and $4.22 in California. That represents a 59% increase YoY.

What causes the state’s variation in prices?

Some states tax gas more heavily than others — California for example has a 61 cents per gallon tax, whereas Alaska only charges 14.6 cents per gallon. There is also a federal tax of 18.4 cents per gallon. The distance to a refinery also makes a difference, because that gas at the gas station has to be hauled in, one way or another. Some states (such as CA) also have certain blend requirements that can also drive up price.

Okay, so what can the government do about it?

Lyn Alden is one of the clear voices on inflation and macroeconomics that I follow. She has been saying lately that the government can print money, but they can’t print oil.

In the last episode we heard from President Biden that he announced on March 31st that he would be releasing 1MM barrels a day from the nation’s Strategic Petroleum Reserve. This will be the biggest withdrawal in the 46-year history of the reserve. In this speech Biden also blamed oil companies for leaving drilling prospects idle — this doesn’t make a ton of sense because his administration recently announced (after his March 31st speech) that the Biden Administration will not hold a lease sale for offshore drilling this year. They are also letting a 5-year plan for offshore drilling expire next month.

This prompted Frank Macchiarola Match-E-Roll-A of the American Petroleum Institute to respond: “Unfortunately this is becoming a pattern— the administration talks about the need for more supply and acts to restrict it. As geopolitical volatility and global energy prices continue to rise, we again urge the administration to end the uncertainty and immediately act on a new five-year program for federal offshore leasing.”

Links:

AAA Gas Prices: https://gasprices.aaa.com/

Strategic Petroleum Reserve: http://www.spr.doe.gov/dir/dir.html

DOE Strategic Petroleum Reserve Fact Sheet: https://www.energy.gov/fecm/strategic-petroleum-reserve-9

Air travel price elasticity of demand (IATA): https://www.iata.org/en/iata-repository/publications/economic-reports/air-travel-demand/

https://divestmentdatabase.org/

https://www.bloomberg.com/news/articles/2022-06-01/uk-windfall-tax-hits-north-sea-focused-oil-firm-valuations#:~:text=The%20UK%20government%20announced%20May,commit%20to%20fresh%20capital%20expenditure.

https://www.marketwatch.com/investing/future/brn00?countrycode=uk

https://www.wsj.com/articles/a-decade-in-which-fracking-rocked-the-oil-world-11576630807