Episode 133: The Inflation Equation with David Stockman

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This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:

Welcome to the Wealth Ability Show, where we’re always discovering how to make way more money and pay way less tax. Tom Wheelwright, your host, founder, and CEO of Wealth Ability. So, inflation is supposedly on the downturn here. Is it really? Is it going to continue? And what can we do about it?

We have an expert on this topic, David Stockman, former budget director for Ronald Reagan and Washington Insider and Wall Street Insider. David just written a new book. So, tell us a little bit about why you wrote this book and what you’re looking at here.

David Stockman:

Well, the title is The Great Money Bubble. I think that links pretty clearly to your point about the inflation. But the theme of the book is inflation didn’t just appear in the last year, 12 months. It’s not peaked, it’s not going away rapidly. But to the contrary, Federal Reserve Policy, and then on top of that, the borrow and spend policies of Congress have built in an inflationary tidal wave that I think is going to last for quite a while and will require some very Draconian monetary restraint by the Fed to bring it to heel.

So, the theme of the book is, how did we get here? 30 years of history, not three months or a year of argument about Fed policy. The answer is, just go to the point when Alan Greenspan became Fed Chairman. Some people may remember that. It was August, 1987. If we look at the balance sheet of the Fed, which basically is a measure of how much money it’s printed over time, kind of the cumulative print, if you want to put it that way. It was $200 billion, and the GDP was $5 trillion, kind of the historic ratio of Fed balance sheet, a few percent of GDP.

Now, here we are, a little more than 30 years later, the balance sheet of the Fed peaked recently at $9 trillion, and the GDP was only 25 trillion. To reduce it down, the Fed’s balance sheet grew by 45-fold during that three-decade period, whereas the GDP increased by only five-fold.

Now, I think if people think about that proposition that the balance sheet of the Fed, the money that they’re printing and injecting into the economy, grew nine times faster than the GDP, and not for a month or two months or two years, but for more than three decades, then you can see that something is badly out of balance, and why we’ve built in this huge inflationary bubble that first ended up in the financial markets with stock prices and bond prices being inflated way beyond their sustainable levels. Then basically worked its way into the global economy and finally came roaring back to the US when the supply chain broke down owing to the Covid disruption.

So, that’s how we got here. And until the Fed fundamentally changes its ways and Washington starts to embrace prudent economics, we’re going to have one economic crisis, in my view, after another.

Tom Wheelwright:

Well, if we can, let’s break this down a little bit for our listeners. Our listeners are primarily entrepreneurs and investors here, so not economists. And so help us understand what impact, why does the Fed’s balance sheet… This is money that the Feds created, right? They [inaudible 00:04:26] put this money on their balance sheet. They just kind of printed the money, so to speak. Why do you think that has such a big impact on inflation, and why aren’t we seeing greater inflation, if it does have such a big impact?

David Stockman:

Well, it has a big impact, but it works through the financial markets with a lag. And the point that I’m making is that when the Fed increases its balance sheet by more than almost $9 trillion, it’s essentially injecting $9 trillion of demand into the world economy with no additional supply.

And so demanded and supply gets way out of balance, and pretty soon it ends up in rising prices. But in the initial instance, this massive Fiat credit produced by the Fed never left the canyons of Wall Street. It got absorbed by speculators and traders and leveraged arbitrage artists who took that cheap money that the Fed was injecting into the financial markets, used it to buy assets that we’re appreciating, and thought they were going to live happily ever after.

Now, that’s why, for instance, if we look at the crisis in 2007 and ’08, if we look at the growth of the stock market, and I use the NASDAQ 100 as kind of a benchmark because it’s really the leading edge of the stock market of the big tech companies, of the growth sector, so-called, from the bottom in December 2008 to the high early in 2022, the NASDAQ 100 rose by 1250%. During the same period, the GDP rose by 55%.

Now again, you have to go to basic economics 101. It doesn’t require a PhD in economics to question whether the economy can… I mean, whether the stock market can sustainably grow 23 times faster over nearly a decade, or more than a decade, than the GDP. Because remember, the GDP is just a proxy for the wages, salaries, and profits that are being generated by the American people. And how in the world can you have 23 times more value in the stock market than you have wages, salaries, profits, and output in the mainstream economy? You can’t. Again, that’s another measure of how the inflation occurred, this time, in financial assets.

Tom Wheelwright:

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Yeah, so let’s talk about that difference because we have price inflation, asset inflation, which we’ve seen in the housing market, we’ve seen in the stock market, we’ve seen in asset prices generally. We haven’t seen it until recently in consumer goods, right? Why has it taken so long for there to be any kind of significant inflation in consumer goods, and why is that inflation coming down?

David Stockman:

Okay. First of all, I’m not sure the inflation is coming down. You’re looking at short-term movements in the, let’s say, the CPI. But what I did recently in the newsletter that I post every day was to say, “Wait a minute, let’s look what happened from the spring of 2021 through early 2022 to commodity prices and manufacturing components of the CPI versus services,” and maybe we’ve got some perturbations in there that we need to look through.

And so what I did was take the rate of CPI increase on a two-year stacked basis. And what I mean by that is we go back two years and look at the annual rate of growth between, let’s say, December, 2022 and December ’20, and write that down. And then do that for November and October and so forth.

What we find is that the CPI on a two-year trend basis, where we took out some of this extreme whipsawing, yo-yoing, as I call it, never rose at 9%, as they say it did in June, the one-year rate a little under 7%. And by December it was still rising at 7%.

In other words, what the two-year stacked analysis shows is that inflation is pretty much plateaued around 7%. But not withstanding the Fed raising the interest rate from essentially zero to 4%, the inflation rate is now plateauing at an unsustainable 7%. You can’t have 7% inflation year in and year out and have, for instance, the 10 Year Treasury, this very moment, trading a 3.5%.

I mean, what kind of sense does that make? That’s almost a negative 4% real yield. So, basically the Fed is not nearly done raising rates. It’s going to take much higher rates to bring this inflation to heel. It’s not coming down, if you really look at the underlying trend of the numbers. And it’s going to take a pretty rip-roaring recession in 2023, maybe into 2024, to finally bring it to heal because the Fed is not nearly done. That’s my first point. The second point is-

Tom Wheelwright:

Let me stop you there just for a second, David. The market seem to think that the Fed’s almost done because they’re pricing in that… We don’t have a tumble in the stock market right now, and they’re thinking that the Fed’s not going to continue raising rates aggressively. How high do you see the Fed needing to raise rates in order to bring that inflation back down to that 2% range?

David Stockman:

I would say 7% to 8% or maybe more. And I base it on my experience in the late ’70s when I was a member of Congress and then the Reagan administration when I was budget director beginning in ’81, and what Volcker had to do to bring inflation to heel back then. When he became Fed chairman out of desperation, Jimmy Carter was desperate. Inflation was in double digits in 1979, so he became chairman in August, 1979.

If you look at the real rate on the 10 Year Treasury, when he became Fed chairman, it was negative 2%. In other words, inflation was running 10, the yield was eight, it was negative 2%. He had to raise rates for the next 24 to 30 months continuously and aggressively, until he got the real rate from negative two to positive nine. I mean, that is a huge… If you had to do that today, it would imply a treasury rate of around 15%.

Well, I’m not predicting that or suggesting it’s necessary, but what I am suggesting was the fundamental truth that Paul Volcker operated on and got people finally to understand in the early ’80s, was you can’t break the back of inflation and the speculation that underlies it, if you have negative real rates. You’ve got to have strongly positive real rates.

Now, where are we today? Well, I just said, inflation is still running on a trend basis, 7%. The treasury 10-year bond, the benchmark for the entire system, is 3.5. That’s negative 3.5. They’ve got a long way to go to get to the Volcker standard. And so therefore, the market is always right in the moment, except it changes its mind every three seconds. So, the point I want to make here is the market has been pricing in the Great Fed Pivot over and over and over since the market peaked in January, 2022.

And the pivot keeps getting deferred in time as the facts become more apparent, and as even the Fed heads put out their missives and speeches warning people, “Don’t think that we’re going to pivot tomorrow,” and the markets can’t seem to let go of that theme because, and here’s the reason, and it goes back to the fundamental point of my book, the 30 Years of Money Printing, the market has been house trained to think that the Fed will never allow financial markets to normalize, interest rates to normalize, or the stock market to correct seriously and sustainably.

And so therefore, they keep making up excuses for why the Fed is almost done and about ready to pivot to rate reductions. Of course, that’s all priced in, but if you look at what the short-term markets have been pricing in for the funds rate, the federal funds rate, they’ve been wrong and repricing constantly for the last year, and I think they’re going to be wrong for a good while yet to come.

Tom Wheelwright:

If I can, let me break this down a little bit just going back to the basic premise that inflation is too much money chasing too few goods, just that fundamental… And understanding that the Fed, when they had that money on their balance sheet, that money’s going into treasury bonds, presumably, and that’s how it’s getting into the economy. When they raise interest rates, how is it coming out of the economy?

So, if you’ve got too much money and you’re trying to reduce the amount of money, how does raising the rates, if you can just explain this for listeners, how does raising rates take money out of the economy?

David Stockman:

Well, two things. They’re doing two things. I think you got to link them together. They’re raising the rate and they’re implementing QT, quantitative tightening. And QT means that essentially they’re draining $95 billion a month out of the financial markets. That is, their balance sheet is shrinking because as bonds mature, instead of extending them, they mature, and the Fed’s balance sheet shrinks by that amount. So, they’re basically draining from the bond pits, supply and demand where bonds are priced, $95 billion a month.

And in my judgment, that is far more important in terms of the battle that they’re trying to wage against inflation, than just raising the rates. Now, on the other hand, as they raise rates, they make it more painful for borrowers who are on variable rates or short-term loans and have to roll over their position. They’re making it more painful for people to keep that much debt outstanding.

And there was a great piece recently in the Wall Street Journal about how big time commercial real estate investors thought they were being very smart by funding their purchases of rising office building values or mall values on variable rate loans. It didn’t cost anything. I mean, it was practically a rounding error, but their lenders required them to buy rate caps. So, in the unexpected event that rates went up, the cap would protect the lender.

But these rate caps were short-term. And as the rate caps now expire and they have to roll them over, the cost of a one-year rate cap to keep their loan intact is 10 to 30 times higher than it was a year ago or two years ago. What I’m saying is, this is just one example, but the effect of it is going to force people to sell buildings, sell assets, reduce their loan position. And when the selling starts, that contributes to the deflationary dynamic.

Tom Wheelwright:

Got it. Because at that point, the loan’s going away and you’re taking the money out of the market.

David Stockman:

And when the loan is going away, you’re taking the money out of the market, but also on the margin, the sales that will be made by people that are… asset sales, that are being forced to liquidate their funding, their loans, will drive down average prices, which will discourage investors and speculators from starting new bills, from making new investments.

It’s bad enough in the office sector already or strip malls and much else of commercial real estate. But as the liquidation of loans, because of rapidly rising interest carry costs accelerates, the sales are going to accelerate, prices are going to fall, and economic activity in that sector will be curtailed.

Now, that’s just one sector. Commercial real estate is important, but it’s not the whole GDP. But the point is, this is illustrative of what happens when you reverse the easy money debt dynamics of what we’ve had for the last 30 years.

Tom Wheelwright:

Let’s talk about this coming recession then that you’re talking about. What do you see the tipping point is going to be to really plunge into that recession, and how deep do you see that recession going?

David Stockman:

Well, I think it’s very hard to predict exactly how deep, but I think it’s pretty apparent that we went through an aberration with the Covid lockdowns, and the massive Covid so-called recovery spending that occurred in response. There was $6 trillion in three different bills from March ’20 to March ’21.

Now, the effect of this was to totally unsettle the labor market, and it created a condition where millions of people left the labor market because they were getting all their STEMI checks. They were getting 600 a week on top of their regular unemployment. They were taking early retirement. They were suddenly finding they had Carpal tunnel and got on disability, food stamps, housing, the rest of it.

But millions of people left the labor market. And as a result of that, employers suddenly found a much tighter situation in terms of filling their current open positions, as well as expected open positions. And what I think happened over 2020 through 2022 was HR departments, especially in Silicon Valley and in the tech sector, began to hire preemptively, began to hoard labor because they went through this trauma of not being able to hire when they needed.

So, what I think we have out there now is a tremendous excess inventory of labor, especially in the big companies and especially in the tech sector. But quite generally, because HR departments began to do this across the board, that suddenly they’re going to start realizing that they’ve way overstocked their labor, they’ve way over hoarded. And they’re going to begin to reverse policy quite unexpectedly and quite dramatically.

Maybe we had a recent example of that when Microsoft announced that they’re going to lay off 10,000 people, which supposedly wasn’t going to happen. And the same thing is true with recent announcements by a lot of the other tech companies as well.

I think what we’re going to get over the next few months, maybe this is what you’re looking for as the tipping point, is a sudden reversal of hiring practices, especially among the Fortune 500, and layoff announcements, because they basically are stuck with unproductive labor that’s hitting their earnings.

A good example of that recently was Salesforce. They laid off 10% of their workforce. That’s a lot. Of 75,000 people, they laid off 10% of them because essentially their earnings have been shellacked by the carry of excess labor. Everybody else is going to figure that out as well, and that’s where it’ll start. Then, once the layoffs start and we get some big unemployment numbers, it’ll begin to work its way through the psychology of the main street, as well as the Wall Street economy.

Tom Wheelwright:

So, the labor reports, what we’re looking for here, that’s your indicator.

David Stockman:

Yeah, but I might say not just the monthly BOS, because the BOS Labor Report is hardly worth the paper it’s printed on. It’s a lagging indicator. There’s all kinds of Mickey Mouse shenanigans that go on in terms of how it’s formulated.

But if you look at the daily announcements of layoffs and labor force adjustments, you can see it’s beginning to happen already. And that’s the thing to watch, not just the monthly BOS. The BOS will catch up with the lag. So, to stay ahead of the game, it’s important to remember that we’re way over-hired, we’re way over-hoarded on the labor front, and that balloon or that bubble is about ready to bust.

Tom Wheelwright:

Okay. The subtitle of your books is Protect Yourself from the Coming Inflation Storm. What are your recommendations for investors to protect themselves from what’s coming?

David Stockman:

Well, I think twofold. One is the name of the game, after all, is net worth. That is the difference between your assets and liabilities, not just assets. And that the game going forward will be more to focus on the liabilities and reduction of liabilities, because you’re going to pay interest on those. And the interest rates are going to be continuing to climb, I think, quite substantially as we’ve discussed. Rather than the game of the last 30 years, which has been borrow cheap money, buy assets and capture the difference between rapidly appreciating assets and cheap liability.

The first thing, that’s a big change, that’s an epical change. That is a change in the fundamentals to a liability reduction focus, rather than an asset appreciation focus. The second thing is not to fall for the Wall Street story that the pivot is near, that the bottom is almost in, and now’s the time to back up the truck, as Jim Kramer might say, and buy these beaten up stocks.

No, the stocks are not beaten up nearly enough. The market today is at 38, 3900, the S&P 500. It’s got a long way down to go before we get back to some kind of sustainable PE ratio.

Tom Wheelwright:

I got one final question for you.

David Stockman:

Sure.

Tom Wheelwright:

Shifting a little bit to the crypto market, which has seen very big increases in the last couple of weeks, do you see that also being kind of a false indicator that will also turn like the stock market will?

David Stockman:

Yeah, I think the crypto market, unfortunately, and I don’t like government money, and I’m a violent almost critic of the Fed. So, when the crypto coins came along, I said, “Good. Private money, that’s what we ultimately ought to go for.”

But the Fed has so corrupted the financial system with all this easy liquidity and all this easy, low interest rate borrowing that the speculators simply said, “Oh, we like the crypto coins. It’s just another asset class that we can dive into, borrow money, buy the asset, watch it go up, and make another killing.” And they wrecked the crypto market. The crypto market now is just a dangerous subsidiary of Wall Street.

And so as Wall Street has had a bit of a recovery since December, the crypto market has as well. But as soon as the Wall Street goes into its next stock market dive, the cryptos will go right with them.

Tom Wheelwright:

Got it. The book is The Great Money Bubble: Protect Yourself From the Coming Inflation Storm. And David, it’s been a pleasure. Any final words for our listeners?

David Stockman:

Well, I think the best final word is: the game has changed, and so therefore, everything that worked, that seemed true, that you became accustomed to over the last decade or three decades, is now inoperative. We’re in a new ball game and it’s a dangerous one. And so people need to think about protecting their assets rather than speculating for higher gains.

Tom Wheelwright:

Awesome. Thank you very much.

David Stockman:

Okay.

Tom Wheelwright:

Again, David Stockman, you can find him at DavidStockmansContraCorner.com. Did I get that right?

David Stockman:

That’s correct. That’s correct.

Tom Wheelwright:

And the book, again, is The Great Money Bubble: Protect Yourself From the Coming Inflation Storm. This is just more financial education. We really do need to understand the macro version of what’s going on, if we’re going to understand what we do in our own micro investing. And when we do that, we’ll always make way more money and pay way less tax. Thanks everyone.

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