Why the Drivers of Lower Inflation Matter
Competing effects of central banks, healing supply chains affect recession odds
Competing effects of central banks, healing supply chains affect recession odds
Recent good news on inflation has ignited a debate over how much central banks’ interest-rate increases are responsible.
The answer matters for where inflation and interest rates are headed. The Federal Reserve and the European Central Bank in the past week lifted their benchmark interest rates to 22-year highs and left the door open to additional increases.
If higher rates weren’t responsible for the progress on inflation to date, that suggests central banks may be able to lower them before a painful recession sets in.
Central banks generally see their influence on inflation coming through higher rates damping the demand for goods, services and workers, which leads to higher unemployment. That in turn puts downward pressure on prices and wages.
Only the second part of that sequence has occurred. Inflation fell to 3% in the U.S. in June, according to the Fed’s preferred gauge, the personal-consumption expenditures price index, down from 7% one year earlier. Yet the unemployment rate, at 3.6% in June, has held steady for the past year.
In the eurozone, inflation declined to 5.5% in June, the lowest level in nearly 18 months, and unemployment has drifted to the lowest in more than 25 years.
There are competing explanations for this.
One camp argues that inflation has been mostly driven by supply shocks that are going away on their own—much as a postwar surge in the late 1940s unwound by itself. The ripple effects gave the illusion of broader, more persistent price increases.
Take the auto market. Sellers weren’t able to meet pent-up demand two years ago, leading to huge price increases, which in turn spawned higher prices later on for car repairs and auto insurance.
Similarly, a surge in household formation during the pandemic sent up housing prices and rents.
The first camp attributes most of the recent decline in inflation to the ebbing of these one-time supply disruptions, not rate increases, which are supposed to work through the labor market. “It’s calling into question a lot of the old assumptions,” said Lindsay Owens, executive director at the Groundwork Collaborative, a liberal think tank.
A second camp, which includes most economists, disagrees. They say monetary policy kept demand for goods, services, and labor lower than otherwise, taking pressure off strained supply chains and allowing price pressures to ease.
Interest rates can also influence behaviour. The prospect that central bankers would risk a recession to bring down inflation may have influenced expectations of price- and wage-setters, including corporate executives who plan annual budgets for investment and hiring.
Jamie Dimon, chief executive of JPMorgan Chase, warned one year ago of an economic “hurricane” as central banks accelerated rate increases. “You’d better brace yourself,” he said in June 2022, and pledged the bank would be “very conservative” with its balance sheet.
“Inflation is coming down precisely because the Fed avoided more excess demand growth, and they anchored inflation expectations,” said Angel Ubide, head of economic research for global fixed income at Citadel, a hedge-fund firm.
Inflation would be higher now if not for Fed rate increases, “and maybe still rising,” said Karen Dynan, an economist at Harvard University.
In 2021, supply-chain constraints meant even marginal increases in demand led to unusually large price increases. The reverse might be true now: Marginal decreases in demand can bring down prices faster, particularly if more supply is becoming available.
The car market illustrates how monetary policy has been transmitted. Rising rates raised monthly payments, damping demand and robbing sellers of pricing power. In addition, since March, banks appear to be rejecting more car-loan applications.
“That’s leading to a new group of people getting squeezed out of the market, and therefore, it’s playing a role putting downward pressure on prices,” said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives.
In Europe, economic growth has stalled since late last year. Business surveys in the past week suggest that growth is weakening sharply, especially in manufacturing, which is most sensitive to interest rates.
The net share of banks reporting increased loan demand declined to a record low in the three months through June, according to an ECB survey of banks. Credit growth to households is the lowest since mid-2016.
Asked at a news conference on Thursday about the transmission of ECB rate increases to growth and inflation, President Christine Lagarde said that in the financial system, “a lot has been transmitted. A lot. We know that. In the economy at large, not as much yet.”
A report published by German insurer Allianz identifies three different forces on the U.S. inflation rate since the second quarter of 2022. Higher inflationary pressures from consumption growth, strong labor markets and government spending added 4 percentage points; fading supply-chain disruptions subtracted five points, and Federal Reserve actions subtracted another five. The net impact was that inflation fell 6 percentage points, whereas it would have fallen only one point without the Fed’s actions.
Fed Chair Jerome Powell said rate increases are “working about as we expect, and we think it’ll play an important role going forward” in bringing down prices for the most labor-intensive services.
Monetary policy has also affected the labor market, but this has shown up in declining job-vacancy rates rather than rising unemployment, some economists say.
Hiring plans in the eurozone services sector are dropping rapidly, according to a survey this month by the European Commission, the European Union’s executive body.
“The labor market is normalising on both sides of the Atlantic, reflecting the impact of higher rates,” said Stefan Gerlach, a former deputy governor of Ireland’s central bank.
The debate over the effect of rate increases also matters for how much further, if at all, central banks need to lift them. Optimists underestimated how much strong demand lifted inflation two years ago. Pessimists may be overestimating the importance of constraining demand to bring it down now.
Gerlach expects inflation to continue declining as higher rates sap demand. “I’m worried central banks have done too much,” he said. “They may have felt embarrassed about having misunderstood inflation the first time.”
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When will Berkshire Hathaway stop selling Bank of America stock?
Berkshire began liquidating its big stake in the banking company in mid-July—and has already unloaded about 15% of its interest. The selling has been fairly aggressive and has totaled about $6 billion. (Berkshire still holds 883 million shares, an 11.3% interest worth $35 billion based on its most recent filing on Aug. 30.)
The selling has prompted speculation about when CEO Warren Buffett, who oversees Berkshire’s $300 billion equity portfolio, will stop. The sales have depressed Bank of America stock, which has underperformed peers since Berkshire began its sell program. The stock closed down 0.9% Thursday at $40.14.
It’s possible that Berkshire will stop selling when the stake drops to 700 million shares. Taxes and history would be the reasons why.
Berkshire accumulated its Bank of America stake in two stages—and at vastly different prices. Berkshire’s initial stake came in 2017 , when it swapped $5 billion of Bank of America preferred stock for 700 million shares of common stock via warrants it received as part of the original preferred investment in 2011.
Berkshire got a sweet deal in that 2011 transaction. At the time, Bank of America was looking for a Buffett imprimatur—and the bank’s stock price was weak and under $10 a share.
Berkshire paid about $7 a share for that initial stake of 700 million common shares. The rest of the Berkshire stake, more than 300 million shares, was mostly purchased in 2018 at around $30 a share.
With Bank of America stock currently trading around $40, Berkshire faces a high tax burden from selling shares from the original stake of 700 million shares, given the low cost basis, and a much lighter tax hit from unloading the rest. Berkshire is subject to corporate taxes—an estimated 25% including local taxes—on gains on any sales of stock. The tax bite is stark.
Berkshire might own $2 to $3 a share in taxes on sales of high-cost stock and $8 a share on low-cost stock purchased for $7 a share.
New York tax expert Robert Willens says corporations, like individuals, can specify the particular lots when they sell stock with multiple cost levels.
“If stock is held in the custody of a broker, an adequate identification is made if the taxpayer specifies to the broker having custody of the stock the particular stock to be sold and, within a reasonable time thereafter, confirmation of such specification is set forth in a written document from the broker,” Willens told Barron’s in an email.
He assumes that Berkshire will identify the high-cost Bank of America stock for the recent sales to minimize its tax liability.
If sellers don’t specify, they generally are subject to “first in, first out,” or FIFO, accounting, meaning that the stock bought first would be subject to any tax on gains.
Buffett tends to be tax-averse—and that may prompt him to keep the original stake of 700 million shares. He could also mull any loyalty he may feel toward Bank of America CEO Brian Moynihan , whom Buffett has praised in the past.
Another reason for Berkshire to hold Bank of America is that it’s the company’s only big equity holding among traditional banks after selling shares of U.S. Bancorp , Bank of New York Mellon , JPMorgan Chase , and Wells Fargo in recent years.
Buffett, however, often eliminates stock holdings after he begins selling them down, as he did with the other bank stocks. Berkshire does retain a smaller stake of about $3 billion in Citigroup.
There could be a new filing on sales of Bank of America stock by Berkshire on Thursday evening. It has been three business days since the last one.
Berkshire must file within two business days of any sales of Bank of America stock since it owns more than 10%. The conglomerate will need to get its stake under about 777 million shares, about 100 million below the current level, before it can avoid the two-day filing rule.
It should be said that taxes haven’t deterred Buffett from selling over half of Berkshire’s stake in Apple this year—an estimated $85 billion or more of stock. Barron’s has estimated that Berkshire may owe $15 billion on the bulk of the sales that occurred in the second quarter.
Berkshire now holds 400 million shares of Apple and Barron’s has argued that Buffett may be finished reducing the Apple stake at that round number, which is the same number of shares that Berkshire has held in Coca-Cola for more than two decades.
Buffett may like round numbers—and 700 million could be just the right figure for Bank of America.
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