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Why inflation may be a good thing for U.S. economy, unless stagflation hits

Not only are you paying more for stuff than a year ago, but the consistently higher-than-expected readings in the Consumer Price Index continue to devastate the stock market, sending the S&P 500 down over 1,000 points on Tuesday, its worst day since June 2020

One of America’s top financial historians says this moment calls for a lesson in economics.

“The reopening inflation we’ve had has so far been a very good thing,” Brad DeLong, a professor at UC Berkeley, told Fortune. His comments contradict the more hawkish stance on inflation famously championed by Harvard economist Larry Summers, who worked alongside DeLong in the Department of the Treasury during the Clinton administration.

DeLong argues that there is a major economic shift taking place that people should welcome. It all has to do with our strange but kind of wonderful post-pandemic economy.

The Zoom world

The new economy, DeLong says, is one with more time spent online, fewer jobs requiring in-person interactions, and a substantially higher rate of goods production.

It’s like we have zoomed decades into the future in just a few years.

“A couple of decades,” DeLong said when asked about how many years of economic change have been crunched into just over two: “A couple of decades of structural change and social and economic learning about how to be online as a permanent thing.”

“Fewer in-person workers in retail establishments, a lot more delivery orders, substantially more goods production, and also substantially more information entertainment and production as well,” is how DeLong described his vision for the new economy during a separate interview with Fortune last week covering his new book, Slouching towards Utopia. The meeting took place over Zoom, DeLong noted, proving his point.

Inflation in the U.S. is currently serving two functions that could help the economy in the long run, according to DeLong: helping expand new economic sectors poised for big growth, and uncovering and optimizing supply chain snags that have been with us since the beginning of the pandemic.

Unemployment is now at its lowest point since before the pandemic, but the full employment we are returning to is not the same as the one we left behind in 2020, DeLong said. 

“We want to get back to a full employment economy quickly. But it’s a very different full employment economy when we get back there,” DeLong said.

Moving workers away from industries like retail and hospitality and into expanding sectors needs to come with incentives in the form of higher wages, according to DeLong, which means inflation.

“If you want to create economic incentives for people to move into the expanding sectors where we actually need more workers, their wages have to go up,” he said. 

“When you’re coming out of a big recession, the natural rate of inflation has got to be above the normal 2%,” he added. “The rate of inflation that the market really wants to see in order to get production and distribution and transportation into an efficient allocation has to be more than 2%.”

In addition to helping bring the economy into the new era, DeLong sees another benefit of inflation today: it could help resolve crippling supply chain bottlenecks, resorting to the economic adage that high prices are often the best cure for high prices.

With supply chain issues contributing to high prices and making people less likely to buy, it could be the impetus behind a revitalization and ultimately a strengthening of industry, according to DeLong, who says inflation is involving more people with figuring out either how to produce more of what we need, or less of what we don’t.

“That’s the absolutely glorious thing about the market,” he said. “That when prices are aligned with social values, it means that you don’t just have one brain or a few brains working on the problem. Everyone’s brain is working on the problem. And everybody does what they can to solve it in their immediate circumstance.”

But as always, there’s a catch.

Stagflation risks

The positive outlook for inflation does come with a caveat, DeLong and other economists admit. Expectations that inflation will become entrenched in the economy and stick around might become a self-fulfilling prophecy, which would lead to something even worse for the economy. 

The word for that is stagflation: the worst-case scenario of slow economic growth combined with high inflation. DeLong says it is still very possible.

“Worst of all is you get stuck in the stagflation of the 1970s,” he said. “If inflation gets entrenched in expectations, it will be a very bad thing.”

The ideal situation, DeLong says, would be a repeat of the recessions that hit the U.S. in the late 1940s and early 1950s, both of which were relatively short before inflation subsided.

But a worst-case scenario of stagflation also remains possible, DeLong warned, especially if expectations of inflation become entrenched in the economy.

“Entrenched” has been a bogey word for the Fed this year, and a situation it desperately wants to avoid. Entrenched inflation refers to people expecting prices to keep going up, which can lead to inflation staying around much longer than it would otherwise.

Should inflation become entrenched during a recession, it would be a “very bad thing” for the economy, DeLong said. Whether this will happen will likely depend on the direction gasoline and energy prices take, which have been highly unpredictable so far this year.

“Whether or not expectations get entrenched and we get a 1970s problem really depends on the trajectory of energy prices,” he said. “Inflation expectations are always driven by what people see at the pump.”

Top economists and bankers—including Allianz and Gramercy’s chief economic adviser Mohamed El-Erian and Goldman Sachs CEO David Solomon—have warned that inflation is already becoming entrenched and persistent around the world. And the World Bank has issued multiple warnings this year that persistent inflation combined with slow economic growth is leading to a very real risk of stagflation in multiple countries around the world.

Also, not every economist shares DeLong’s view that there is much good at all about the current inflation, with many saying it is a much more pressing issue that the government is failing to adequately control. 

Steve Hanke, an economist at John Hopkins University, recently criticized the Fed for “incompetence and mismanagement” that has led to inflation, and predicted that the Fed letting the U.S. money supply run short could lead to a “whopper” of a recession next year.

DeLong’s old boss Larry Summers has been singing a dire tune on inflation for over a year, warning last year that the Federal Reserve was being too passive about rising prices. At the release of this week’s CPI report, Summers wrote that the Fed was faced with a “serious inflation problem,” and cautioned that unemployment will likely have to start ticking upward before inflation recedes significantly.

Many economists fear that today’s high levels of inflation, and the Fed’s commitment to containing it, could trigger a recession as early as next year, although the jury is still out on whether this would constitute a deep or shallow downturn. 

In a blog post last year, when inflation was already becoming a source of concern, DeLong compared the recovering U.S. economy to a driver suddenly accelerating away. The skid marks left on the asphalt represented inflation—a blemish and a nuisance to be sure—but worth it to get the economy back on track. 

A year later, inflation can still just represent a temporary skidmark on the road to recovery, he says. But between the war in Ukraine and uncertain energy markets for the foreseeable future, DeLong admits the outlook is much cloudier now.

“We have energy price inflation and food price inflation springing from Russia and its attack on Ukraine. That is greatly complicating the picture and making the situation much more fraught,” he said.



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Santos gets $1.4B offer for PNG LNG stake from Papua’s state oil company (OTCMKTS:STOSF)

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Santos (OTCPK:STOSF) said it received a binding conditional offer from Kumul Petroleum Holdings, Papua New Guinea’s national oil and gas company, to buy a 5% interest in the PNG LNG liquefied natural gas project for US$1.4B plus ~$300M in project finance debt.

Santos (OTCPK:STOSF) said Kumul paid $55M to be held in escrow to secure the offer, which will remain open for acceptance until December 31 and is conditional on Kumul obtaining waivers on some pre-emptive rights by other PNG LNG project partners.

With the sale of a 5% stake, Santos (OTCPK:STOSF) would own 37.5% of the project, still ahead of operator Exxon Mobil (NYSE:XOM) with 33.2%, while Kumul Petroleum would own 21.8%, with the remaining shared between Japan’s JX Holdings and Papua New Guinea’s state-owned Mineral Resources Development Co.

Santos (OTCPK:STOSF) became the largest shareholder in PNG LNG, Papua New Guinea’s largest resource project, with its takeover of Oil Search Ltd. last year.

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U.S. steel industry activity rate slides to lowest since January 2021 (NYSE:NUE)

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U.S. raw steel production fell 0.6% to 1.683M net tons in the week ended September 24 while the capability utilization rate slipped to 76.4%, its lowest rate in 20 months, according to the latest weekly report from the American Iron and Steel Institute.

Adjusted YTD raw steel production through September 24 totaled 66.418M net tons at a capability utilization 79.6%, down from the same period last year when 69.208M net tons were produced at a capability utilization of 81.0%.

Potentially relevant tickers include (NYSE:X), (NYSE:CLF), (NYSE:NUE), (STLD), (SLX)

The AISI also reported the U.S. imported 2.51M net tons of steel in August, including 2.084M net tons of finished steel, down 6.2% and 8.4% Y/Y, respectively, from July.

YTD total and finished steel imports are up 8.8% and 28.7%, respectively, compared with the same period in 2021.

Nucor (NUE) recently warned it expects Q3 earnings of $6.30-$6.40/share, well below Wall Street estimates.

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Falling home prices shouldn’t collapse the financial system, says hedge funder who made $4 billion betting on the 2008 housing crash

The U.S. housing market is experiencing one of the most rapid and dramatic shifts in its history.

The reason is pretty simple: Spiked mortgage rates are sidelining buyers across the country. 

And it’s far from over. Last week, Fed Chair Jerome Powell even went as far as to call it a “difficult correction.”

While the speed and breadth of the slowdown have some Americans worried about a repeat of the 2008 housing bust and subsequent global financial crisis, others aren’t as concerned. John Paulson, the hedge funder who famously pocketed $4 billion betting against the U.S. housing market in 2008, is among those who believe history isn’t repeating itself.

“We’re not at risk of a collapse today in the financial system like we were before,” Paulson told Bloomberg on Sunday. “Yeah, it’s true, housing may be a little frothy. So housing prices may come down or they may plateau, but not to the extent it happened [in 2008].”

A tale of two Wall Street oracles

Paulson, who started his hedge fund (which has since been converted to a family office), Paulson & Co., in 1994 and boasts a net worth of $3 billion, believes that the housing market is on stronger footing than it was at the start of the Great Financial Crisis.

“The underlying quality of the mortgages today is far superior. You don’t even have any subprime mortgages in the market,” he said. “In that period [2008], there was no down payments, no credit checks, very high leverage. And it’s just the opposite of what’s happening today. So you don’t have the degree of poor credit quality in mortgages that you did at that time.”

After the blow-up of the 2008 housing bubble and subsequent global financial crisis, senators passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in order to ensure the stability of the U.S. financial system and improve the quality of U.S. mortgages.

The act created the Consumer Financial Protection Bureau (CFPB), which is tasked with preventing predatory mortgage lending. In the years since the CFPB’s creation, the average credit rating of homebuyers has improved dramatically. Leading up to the 2008 housing bust, U.S. homebuyers’ average credit rating was 707. In the first quarter of this year, it was 776, according to data from Bankrate.

Bank of America Research analysts led by Thomas Thornton also found that the portion of buyers with so-called “superprime” FICO scores of 720 or above hit 75% this summer. During the years preceding the 2008 housing bust, just 25% of buyers boasted similarly strong credit.

The Dodd-Frank Act also established the Financial Stability Oversight Council which monitors the health of major U.S. financial firms and sets reserve requirements for banks, and the Securities and Exchange Commission (SEC) Office of Credit Ratings which verifies the credit ratings of major firms after critics argued private agencies gave misleading ratings during the financial crisis. Both of these regulatory bodies have helped to improve the resiliency of the U.S. financial system and banks during times of economic stress.

Paulson noted on Sunday that banks were highly leveraged during the financial crisis and took risks that would be seen as unacceptable in today’s markets after the Dodd-Frank act established the Volcker Rule, which prevents banks from making some specific types of risky investments.

“The problem, in that period of time, was the banks were very speculative about what they were investing in. They had a lot of risky subprime, high-yield, levered loans. And when the market started to fall, the equity quickly came under pressure,” he said, noting that the average bank now has three to four times as much equity as they did during the Great Financial Crisis of 2008, which makes them less susceptible to default.

While Paulson isn’t worried about a repeat of 2008, hedge funder Michael Burry, who also rose to fame predicting and profiting from the Great Financial Crisis, as depicted in the book and movie “The Big Short,” has warned for years that he believes the global economy is in the “greatest speculative bubble of all time in all things.”

Burry argues that central banks created a bubble in everything from stocks to real estate with loose monetary policies after the Great Financial Crisis, and pandemic-era spending meant to boost the economy only made things worse.

Now, as central bank officials around the world shift stances to fight inflation and continue raising interest rates in unison, the hedge fund chief argues asset prices will fall dramatically.

“There is risk growing in many sectors. The unfettered narrative feeding itself until the absurdity explodes, revealing the folly to all and easily starting a revolution,” Burry said in a cryptic, since-deleted Sept. 21 tweet.

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