Good morning. Ethan here; Rob was out yesterday but will be back in time to enjoy CPI day with the rest of us. Forecasters are expecting an 8.8 per cent headline reading today, but what’s in the inflation report’s guts will be most interesting. Or maybe it will look a lot like last month’s report, and everyone will quickly lose interest. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.
Recession vs inflation
Will recession kill inflation? Our knee jerk answer: sure it will. Generically, a recession happens when everyone stops spending at once. Inflation is coming from lots of spending crashing into restricted supply. So if the Fed lowers that spending by raising interest rates, we might get a recession but the inflation problem will go away. Add to that evidence of overstocked inventories, which should bring down goods prices as retailers roll out discounts, and it’s hard to see how inflation would roar through a recession.
Markets also seem to expect an inflation-killing slowdown, if not a recession. We’ve been over the indicators before, but to repeat: the 10-year yield is below its peak and trending sideways, two-year inflation break-evens have fallen from nearly 5 per cent in March to 3.2 per cent now, futures markets are expecting rate cuts in 2023, and so on. We’ve heard some version of this assessment from practitioners too. Evan Brown at UBS Asset Management told us last month he is “very confident” recession would significantly curb inflation.
For a different view, consider the yield curve. Rather than a disinflationary recession, Jim Caron of Morgan Stanley argues the curve is poised for something rather more stagflationary. He contrasts the 10-year/2-year spread, which he sees as tracking output expectations, with the 30-year/5-year spread, which he sees as an indicator of the inflation risk premium (the 30-year’s longer life means its value can be slowly sapped by secular increases in inflation). The 10/2 is inverted while the 30/5 has been steepening:
An inverted 10s/2s is pointing to a near-term recession (though the 10-year/3-month, a more reliable indicator, disagrees), as the Fed raises rates over the next two years but must eventually slash them to revive growth. Yet the steeper 30s/5s reflects a growing chance that inflation won’t remain sustainably low, and so long rates must rise as compensation, Caron argues.
These are not massive moves and, in any case, the curve changes its shape quickly these days. Still, Caron’s argument got us thinking about what economic outcomes might get us stuck with proper stagflation in 18 months’ time.
In a recent note, Ethan Harris at Bank of America chides markets for getting too sanguine on inflation — a “sticky, slow moving variable” that “tends to move in a gradual lagged fashion”. Harris offers this table of how much trimmed personal consumption expenditure inflation, a measure of underlying price pressures that excludes the most and least inflationary items, has fallen in past recessions. For each downturn, the table looks at how far trimmed inflation falls two years after peaking. The final row compares current inflation to what markets expect in July 2024:
Outside of a 1980s strangle-inflation-to-sleep approach, recessions have tended to apply a bit, not a lot, of downward pressure on price increases. Yet markets are expecting inflation to decline steeply, as in 1980, rather than gradually, as in 1990. Harris puts up five explanations for why markets could be feeling like this time is different (he leans towards 1 and 5):
There is something technical going on in the bond markets that overstates the expected drop in inflation, and participants don’t really expect a sharp drop in inflation.
The markets think virtually all the inflation is noncyclical and related to the supply side and will go away rapidly once supply chains unclog.
The markets expect a massive recession.
The markets think the Phillips curve has gone from remarkably flat to remarkably steep, such that a modest increase in the unemployment rate causes a sharp drop in inflation.
The markets are simply ignoring economic history.
We prefer explanation 2. As we noted yesterday, markets are still pricing in a fair chance of a soft landing. The hope is that falling demand, with an assist from supply, brings inflation down fast enough that the Fed can increase rates only moderately.
But the fact that inflation has tended to fall slowly in recessions points to how much the Fed’s reaction function could start to matter. As inflation has spun upward alongside a strong economy, it has been clear what the Fed needs to do. Hawks and doves are in agreement on raising rates. Once inflation begins to ease down, the right policy is less obvious, and the trade-offs are uglier. Stop tightening too early and risk a resurgence in prices; stop too late and risk getting millions fired for no reason. The Fed’s job may get harder yet.
Where’s the crypto bailout money coming from?
We wrote last week about Sam Bankman-Fried, the chief executive of crypto exchange FTX who has taken the wreckage in crypto as an opportunity to go shopping.
He isn’t the only one. Any crypto company with cash to spare is thinking about buying peers who have fallen on hard times. That’s true, notably, of Changpeng Zhao, chief executive of crypto exchange Binance, FTX’s main rival. He told an interviewer last week, “I think you will see that we will be investing, bailing out, saving multiple projects.”
These buyouts are chiefly about buying at attractive valuations, rather than stopping contagion. The last big crypto crash in 2018 saw a similar spike in opportunistic M&A. But one FT commenter on Friday’s letter asked an important question: where are acquirers getting the money?
Why doesn’t SBF/FTX have the same liquidity issues as others in the crypto industry though? They seem to have a huge amount of capital available.
The easiest answer is that crypto trading volume hasn’t fallen as much as you might think. Fake volume makes it hard to get a reliable measure, but The Block’s index of daily volume on exchanges with “trustworthy reporting” is around $17bn, far from peak bull market volume of $89bn, but still well above pre-coronavirus pandemic levels ($2bn in February 2020). Healthy volume translates into fee revenue for crypto exchanges, which means real cash for real bailouts.
There are still lots of people interested in trading crypto. And that means there are funds available, and deals to be had.
One good read
Trump and BoJo are gone, but their successors will be savvier. A typically sharp column from Janan Ganesh.
Source: Economy - ft.com
