Good morning. Yesterday’s consumer price index release turned out to be pretty interesting, as did the market reaction. Whoever circulated that fake CPI report wasn’t dreaming big enough: their made-up 10.2 per cent headline inflation number was barely bigger than the real 9.1 per cent figure. Send your fabricated economic data our way: [email protected] and [email protected] inflation, chill marketsThere’s no spinning it — June’s headline inflation reading was bad. And the details of the CPI report were no better. A quick rundown of the horror: Energy prices rose 7.5 per cent (month-over-month, seasonally adjusted)Core inflation (excluding food and energy) stayed hot at 0.7 per cent, with stickier components like core services (0.7), rent (0.8) and owners’ equivalent rent (0.7) all hotCategories that many thought would moderate soon refused to do so. Durable goods prices rose 0.7 per cent, used cars and trucks 1.6 and transportation services 2.1No drinking your troubles away, either: alcoholic beverages rose 0.4 per cent, making for a 6 per cent annualised increase in the first half of the year (H/T Omair Sharif at Inflation Insights)Futures markets responded. The peak fed funds rate is now expected to be 3.65 per cent in January, up from 3.4 per cent yesterday. The really interesting point, though, is that stocks took the news with equanimity — indifference, almost. The S&P 500 ended a touch down and the Nasdaq was flat. The Treasury market kept its cool, too. The two-year bond yield had to rise (10 basis points or so) to match fed funds expectations. But the 10- and 30-year yields fell a little, suggesting markets still don’t think inflation will stay entrenched. The market still prices in the Federal Reserve cutting rates next year. One possibility is that markets are focused less on CPI than on other data that suggest we are at the start of an inflation-killing recession. Dom White at Absolute Strategy Research notes four areas where the data point to recession: the bullwhip effect cutting spending on manufactured goods, falling commodities prices, a fast-cooling housing market and decelerating wage growth. He shared this wage growth chart on Twitter on Monday:
A disinflationary recession is a fair bet. But the dominant market narrative relies on a tightly timed sequence of events: rate hikes, bringing on a recession that lowers inflation enough for rate cuts to follow, perhaps as early as the Fed’s first 2023 meeting. Oh, and this recession has to be shallow enough that stocks do not take another big leg down from here and the yield curve does not invert further. That’s all possible, but feels like a lot to hope for. Inflation is a slow-moving variable. Recessions are not all shallow. And the Fed may make a mistake.In a sense, the Fed’s job is easy now. Inflation is very high and unemployment is very low. What it must do — raise rates, fast — is clear. But imagine a scenario in which inflation is still way too high, say 5 per cent, and falling. At the same time, imagine that unemployment is higher, say approaching 5 per cent again, and rising. What does the Fed do then? And what is it under political pressure to do? Already, with inflation above 8 per cent and unemployment below 4, some senators are telling Fed chair Jay Powell things like this:Right now, the Fed has no control over the main drivers of rising prices, but the Fed can slow demand by getting a lot of people fired and making families poorer. You know what’s worse than high inflation and low unemployment? It’s high inflation and a recession with millions of people out of work. And I hope you’ll reconsider that before you drive this economy off a cliff.How many politicians will be saying something similar in six months, if we are at 5 and 5? (Ethan Wu)Fin de siecle, or just a cycle?The big debate about the current inflationary period has been how long it will last. But another debate, years from now, may look much more important. After this period of acute inflation ends, will we return to something like the pre-pandemic status quo? Or will the pandemic mark the end of a 40-year regime of low inflation which, while it was punctuated by crises, featured long steady stretches of high returns for both bonds and stocks?The BlackRock Investment Institute, the research wing of the world’s largest asset manager, has thrown in its lot with team fin de siecle. In its mid-year investment outlook, the BII team writes that since the mid-1980s:We were in a demand-driven economy with steadily growing supply. Borrowing binges drove overheating, while collapsing spending drove recessions. Central banks could mitigate both by either raising or cutting rates . . . The policy response did not involve trade-offs; there was no conflict between stabilising both . . . That period has ended.The end of the “great moderation” will result from a cabal of factors. Geopolitical fragmentation — particularly a China-US split — will make the labour shortages that have characterised the pandemic years a permanent feature of the world economy. There will also be supply disruptions in energy and materials because of a rocky transition to net zero. The economic effects of these supply constraints will be amplified by the high global debt burden, which will make the fiscal and economic consequences of higher interest rates more dramatic. A BII chart shows how interest payments could come to sop up GDP:
Central banks will try to manage the ensuing volatility, but will alternately undershoot and overshoot. Meanwhile, political polarisation will block sensible policy solutions. “The result? Persistent inflation amid sharp and short swings in economic activity.” Higher volatility will mean higher term premiums for bonds and higher equity risk premiums for stocks. Ultimately, in the face of political pressure and slowing growth, central bankers will be forced to tolerate permanently higher inflation. Persistent tension between growth and inflation will mean that bonds and stocks will never enjoy simultaneous sustained bull markets. If this story is familiar, that is because other versions of it have been told already. Charles Goodhart and Manoj Pradhan tell a version of it, laying the emphasis on how demographics will lead labour shortages, which, in combination with a shift in the savings/investment balance, will drive inflation. Nouriel Roubini emphasises the causal role of high debt in his own apocalyptic stagflationary vision. Albert Edwards of SocGen has modified his “ice age” thesis to include the onset of unrestrained fiscal and monetary excess. Of the Fin de sieclists, Michael Hartnett of Bank of America has summed up the thesis most succinctly, as we’ve quoted before: Deflation to inflation, globalisation to isolationism, monetary to fiscal excess, capitalism to populism, inequality to inclusion, US dollar debasement . . . long-term yields >4 per cent by ‘24So BlackRock’s argument is notable less for its originality than for the fact that the world’s biggest money manager has jumped on a burgeoning bandwagon. One prominent voice taking a different line than the new-era theorists is Larry Summers. Here is our friend James Mackintosh describing Summers’ view in the WSJ (Mackintosh does not agree with Summers on this, by the way):“It’s 60-40 that we’re going back to something that’s kind of secular stagnation,” [Summers says]. Just as in the aftermath of the 2008-2009 recession, interest rates will be held down by increased savings resulting from an ageing population and the uncertainty that comes after a crisis. Rapid technological development will again keep the cost of capital goods down. More savings and less investment means lower after-inflation interest rates are required to balance the economy.On balance, we’re with Summers. We agree with him that the savings/investment imbalance is, contra Goodhart and Pradhan, set to persist. We also think the deflationary effects of globalisation have room to run, particularly as they extends from goods into services, a point urged on us by Barings’ Christopher Smart. As Smart says: if you can do your job from home, someone else can do it from across the world — for a lot less.One good readThe UK’s total lack of seriousness about public policy did not begin with Boris Johnson. More
