Much ado about inflation
Powell at Jackson Hole...now what?
The long-awaited speech by the chairman of the Federal Reserve has been delivered and we, along with the rest of the world, are debating its consequences. There are four key takeaways
The labour market is too tight.
The labour market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers.
The Fed is focused on easing demand.
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.
A recession won’t necessarily mean rate cuts.
We must keep at it until the job is done. History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting.
Expect economic pain.
While higher interest rates, slower growth, and softer labour market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
“We will keep at it until we're confident the job is done.” It is not unlike Draghi’s comment in 2012 that he would “do whatever it takes”. That was a purely political decision. The political decision to create the EU and the euro overrode any financial commitment. For Powell it was more of a financial statement. There was a nod to the elections in November by saying that in September, the data may allow them to slow the rate of increases, but not to stop or reverse them, which is a significant point. The Biden administration will not like his use of the “R” word; however one defines it…
The issue he also highlighted was that raising rates didn't help supply issues. And this is the ongoing problem. Headline inflation is rolling over. We have seen that particularly in the commodity complex, and that really is just a reflection of less growth in the economy. And less demand creates lower prices. Supply issues are another matter. And this is a bigger problem.
In Europe, the second derivative effects of cutting imports of oil and gas from Russia hasn't really been thought through. It has pushed electricity and gas prices up to extraordinary levels. In Germany, the cost of generating electricity has increased by 3,000%. In other words, the power policy is completely broken. German industry along with German households cannot afford to run their businesses, or their households, at that level of price increases. The inevitable closing of unprofitable businesses will further crimp supply issues. The whole German manufacturing economy is predicated on cheap energy. Remove that and the German powerhouse collapses. On top of which, demographic issues in Germany, not just in Italy, compound the problem. Who is going to take over the top spot? France?!
The Europeans have three options. They can continue to refuse supply from Russia, in which case they will either starve, or freeze, or both. And it won't take too long before the population realises that it's all very well having an environmental policy until it impacts them in a negative way. So the political agenda is certainly up for grabs.
The second option is to embrace some sort of agreement with Russia over Ukraine and over oil and gas supplies and relieve the pressure on prices in that way. We've already seen this happening in Asia. China is quite happy to import Russian oil and gas and pay for it in renminbi, or gold. Taiwan has signed an agreement for gas supplies from Russia, as has Hungary, and it looks like Japan has taken a slightly different route by reopening nine of its nuclear reactors. And that is something that the green lobby have an issue with, even though nuclear waste can now be dealt with in a safe way. But that's a debate for another day.
The third option, unlikely for now, but it is getting more air time, is for the EU and any other nation that wants cheaper energy is to change the means of payment to include a “sweetener” – a little bit of physical gold with each barrel of oil, valued at either the current western gold price or possibly at a premium which would serve to revalue EU, Russia, China, India and US gold holdings up using Russia’s oil and gas, ie Russia’s oil and gas would be use to re-capitalise the system. It may sound farfetched, but it has happened before in the aftermath of the first Gulf war. Option 1 looks inevitable, but if options 2 or 3 happen then owning gold and energy plays will become de rigeur.
It is similarly a problem for the US, but to a lesser extent as they are net exporters of energy. What the US has done though, in the short term is to ask oil companies to reduce the exports of oil and gas, particularly to Europe, which of course gives Europe an even bigger problem. With the American strategic oil reserve at an all-time low, they are obviously conscious that they need to build that up, particularly if we're going to have a long cold winter.
Supply chain issues are here to stay, and, on top of the oil and gas pricing and availability, we are experiencing drought conditions in many parts of the world, particularly in China. They're struggling not only with drought, but also with zero COVID lockdowns and problems in the housing sector, which they've started to address by reducing interest rates; something not on the agenda for central banks in the rest of the world. Globally the pandemic appears to be contained, but as Australia has shown us, winter is likely to bring an increase in “ordinary” flu as winter arrives in the northern hemisphere. This has the potential to further exacerbate supply chain issues.
The whole global economy is slowing. And this is one of the pluses in a strange way for reducing inflation. But the supply chain issues aren't going to go away in a hurry. They require structural change and that takes time. We may see headline rates and oil petrol gas and energy prices come back and that will be reflected in inflation numbers. But wage inflation is still happening, and people are going to be asking for more pay. In the UK, the postman and the railway men are on strike, and it has a kind of ring to it of the 1970s although the militancy of the unions is nothing like it was then. But, on the other hand, we don't have a Mrs Thatcher with a political will to deal with them.
Similarly, in Europe, the strong man was Germany. But when Merkel was in power, she marginalised the opposition and competition in politics using her experience gained from her time in East Germany. She pretty much removed anyone in the German political arena with any serious intent and ideas, which has allowed the Green Party to hijack German politics and create this energy policy that they haven't thought through properly yet.
In the US, one of the biggest issues around the fight against inflation, quantitative tightening, is the effect that it may have on the US Treasury market. Foreign buyers have stopped buying US Treasuries but the issuance of new Treasuries to fund the budget deficits is going to start growing again later this year. Who is going to be buying them?
The Fed also have a problem in that they are currently paying the banks something over 2% to keep money in reserve accounts at the Federal Reserve. As rates continue to rise, their interest rate bill paid to the banks on these reserves will exceed the interest that they're receiving on their US Treasury holdings. They're not allowed to keep this interest on the Treasury holdings; it must be paid back to the US Treasury. But if they're running at a loss, they will have to effectively print money to do so. This would be inflationary. If, on the other hand, they stop paying interest to the banks that will release a huge volume of reserves into the economy, which again is inflationary. Inflation is not transitory
Whilst the Fed continues to raise rates, the only game in town is the US dollar. In the short term, the headline inflationary trend will start to roll over and we may then see lower rates on longer duration US Treasuries which will be useful, but how long will that last given the potential supply chain issues that we have highlighted. The key for a market turnaround is an improvement in GDP growth rates and that seems to be unlikely in the short term, certainly not this year.
We will also be observing the data as it unfolds into a world where few have had any actual experience of dealing with inflation. The transition from a 40-year deflationary period to something quite different is going to be volatile, but full of opportunity for the observant.