Quote of the day

“I find economics increasingly satisfactory, and I think I am rather good at it.”– John Maynard Keynes
Showing posts with label deflation. Show all posts
Showing posts with label deflation. Show all posts

Saturday, 30 March 2024

The Federal Reserve may be ready to pivot:

 


The Federal Reserve is preparing for a hand-brake U-turn on interest rates

US economy’s ability to reset itself when imbalanced is being stunted by interventions

Federal Reserve Bank Chairman Jerome Powell
Jerome Powell may soon be forced to oversee rapid interest rate cuts at the Fed CREDIT: Kent Nishimura/Getty Images

If you want an idea of how the current fiscal and asset bubble in the US might end, pay close attention to Bernard Connolly, esteemed consigliere to hedge funds and central bankers across the world for the last quarter century.

It will not end in a soft landing – a “chimaera” – and will certainly not end in another leg of accelerating economic growth. Nor will it end in soggy stagflation.

The invidious choice facing the Federal Reserve, he warns, is either to allow a deep economic slump to unfold, or slash rates to the bone before inflation has fallen back to target. The latter course will send the dollar into free fall and destabilise the world’s dollarised financial system, an outcome already being sniffed out by the reawakening gold market.

Mr Connolly is one of the very few prophets who foresaw both the Great Recession and the eurozone sovereign debt debacle, not just in vague terms – many did that – but with eerie precision and with a powerful intellectual argument for why they would happen and why they would prove so intractable.

His new magnum opus, You Always Hurt the One You Love: Central Banks and the Murder of Capitalism, is the story of the Faustian Pact made by central bankers from the 1990s onwards, when they first became addicted to bubbles and started stealing prosperity from the future.

His blistering critique over the decades has not stopped top officials at the Fed, the Bank of Japan, and the Bank of England from seeking his advice whenever trouble hits. After a long silence, he is again issuing warnings.

“There can be little doubt that there will be a US recession unless the Fed loosens hard and soon. The labour market is weakening and ‘excess savings’ from the pandemic-era handouts are exhausted,” he said.

“The likeliest near-term outcome is that, as in 2000 and 2007, the Fed holds off cutting interest rates just yet, citing worries that inflation is not convincingly and sustainably moving to target. By mid-year the weakening of the economy will have become evident even to the Fed’s modellers. But they will not cut far enough or fast enough,” he said.

Mr Connolly said the next step will be highly political. Fed officials are alarmed by the prospect of a second Trump presidency – this time unbridled – fearing that he will change the Federal Reserve Act and open the floodgates to inflationary fiscal dominance.

Joe Biden has already packed the Fed with allies, much as Trump packed the Supreme Court. We can assume that they will strive to engineer his reelection, disguising this with creative economic science. “The temptation to say that inflation has already come down a long way will be very strong,” he said.

This points to an initial rate cut in June, followed by cascading cuts in rapid succession, though still too little, too late. The Fed Board is already preparing for a hand-brake U-turn. Governor Adriana Kugler recently reminded everybody that the Fed has a “dual mandate”: jobs as well as inflation.

Days earlier, New York Fed chief John Williams said the supply-side shock of the pandemic had blown over and that US inflation had carved out a near perfect round trip, “like the Apollo missions to the moon and back.” He said three-year inflation expectations are now below their 2014-2019 average. This is a Fed preparing its alibi.

As I wrote last week, the US economy has lost a net 900,000 workers since November, based on the US household survey. This has lifted unemployment from 3.4pc to 3.9pc. The jump is close to triggering the Fed’s ‘Sahm Rule’ recession indicator.

The US economy is not as strong as widely assumed. The latest US financial accounts show that gross domestic income (GDI) grew by just 1.2pc last year. This measure has been consistently weaker over recent quarters than the GDP figure, which ought to give pause for thought.

A Fed study found that GDI is more accurate when the economy rolls over. It foretold a recession in 2007 at a time when the GDP figures (revised down later) were still signalling clear blue sky.

Such modest growth is thin gruel for an economy running a war-time $2 trillion fiscal deficit at the top of the cycle. So what will happen this year as the caffeine fades and the fiscal impulse turns negative?

The Wicksellian theme running through Mr Connolly’s book is that central banks have created a chronic ‘intertemporal’ misalignment in the western economies, starting with Alan Greenspan in the 1990s.

They have let asset booms run unchecked but have always stepped in to prevent the economy coming back into balance during downturns. But you cannot pull consumption from the future forever without consequences. The future catches up with you.

“The real difficulty with the Greenspan maxim – that a problem deferred is a problem solved – is that you have to keep on deferring, via ever-bigger bubbles that ultimately threaten to destroy both capitalism and democracy,” he said. Furthermore, this reflex obstructs the Schumpeterian cleansing process of creative destruction.

As Joe Biden’s budget boom deflates this year it will become clear that the US economy cannot handle interest rates anywhere near the current level of 5.33pc. America and the West will discover that they are on the same conveyor-belt towards “ever-lower real interest rates”, requiring drastic cuts to refloat the next bubble in equities and credit.

My angle is slightly different. Deflation will keep coming back to haunt us with each cycle – requiring zero rates and crazy money – because of ageing demographics, digital technology, and above all the Asian saving glut.

The cardinal fact is that China produces 31pc of global manufactured goods but accounts for 13pc of total consumption. Xi Jinping’s regime is dumping massive excess capacity on the rest of us. It is reverting to the worst practices of Leninist capitalism. This is the elephant in the global rowing boat.

Whether Mr Connolly is right or savings glut theorists are right, both imply a secular collapse in the natural rate of interest and the subversion of western free market system.

The central banks and the academic priesthood are floundering because their canonical DSGE model – new neoclassical synthesis – assumes that the economy comes back into equilibrium when it patently does no such thing. The model is self-evidently defective but all other voices – Wicksellian, monetarist, Austrian, or old Keynesian – have been shut out of the debate.

The priests were badly wrong in 2007-2008. We will find out who is badly wrong this year soon enough.

Friday, 12 January 2024

Your current monetary policy topic just got a boost from China:

 

China central bank set to cut key rate, boost liquidity Monday to aid economy

China's central bank is expected to ramp up liquidity injections and cut a key interest rate when it rolls over maturing medium-term policy loans on Monday, as authorities try to get the shaky economy back on more solid footing.

Expectations of monetary easing have heightened after major Chinese commercial banks lowered deposit rates late last year, paving the way for further reductions in policy rates at a time when persistent deflationary pressures also warrant additional stimulus.

A protracted property crisis, cautious consumers and geopolitical challenges are also pointing to another bumpy year for the world's second-biggest economy.

In a Reuters poll of 35 market participants conducted this week, 19 or 54.3% expected the People's Bank of China (PBOC) to cut the borrowing cost of one-year medium-term lending facility (MLF) loans.

The central bank last cut the MLF rate in August 2023 by 15 basis points (bps).

Thirty, or 85.7% of all respondents, predicted the central bank would inject fresh funds into the financial system exceeding the maturing 779 billion yuan ($108.73 billion) of MLF loans due this month.

"Inflation could be of higher priority for the PBOC to prevent a negative feedback loop between deflation and activities," Citi analysts said in a note.

"We reiterate our view for a policy rate/LPR cut as early as in coming weeks within January.. We maintain our expectations of 50-basis-point reserve requirement ratio (RRR) cuts and 20-basis-point MLF rate cuts for the whole year."

The interest rate on MLF loans currently stands at 2.5%. As it serves as a guide to the loan prime rate (LPR), markets mostly see the rate as a precursor to adjustments in the LPR. China is due to announce the monthly LPR fixing on Jan. 22.

"I think the central bank should take action as early as possible: it should lower both interest rates and RRR as early as the beginning of the year," said Wang Tao, chief China economist at UBS.

However, she added that the PBOC might be rather cautious as it has to pay close attention to U.S. Federal Reserve and dynamics of interest rate movements in global markets.

Wang expects a total of 10 to 20 bps of rate reductions and 25 to 50 bps points of RRR cuts this year.

Investors' expectations for an RRR cut also rose after Zou Lan, monetary policy department head of PBOC, highlighted reserve requirements as one of monetary policy options to support credit growth, according to a state media report this week.

This article was wfrom Reuters and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.

Saturday, 19 August 2023

China and the Middle Income Trap

 We have to keep an eye on China; it may end up exporting deflation to the West which could have several negative impacts on us - but what about China?



China’s property crash is becoming more dangerous by the day

The country’s ticking time bomb economy is nearing the point of detonation


Xi Jinping faces an invidious choice between hurling credit at his deformed economy or biting the bullet and risking a depression CREDIT: REUTERS/Tingshu Wang

China’s financial system is one step away from a full-blown crisis. Unless radical action is taken to stem contagion through the shadow banks and halt the contractionary slide in demand, China risks tipping into a classic liquidity trap.

Cai Fang, a rate-setter at the central bank, has called for a $550bn blast of helicopter money – or high-powered QE injected into the veins of the economy – in order to stop a deflationary psychology taking hold as frightened households retrench.

“The most urgent imperative now is to stimulate consumer spending. It is necessary to use all reasonable, legal, and economically viable channels to put money into people’s pockets,” he wrote on China Finance 40, the opinion forum of the elite.

This increasingly feels like the make-or-break moment faced by the US Treasury in 2008 after Lehman Brothers collapsed, or faced by the eurozone in 2012 when the doom-loop threatened to engulf Italy and Spain. 

America and Europe acted in time, after a string of errors. 

It is far from clear that Xi Jinping has recognised the destructive mechanisms at work in China, or that economists in the West are alert to the global dangers through multiple channels of transmission, starting with an exchange rate shock. 

The yuan has fallen to a sixteen-year low against the dollar. The East Asian currency bloc is falling in tandem, pushing the euro trade-weighted index to a record high. 

The effect is to bludgeon a eurozone economy already in a deep industrial recession. The cheaper the yuan, the greater the tsunami of Chinese electric vehicles, machinery, or wind turbines, heading for Europe.  

Westerners emerged from the pandemic with windfall savings, thanks to furlough schemes. 

The Chinese endured draconian lockdowns for three years with far less support. The damage has undermined the finances of millions of small family businesses. A large chunk of the population has slashed spending in order to rebuild depleted savings. 

It is the immediate reason why the post-pandemic rebound has already fizzled and why the economy has tipped into deflation. 

The deeper reason is the painful unwinding of the great Communist debt bubble, an episode uncannily similar to the debt woes of the late Qing dynasty. 

The giant developer Country Garden, with total liabilities of $200bn, is days away from default after missing payments on dollar loans issued in Hong Kong. 

Ting Lu and Jing Wang from Nomura estimate that the company has already received payment for a million properties that have yet to be built. 

Like other developers relying on China’s “pre-sale” model it depends on a constant flow of new buyers to cover old debts.

The buyers have dried up. The CRIC Research Centre says sales in July by the top-100 developers were just 30pc of levels three years ago. 

“We believe the Chinese economy is faced with an imminent downward spiral with the worst yet to come,” they said, warning that half-hearted tinkering by the authorities so far will not stop a wave of defaults and chain-reaction through the economy.

“In our view, Beijing should play the role of lender of last resort to support major developers and financial institutions in trouble, and should play the role of spender of last resort to boost aggregate demand,” it said.

China’s $60 trillion property edifice is by far the largest asset class in the world. 

It accounts for half of the world’s entire property sales, an astonishing figure given that China’s workforce is already contracting and net migration from the countryside has stopped.

The developers have debts of $5 trillion. By comparison, this is six times greater than America’s $800bn subprime property debt on the eve of the Lehman crisis. 

They rely heavily on the $3 trillion “trust” segment of the shadow banking nexus known, which has no lender of last resort. These trusts are starting to blow up. The $140bn Zhongzhi Empire is the most disturbing casualty so far. 

The property bubble is the Ponzi scheme that keeps China’s local governments afloat. 

They rely on property for 38pc of total revenue, mostly from land sales. These sales have collapsed. The finance ministry says local government income fell 21pc in the first half of 2023. 

This must lead to a severe fiscal squeeze unless Beijing comes to the rescue with a huge stimulus package stimulus. The signs are that Xi Jinping is still reluctant to do so. 

His allies have published a media note entitled “Clarifying the Eight Misconceptions about Expanding Domestic Demand”.

Xi faces an invidious choice. Hurling credit at the deformed Chinese economy every time the sugar rush fades and the economy slows is what has led to this colossal mess, but biting the bullet risks an economic depression and a crisis of legitimacy for the Communist Party. 

His immediate reflex is to silence unpleasant statistics. Youth unemployment data has been suspended after the rate jumped to a record 21pc.

A Beijing professor thinks the rate is nearer 46pc once you include those “lying flat”, the Chinese term for dropping out, living at home, and sponging off grandparents (four per child) to while away the day with friends in coffee shops. 

The Party’s first mistake was to ignore warnings by premier Li Keqiang a decade ago that China risked falling into the middle income trap if it clung too long to a catch-up model of state-led construction.

The second mistake was to launch a political purge against business bosses and turn away from Deng Xiaoping’s outward-looking economics, the motor force of China’s revival. 

The third was to revert to economic Leninism, thinking that 2008 was a systemic crisis of US-led capitalism and a validation of Party control over credit. 

The fourth was to pick a fight with the liberal West before China was close to economic parity.

The evidence is in. The growth rate of total factor productivity has fallen to the levels of mature economies before China is mature. 

The country is no longer on the same trajectory as Japan, Taiwan, and Korea at a comparable point of development. The nail in the coffin is an 87pc fall in foreign direct investment last quarter, the lowest level since records began in the 1990s. That is Xi’s legacy.

Capital Economics thinks China’s (true) trend growth will drop to 2.8pc over the late 2020s. If so, China will not surpass the US this decade, and will then fall back as the demographic decline gathers pace.  

China denies vehemently that it is succumbing to ‘Japanification’. 

In my view, it will be lucky to do as well as Japan. It has the same pathologies of boom-bust deflation and vanishing workers, but is further blighted by totalitarian leaders with a deep fear of the free market. 

Unlike Japan, it has angered the West and must now contend with strategic reshoring and a hi-tech blockade.

Joe Biden calls China’s economy a “ticking time bomb”. 

My presumption is that Xi Jinping will not let it detonate on his watch. At some point he will blink and take drastic action to shore up the property market and the shadow banks, putting off the day of reckoning for another cycle. 

If he does not, the global financial system is in for a dangerous denouement this winter.

Friday, 14 July 2023

One of the really big debates this year will be deflation vs inflation

 From the number of articles lined up on both sides it is clear that this is not one that can easily be answered. Here is one take - although there is a very misleading "error" right at the beginning, the points being made need to be analysed (critically) in order to have some understanding of both sides of the argument:

ANALYSIS (PHILIP PILKINGTON)

STRIKING WORKERS PROLONG PERIODS OF STAGFLATION BY DEMANDING HIGHER WAGES

Are central bankers fighting the last war?

Some economists point to a falling money supply as a harbinger of recession and a period of deflation. They have got it wrong, says Philip Pilkington. Expect protracted stagflation instead

Ascentral banks fret over inflation, a small number of contrarian but influential economists are saying that the central bankers have it all wrong. They argue that by tightening interest rates the central banks are fighting the last war and that the real threat to the economy is, in fact, deflation. They foresee a large recession ahead that will lead to falling prices and living standards.

The economists who espouse these views are associated with the monetarist school, which came to prominence in the 1960s and 1970s through the work of Milton Friedman. The school teaches that inflation is caused by excess growth in money supply – the amount of currency and other liquid assets circulating in the economy. “Inflation,” Friedman famously wrote, “is always and everywhere a monetary phenomenon.”

The idea is simple enough. Monetarists believe that the money supply is controlled by central-bank policy. By flooding the banking system with monetary reserves, the central bank increases lending as these reserves are released as loans into the economy. When central banks shrink the reserves in the banking system by selling government bonds to soak up the reserves, as central banks are now doing as part of their monetary tightening, the loan books of the banks contract and the money supply decreases.

Monetarists believe that movements in the money supply precede movements in prices. So, if we see a shrinking money supply now, we should expect falling prices and possibly a recession soon. This is why the monetarists believe that they know something that the central banks do not: they are laser-focused on their money-supply measures, while the central banks are still looking at inflation metrics.

MONETARISM IS BROKEN

One might be forgiven for assuming some arrogance on the part of the monetarists. Far be it from me to think that economists working at central banks always get things right. But the people who work at these institutions are well versed in macroeconomics. If there were a single metric that could reliably predict the swings in inflation and had been widely discussed by famous economists since the 1960s, it is hard not to think that the central banks would pay more attention. 

The truth is, however, that monetarism does not work. Money-supply metrics can be interesting, as part of a broader basket of leading economic indicators. But they are far from perfect. In the 1980s, the Bank of England tried to use monetarist theory to steer the economy, but it soon abandoned this after it realised it did not work as advertised. 

“STAGFLATION IS PRECIPITATED BY A SUPPLY SHOCK, SUCH AS OPEC WITHHOLDING OIL IN THE 1970S”

In the case of the United Kingdom, there is simply no debate. The M3 money supply metric is the broadest gauge of the money supply. It comprises the currency in circulation, deposits with a maturity of up to two years, deposits redeemable at notice of up to three months, repurchase agreements, money market fund shares, and debt securities of up to two years. A chart going back to 1988 shows that M3 does not seem to have any meaningful, reliable relationship to inflation (measured by the consumer price index). In a US chart going back to 1960 we do see some correlation, sometimes, but it is not remotely reliable. The reason central banks do not use money-supply metrics alone to forecast the path of future inflation is because they have looked at this data and drawn the obvious conclusion that it does not work.

This is why the Bank of England continues to raise rates. Some prominent monetarist-inspired commentators are saying that the rate hikes are now going too far. They point to the falling money-supply growth and say that a recession is on its way. It follows from this that any further rate hikes are harmful. They are not needed to get inflation down – because, monetarists say, inflation will follow the money supply – and they will only produce a deeper recession.

When faced with this argument, the economists at the Bank of England are not moved. They know that the money supply metrics are not a reliable future predictor of inflation. So they keep hiking, as they can no longer allow inflation to run rampant. Their position, in this regard, is perfectly reasonable.

GROWTH, INFLATION, OR STAGNATION?

Another argument made by the deflationists is that world growth is contracting. Proponents of this view point to the obvious stagnation in the developed countries and the failure of the much-vaunted Chinese reopening. There is no doubt that developed economies are mired in stagnation. But the deflationistas seem to be confusing growth and inflation.

In normal times, growth and inflation move in lockstep. When the economy starts growing too quickly, we see inflation. When we see the economy slow, we see deflation. But the current stagnation is accompanied by very high inflation. What we have been experiencing for the past two years is stagflation, the combination of economic stagnation and inflation.  We had a bout in the 1970s, too.

Stagflation has several interlocking causes. The precipitating factor is almost always a supply shock: a random event that negatively affects the supply side of the economy. In the 1970s, the supply shock was the Opec oil cartel withholding supplies from global markets in response to US support of Israel in the 1973 Yom Kippur War. Today, the supply shock is a combination of the supply-chain disruptions caused by the lockdowns, together with the disruption to energy and fertiliser markets due to the war in Ukraine.

After the initial supply shock, stagflation is carried forward by rising wages. Workers get angry that the prices of goods have risen and so they demand higher wages. These wages are then passed on to consumers in the form of rising prices and so inflation gets worse. We end up in a vicious spiral, which economists call a wage-price spiral. The problem today is that the low growth – which is giving rise to interminable “recession-watching” – is coupled with high inflation.

It is true that the Chinese recovery has disappointed. Growth in services in the country have been robust, but the manufacturing sector has lagged. This is because the Chinese government hoped that consumption would pick up the slack so that the economy would no longer have to rely on very large amounts of investment. In past cycles when consumption growth has failed to materialise, however, the Chinese government has turned back on the investment tap to hit its growth targets. Expect a repeat performance in the coming months. 

“A REAL RECESSION DOES NOT OCCUR UNTIL PEOPLE ARE LOSING THEIR JOBS”

This raises the prospects of an inflationary recession. The deflationists may be correct that the developed economies may be about to tip into recession. But it does not follow from this that the recession will be accompanied by falling prices. Price pressures may well stick around. The destabilisation of supply chains associated with the war in Ukraine has not gone away. European gas prices, for example, remain high because we have replaced cheap piped Russian gas with liquefied natural gas (LNG), which costs about 40% more. The situation with fertilisers will not get any better simply due to a recession, and so food prices may remain high.

Then there is the wild card of China. If the government increases investment to meet its growth targets, we may see a “two-track” world economy emerge, with China bolstering growth in developing economies while developed ones slip into recession. If this happens, energy prices are unlikely to fall very far as these countries prop up demand. That may mean even higher prices in developed economies, regardless of how deep the recession turns out to be.

An inflationary recession

How will we know if the dreaded inflationary recession takes place? The first indicator to look out for will be rising unemployment. There has been much discussion of “technical recessions” these past few months. But these definitions are not helpful. A real recession does not occur until people are losing their jobs. When we see unemployment start to tick up – most likely to be led by lay-offs in the construction sector – we can say for sure that the recession has arrived.

At that stage, we will have to keep a close eye on inflation. In an inflationary recession, the rate of inflation will slow. But it will remain higher than it does in a typical recession. For example, during the depths of the 2009 recession in the US, inflation fell at a rate of -1.5%. In an inflationary recession we would expect that either inflation keeps rising at 2%-3%, or that it dips but then takes off quickly after the recovery begins and outstrips the central bank’s 2% target.

At present the prospect of an inflationary recession seems more likely than deflation – or at least sustained deflation. Stagflation hits when there is turmoil in the world that starts to affect the economy. The 2020s have seen an excessive amount of turmoil so far, and there are still enormous risks in the global system, the most notable being the prospect of a trade war – or even an actual war – between the US and China. Either would be catastrophic for the global economy and immediately set off inflation far worse than anything we have seen so far.

But even if the tension between China and the US ebbs, there are plenty of factors that point to structural price pressures. A recession may well drive cyclical inflation down temporarily as workers are laid off and wages fall, but it seems perfectly possible that the structural features will eventually overwhelm the cyclical ones and, after a brief lull, inflation will come back on the menu. 

That is what we saw last time we had stagflation. In the recessions of 1970 and 1973-1974, inflation started coming down, but then shot right back up as the economy recovered. This explains why central banks want to hammer a stake through the heart of inflation. If the inflationary monster were to revive after a recession, it would be nothing short of disastrous.