The Soft Landing is Transitory
Monetary Brake, Fiscal Accelerator
So far, in 2023, the idea of a soft landing of the US economy has become investors’ base case. Economic indicators continue to decline as the Fed puts disinflationary pressure on the private sector. However, the “long and variable” lags that policymakers talk about concerning the impact of monetary tightening have been negated by enormous public spending programmes, which are inflationary. While the Fed is doing what it can to put its foot on the brake, the government’s fiscal policy foot is hard on the accelerator.
Even in monetary policy, all is not what it might seem. Last year, US dollar liquidity declined, and financial conditions tightened as interest rates rose and the Fed balance sheet was wound down. However, by year-end, the US Treasury’s cash account drawdown began to offset the Fed’s ongoing balance sheet reduction. As the government debt ceiling came into view, the Treasury started to run down its General Account at the Fed. Running down the government’s current account has the same financial impact as QE, boosting liquidity and easing monetary conditions. The unintended effect of special measures to avoid triggering political paralysis rekindled the markets’ “animal spirits” and enhanced confidence in an economic soft landing. Risk assets lifted off their lows, and 2023 has resembled 2021 more than 2022.
Powell's Soft Landing
The positive market reaction to Powell’s last press conference was primarily due to his failure to acknowledge these moderated financial conditions. He preferred to focus on the “long and variable” lags in the disinflationary process. Markets interpreted this emphasis as evidence that he had already done enough. So far, in 2023, “less bad” dollar liquidity has slowed down the “process of disinflation” referred to over a dozen times by Powell, further embedding the “soft landing” narrative.
Baked In Inflation
The real economy (goods and services) and the monetary economy (liquidity) drive financial markets. Interest rate policy is a reflection of the bid to tame inflation. Goods inflation is declining, but the rate of its decline is stalling. Meanwhile, inflation has metastasised from goods into services via wage growth. Labour market data continues to reflect strong employment conditions. Inflation is now expected; it is baked into decision-making. While we are in what Powell termed a “disinflationary process” which could yet turn into a full-blooded recession, longer-term constraints in energy and commodity supply, with ongoing structural fiscal deficits, are likely to generate future spikes of inflation. As long as these factors persist, whenever we have a period of economic re-acceleration, expect it to be accompanied by a resurgence in above-target inflation.
Amid this financial economy easing, China’s reopening has delayed the slowdown in the real economy. Furthermore, global financial conditions have been further eased by a significant loosening of China’s monetary policy with policy measures to assist its stressed real estate sector. This is from Mike Howell of CrossBorder Capital: from late November 2022 through December, the PBOC injected RMB 1.56 trillion, adding another RMB 1.45 trillion in January, and so far through February, the rolling 28-day total is a sky-high RMB 1.93 trillion. Admittedly, this breakneck pace of impetus will fall off. Still, in two months, the Chinese have added 3-3 ½ times the liquidity they put in, in total, during the prior two years! However, despite this injection of liquidity, the opening session of the Peoples National Congress has set a somewhat muted economic growth target of 5%. It remains to be seen whether this is sufficient to reverse declines in global growth elsewhere. Furthermore, it is right to question whether 5% Chinese GDP growth is optimistic.
Japan Course Correction
What seems clear is that the recent market rally has been more of a function of the monetary economy than the real economy. Macro strategists Lyn Alden and Adreas Steno warn that the full effect of QT will reemerge as the debt ceiling negotiations pass, amid rising Yen rates later this year, removing another solid buyer of US Treasuries. With a policy rate of 0.5%, the BoJ has been fighting the last war for too long. Its yield curve control (YCC) policy has become prohibitively expensive in a world where rates are approaching mid-single-digit percentages. Any move to increase rates in Japan will divert Japanese investors away from buying other bonds, notably US Treasuries (of which they are particularly fond). All other things being equal, this move will increase rates for everyone else, thus adding to the “higher for longer” narrative.
Powell can maintain or ramp up his hawkish approach if nothing significant breaks and labour markets remain strong. Robust economic data gives him the license to go further on rates, and uniquely in developed markets, the US economy can take the strain. Interest rate markets are already pricing in the upping of forward rate expectations as the “higher for longer” narrative resists the “soft landing” consensus. This scenario suggests that the “soft landing” ends with the economy falling off the end of the runway.
The critical question remains if the targeted 2% inflation can be reached without a recession, i.e. if we get a soft landing, can the Fed keep it at 2% in the next growth cycle? The answer is, almost certainly, no. Lyn Alden says: the Fed is fighting 1940s-style fiscal-driven inflation with 1970s-style monetary policy, meaning the Fed mainly targets bank lending and asset prices to combat private lending-driven inflation. However, as Russell Napier points out, we are in a new era of fiscal dominance and must combat inflation brought about by fiscal deficits, which requires financially repressive policies. There will be mounting pressure for the 2% target to be moved to 3% or 4%, with rates at or below this level combined with rationing debt measures. One should expect green bonds, social impact credits and other efforts to funnel debt into approved purposes. Don’t be surprised if European economies legislate to prevent companies from moving listing venue to benefit from Made in America benefits derived from the tempting Inflation Reduction Act or Chips Act pork barrels.
Disinflation Within Inflation
Lyn Alden, again, we are in a disinflationary cyclical period within what I view as likely a longer-term structural inflationary period. Each of these periods directly contributed to what happened in the subsequent period:
- The 1920s and 2000s = booming private credit growth
- 1929 and 2008 = generational financial crises
- The 1930s and 2010s = economic stagnation and rising populism
- The 1940s and 2020s = deficit-driven inflation and financial repression.”
The main difference in the 2020s from the 1940s is that the Federal Reserve is more independent and is raising rates in the face of fiscal-driven inflation and high public debt-to-GDP ratios. In the 1940s, the Fed held rates at near-zero regardless of record-high inflation and therefore inflated the debt away. Interest rates were below inflation for a decade, and nominal GDP (fueled significantly by inflation) went up much faster than public debt levels, resulting in debt-to-GDP going down. This decade, one of the new developments is trying to raise rates to 5% and keep them there for a while in the face of 120% public debt-to-GDP levels. My base case is that interest rates will spend most of their time this decade below the prevailing inflation rate and the Taylor Rule [currently indicating that Fed Funds Rate should be 10.5%], but we’ll be taking a winding path along the way.
We Are Not There Yet
With the Fed fighting the wrong war with bad policy, this can still end badly. The US can withstand rate levels that other markets cannot, paving the way for a return of the dollar wrecking ball, exporting US inflation to the rest of the world, especially damaging economies vulnerable to imported energy costs and tightening global financial conditions. More currency blocs will be unable to keep pace, effectively devaluing their currencies relative to the worldwide reserve currency. To date, in 2023, we might be briefly revisiting 2021. However, we probably need to revisit 2022 before leaving this downturn behind.
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