Nicholas Glinsman | December 13th, 2021
· The Feds real dilemma
· A deeper dive into Friday’s inflation data further suggests it’s sticky
· Any change in GOP Senate leadership coming?
· Inflation watch – Air freight costs soar to record high
· Trade is the biggest competition at the Beijing Olympics
The Feds real dilemma
What really caused inflation? The inflation that the Fed is supposedly fighting was not caused by them and their tools are insufficient to fight it. Admittedly, zero-level interest rates caused high prices in car loans, used cars, and homes. Raising rates will take care of those problems, but given how the Fed measures inflation, the prices in those markets coming down will not significantly impact inflation.
Quantitative easing? It has an effect on housing but it is more of an impact on asset price inflation especially the stock market and the entire financial system. Quantitative Easing is a massive stimulus program for Wall Street and the stock market, etc. It does nothing for the bottom 60–70% of Americans.
In the “olde days,” when the Federal Reserve would change reserve requirements for banks, that had an impact. Banks are required to have a minimum reserve deposited at the Federal Reserve. Anything above that is called “excess reserves.” Now, a prudent banker would want to have a certain amount of excess reserves. But since excess reserves paid nothing back in ancient times, a prudent banker also would want to try to lend that money out. Today banks are paid a minimal amount for their excess reserves. All that quantitative easing that began in 2009? It ended up back on the balance sheet of the Federal Reserve. It did not cause inflation, which all the Austrians were declaring would be the end of the world in 2009.
The chart below makes my point. You can go to the source at the St. Louis FRED database and find that excess reserves were under $1 billion in the ‘80s and ‘90s. (Scroll along the flat line and you can actually get numbers.) Now excess reserves are in the neighborhood of $3 trillion.
What happened? Two things. First, banks ran out of creditworthy borrowers as defined by the regulatory groups that oversee them. Second, regulatory scrutiny severely crimped the ability of small banks to lend into their neighborhoods. Farmer Jones needs a new tractor? The local banker knew whether he could repay. Farmer Smith might not get the same deal. But regulatory agencies do not recognize the ability of the neighbourhood banker to differentiate between Smith and Jones. So they can penalize the bank for lending to Farmer Jones. Regulators want to see balance sheets that can pass their scrutiny. Thus banks, small and large, are not lending to Main Street in general. Big public companies, and even small ones, can go directly to market and sell bonds that are less expensive than borrowing from a bank. The banking business has changed significantly.
Quantitative easing changed almost nothing but asset prices in the financial markets. Low interest rates affected, again, car loans and mortgages. That is all on the Fed.
But actual inflation? That’s all on fiscal policy and Congress. The Federal Reserve can accommodate Congress with buying government debt, but that shows back up on their balance sheet. It is not “hot money”.
The multiple stimulus packages Congress passed were hot money squared. It went into the hands of people who actually spent it. And since they couldn’t buy services like restaurants, hotels, and travel they bought “stuff.” So we had a “demand shock.” Consumers wanted more than businesses could produce.
Yet, there’s more. Covid seriously impacted supply, too. When your employees can’t come to work shortages start to build up rather quickly (think lumber, chips, etc.). Further, businesses were facing wage inflation and higher costs for their component products. They raised prices, sometimes because it was justified and sometimes simply because they could. Note that profit margins for the largest companies in the US are at all-time highs. It’s not any different than smaller companies. $10–$12 per pound for bacon? A $23 pastrami sandwich in Boston? There are literally thousands of such anecdotal stories.
Cummins Diesel says that they will be dealing with chip shortages for another two years. They’re buying run-of-the-mill, low-end chips. Chip fabricators do not want to build a factory to manufacture low-end chips when the demand will not be there two to three years from now. They need to see 10-year horizons. That is the same for multiple businesses all across the spectrum. Businesses can see an initial demand created by massive stimulus from Congress, supply chain disruptions caused by Covid, and realize that things will settle out and building another production line today will not be useful when demand evens out two years from now. It’s just going to take time to sort through the demand and supply shocks.
And there is nothing the Federal Reserve can do with their policy tools that can fix the cause of inflation created by Congress. However, the Fed has to play the cards it has been dealt.
I am aware of what the Fed hopes to do, in sync with the wishes of the Treasury, but what they should do is draw down all quantitative easing much quicker than any of us anticipate—in 4–5 months max. Then they need to start raising rates. And they need to keep raising rates until inflation is under 2.5%. They cannot repeat the mistake that Arthur Burns made in the ‘60s and ‘70s by letting inflation run hot because he thought it was transitory. Ultimately, the cure for high prices is high prices. Inflation will, if not accommodated by the Fed and Congress, recede and we will be back to a disinflationary/deflationary environment.
Now, as an aside, it is worth considering whether Congress is going to pass another massive stimulus bill. I have listened to Senator Joe Manchin give at least six presentations (both private and public) plus his written record, and he doesn’t sound like he intends to move much. Manchin has said repeatedly that he wants to see inflation coming down before he signs on to another bill. Some in Washington think Manchin is playing “rope a dope” and hoping the BBB will die of its own accord.
Now, given what I have written above, the Fed really does have a dilemma. Jerome Powell’s problem is that Wall Street won’t like a reduction, much less a cessation of quantitative easing. Higher interest rates are not conducive to the ongoing financialization of everything.
There is a very real possibility, if not probability, that the stock market enters a bear market in 2022 while inflation remains high. It could happen before the Fed raises rates. What does Powell do then? Does he fight inflation, as the Fed’s mandate says he should, or follow recent precedent and accommodate the markets?
By continuing to fight inflation he risks a mild recession. We’re not talking 1982 and Volcker. More like 1991, which the markets shrugged off after a year and continued on into a bull market. A mild recession will solve the inflation problem then Powell can come riding to the rescue.
Powell’s mistake was not ending QE and raising rates in late 2020 when the economy was clearly getting stronger. The Fed has already made its policy error. Congress also made a massive bipartisan fiscal policy error, even if well-intentioned.
To compound the problem, COVID has changed the employment market significantly. Many people have simply decided to not be part of the labour force, because of retirement or for personal reasons. We have spiraling wage inflation, which is real and sticky and is not going away soon.
It will be a massive policy error, much more extreme than the last one, if the Fed doesn’t lean into inflation even if the stock market suffers a short-term retreat. What have we learned over our last 50 years? The market comes back and will be stronger and higher. Valuation will matter.
But not if the Fed lets inflation really take hold. Jerome Powell clearly knows the history of Arthur Burns and his successor, William Miller, screwing up. Here’s hoping that Powell is made of sterner stuff.
Indeed, according to the Financial Times, even moderate Democrats are pushing the Fed to move aggressively towards tighter monetary policy to stamp out inflation, in a sign of their mounting concern about the political fallout from high prices. This reflects growing unease within Joe Biden’s party that high inflation could prove toxic with voters in the 2022 midterm elections. Well, of course it will, as inflation is the most toxic regressive tax for politicians.
A deeper dive into Friday’s inflation data further suggests it’s sticky
Here are the most important points from the report, to re-iterate some of Friday’s discussion on the topic.. First, shelter inflation, which makes up a third of the CPI index, has risen to its highest level since 2007:
Inflation in rents is still not that high, but the whole index is geared to it. As rents tend to follow house prices upward with a lag, and house prices have surged since the pandemic, it’s reasonable to expect this number to rise for a while longer. Measurement of shelter costs is the single most controversial aspect of the official inflation statistics. The conceptual problem is that a rise in house prices for those who already own a house actually reduces their cost of living by increasing their wealth and making it easier to borrow.
As I retweeted out on Friday, Bill Ackman garnered a lot of attention for his Twitter thread pointing out that large owners of rental properties are citing a 17% increase in rents over the year. Inputting this in place of the official figure would take the headline rate of inflation up to 10.1%. It’s fair to expect rents to put upward pressure on inflation for a while.
Second, it’s noticeable that this inflation scare is an unusual one. Despite my own doubts, it wasn’t necessarily mad for the Fed to think that inflation was purely transitory back in April and May. At that point, the rise in prices was dominated by a few categories most affected by the pandemic. A few outliers were pushing up core inflation to an unprecedented extent. What is worrying is how that dynamic has now changed. The Atlanta Fed keeps separate indexes of CPI components whose prices can be easily and quickly adjusted, and of those that are “sticky.” The rise in “flexible” prices earlier this year was the highest on record, including at any point during the 1970s:
Here is sticky inflation over the same period, shown on a month-over-month basis. As might be expected, it is almost never negative, but also much steadier:
The sticky problem is nothing like as severe as it was in the 1970s, which is encouraging. A few months ago, when it barely seemed to be moving, thinking that inflation was transitory seemed reasonable to many. Now, that is changing because sticky price inflation is picking up. Here is the same chart for the last 20 years so the movement in recent months is clearer:
Central bankers should be very anxious to ensure that sticky price inflation does not rise any further
Another problem is that while inflation was originally concentrated in sectors directly affected by economic re-opening after the pandemic, that also is changing. The following division of inflation into energy, reopening and non-reopening sectors is from Bloomberg:
To make the trend clearer, the following chart shows just inflation in the non-reopening components:
The rises in sticky inflation and in sectors not directly affected by the pandemic are exactly the things that earlier this year the Fed hoped would not happen. It increases the pressure to craft a response. Despite this, long rates in the bond market suggest minimal concern that the Fed will need to tighten policy very much. The “terminal rate,” to use the jargon, remains very low at not even 2%. This looks overly hopeful to me. A central bank is nothing without a reputation. If consumers and investors don’t trust it to keep inflation under control, it has no alternative but to overshoot aggressively (as Paul Volcker did four decades ago). There has to be a risk that happens.
The Fed is often criticized for hiking rates until something breaks. We believe the low terminal funds rate means it will not take much to break the economy. Relentlessly rising short rates are a signal that the Fed is behind the curve on inflation and needs to hike aggressively. Sideways long rates and a flattening yield curve could reflect the market’s fear that the Fed will impair the economy. If the Fed does not address inflation soon, they risk long rates shooting much higher. But if they follow the market’s lead in aggressively hiking rates, they risk hurting the economy. We understand the Fed’s paralysis given the massive uncertainty coming out of the pandemic. However, as Bill Dudley has so eloquently stated, the longer they wait to address inflation, the worse this conundrum will become.
Mitigating circumstances include that companies and individuals are flush with cash at present; there is more of a cushion if the Fed decides to tighten than there usually is. Also, with the U.S. stock market at record levels, and with the yield curve still a ways from inversion, there is room for the Fed to push down the prices of stocks and short-term bonds without “breaking something,” although this risk is plainly rising.
Mohamed El-Erian, who has been outspoken about the dangers of inflation this year, is similarly critical of the Fed. On Sunday, he described the earlier assessment that inflation was transitory as its “worst-ever call” on CBS television. Asked if he wanted the Fed to “slam on the brakes,” he said this:
“If you’ve hit the brake hard in a few months, there’s a risk you send this economy into recession, and it would be unnecessary harm to livelihoods. What they need to do now, is ease their foot off the accelerator. There is no reason why they should be injecting so much liquidity. There is no reason why they should be boosting the housing market at a time when house prices are pricing Americans out of buying homes. They should ease their foot off the accelerator in order to avoid slamming on the brakes later on.”
The full transcript can be found here. In effect, this is an argument for the Fed to announce a much faster timetable to taper off its asset purchases. At this point, it would be a major surprise if this did not happen when the results of its latest policy meeting are announced Wednesday. What might be more important, and what might have more of an impact on the bond market, would be to shift projections for future interest rates sharply upward. Now that the Fed seems to have admitted that it was wrong about its “transitory” call, it needs to take control of the agenda once more.
The biggest outbreak of inflation in four decades has also been possibly the weirdest outbreak ever. Many assumptions have been challenged. Now that it’s clear that this year’s inflation is more than a transient blip, the Fed needs to show that it can adapt — and the bond market needs to adapt to the new approach.
Any change in GOP Senate leadership coming?
Albert thinks it likely in 2022, the possible replacements for McConnell being:
Inflation watch – Air freight costs soar to record high
The cost of flying cargo around the world has reached record levels as companies attempt to meet surging demand in the run-up to Christmas. Prices have nearly doubled on key air freight routes linking manufacturing hubs in China to consumers in the US and Europe over the past three months, leaving the industry struggling to find enough aircraft to keep up. Prices on routes from Shanghai to North America reached $14 per kilogramme for the first time last week, up from $8 at the end of August and above the previous record of $12 achieved when the pandemic first hit supply chains in early 2020. There have been similar rises from Hong Kong to Europe and the US, and on the transatlantic routes between Frankfurt and North America, according to data from the Baltic Exchange Airfreight index and TAC Freight, cargo data providers.
Supply chains have always been at their busiest during the fourth quarter because of Black Friday sales and Christmas, but the seasonal surge in demand comes with the industry under immense pressure. Companies have turned to air cargo following chaos in the shipping industry, where there is a shortage of containers and bottlenecks at ports.
Half of air cargo would normally be carried in passenger jets, but many have been grounded during the pandemic, and when airlines have recommenced flying it has often been on leisure routes rather than major trade hubs. Omicron also threatens to disrupt passenger traffic. Some airlines have switched to flying cargo and dedicated air freight companies such as FedEx and DHL have picked up some of the slack. Yet the industry is still 13 per cent down on 2019’s capacity, according to Seabury Consulting, an arm of Accenture. The shortfall comes as demand has risen 6 per cent over the same time, leading to a nearly 20 percentage point gap between supply and demand.
Trade is the biggest competition at the Beijing Olympics
If you think the 2022 Winter Olympics, due to open in Beijing on February 4, is about athletes competing for medals, think again. The Olympics is a massive money machine combined with an extension into sport of the battle between communist/authoritarian China and capitalist/democratic America to win global esteem.
The reactions to China’s decision to “cancel” tennis star Peng Shuai for accusing former vice-premier Zhang Gaoli of sexual assault revealed something about Olympics economics. When Steve Simon, head of the Women’s Tennis Association, cancelled all tournaments in China, the WTA forfeited the balance of a $1 billion, ten-year deal that in 2019 produced $30 million in prize money for female tennis players. “This is about what’s right and wrong,” said Simon. Not for everyone. The International Olympic Committee pronounced Peng Shuai safe after a brief video conference call certainly monitored by her jailers. The IOC, of course, has its eye on its own “Olympic gold” — the flow of cash from deals such as NBC’s 2014 payment of $7.75 billion for a broadcast-rights contract until 2032.
And of course, the NBA chose silence rather than support for its fellow athletes in the WTA. Its millionaire players depend on the NBA’s cosy relationship with China for broadcast revenues and brand endorsements from a basketball-mad nation with 800 million fans. In 2019, China banned broadcasts of NBA games because a league official criticised the regime. That cost the NBA $400 million. China now bans broadcasts of Boston Celtics games because a player has criticised its human rights record.
Meanwhile, America’s financial community is stepping up its support for China’s economy, which desperately needs foreign investment. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, raised $1.25 billion for investment in China. Dalio said it was not for him to “be an expert” on government policy. “Should I not invest in the United States because [of] our human rights issues?” Then there are the investment bankers are scrambling to set up in China to flog financial products and help government-controlled Chinese companies raise capital to supplement government subsidies used to compete with US companies — and, capital being fungible, continue to finance its military build-up.
Bankers might ignore the stakes in what seem mere athletics contests, but Chinese president Xi Jinping surely does not. “Chinese athletes, he proclaimed, “strive for good scores and win glory for the nation”. Not incidentally, China is determined to build a multitrillion-dollar sports tourism industry, with Olympic triumphs the cornerstone of that effort. The regime operates 2,000 schools for athletes, selected at a tender age and separated from their families. China focuses on minor sports that are underfunded in the West (female weightlifting, badminton) but bestow gold medals. Gou Zhongwen, head of the Chinese Olympic Committee, said: “We must resolutely ensure we are first in gold medals.” Matched against that state-funded and managed system are American athletes, dependent on a complex system of private-sector contributions and living in a free society neither willing nor able to impose on its young athletes the draconian regime of its communist rival.
Xi knows that president Biden’s decision to have his officials boycott the games, as a protest against China’s human rights abuses, is unhelpful to its drive for international legitimacy. Joe Biden’s critics preferred that he bar US athletes from participating in the games — but judging from the reaction of the Chinese regime, Biden’s move has been effective. “Grandstanding,” sniffed a foreign ministry spokesman, saying the US “would pay a price” for its decision.
At stake in this battle is perhaps the biggest economic prize of all. Up for grabs is leadership in setting the rules of the global trading regime:
● America continues to back a rules-based trading order, China to ignore World Trade Organisation rules.
● America is committed (sort of) to the continued independence of its big chip supplier, Taiwan, while China intends to do to Taiwan — which it is allowing to compete in the Olympics only as “Chinese Taipei” — what it has done to Hong Kong.
● America aims to reduce emissions; China continues the construction of new coal-fired generating stations.
● America wants other countries to continue to recognise the dollar as the world’s reserve currency; China wants to replace it with the yuan.
● American policy is to pressure China to end its human rights violations. Beijing has required the IOC to delete contract clauses that oblige the host city “to respect, protect and fulfil human rights and fundamental freedoms”.
Enjoy the games. But as you watch, keep in mind that the competition for gold is part of a broader war to shape the world in which we will live. The athletics contests are war by other means.