And the whole wide world is whistling. An Inflation Surprise?
A new set of political appointments have administration and political order restored in the US but the macroeconomic realities remain unchanged.
The second I saw a tweet referencing this podcast with Paul Singer (CEO and Founder of Elliott Management) on inflation, I knew it was going to be bleak.
My intuition was confirmed when I listened to 'The End Game' in full.
What did Paul Singer say? These are my notes of what he said with my commentary in blue.
How does the era of central bank primacy end?
The deference that investors have given the central banks has become more pervasive.
Why? After the great recession, central banks took interest rates to 0% and flooded the system with liquidity. Of course, you need to reduce interest rates during a crisis, but they never re-corrected and we've had 9 years of using crisis techniques that remained in place long after the crisis was finished. The central banks came to enjoy their role in power and they weren’t punished by consumer price inflation. They didn’t take into account that they are exacerbating inequality. Moreover, 2010-2019 built consumers' confidence in central bankers to keep the economy growing at al times (stocks always go up!)
In 2018, small attempts to normalize conditions (e.g., the Fed reducing its balance sheet slightly and taking interest rates to 2.5%) seemed to be the catalyst for a 20% downturn in stocks. (Which makes sense, because it's increasing the cost of capital and leads to a reduction of price multiples). But the president blamed the Fed for the downturn, and they reversed course. The Fed was trapped. They couldn’t normalize. (Yup, I remember this).
The Fed has announced that it is dangerous to be under 2% inflation, and in the fall they would like to average to 2%. Average to 2% when you are coming from below means your target has to be above. (Only logical. I remember thinking that in the fall). So when it gets to 2.5% in a couple of periods, how will the Fed react? And is it possible that it causes an inflation break out?
When inflation lifted off, it just kept going in the 1970s. There is a good chance given the determination to spend trillions on COVID-19 relief to guarantee low-interest rates that we will experience a tremendous surprise in the near future.
What would the surprise be?
Consumer price inflation breaking out and keeping going.
The Fed's smug assumptions will start to be challenged, and then what will they do?! (Smug! His word!).
How does inflation take off?
Supply chain policy in the US is likely to change from "just-in-time" to "just-in-case" mentality. In the last 20 years, we bought products (like PPE) where it was the cheapest and most reliable (e.g., China). Now it’s going to be about national security, and political policies are going to force bringing supply chains closer to home. That will raise the prices of basic goods.
With the new power of labor in the new government, we will see wage prices rise (Yup - already talking about that minimum wage). Some combo of inflation or currency movement is highly likely.
Economists don’t have a good history of predicting inflation. They don't have good reasons why it exists or doesn’t exist. A staggering amount of inflation happens in emerging market counties when they print money and adopt similar policies to what the United States has done.
How do people own these bonds with these crazy yields?
- Doesn’t make sense with current inflation to own long-term bonds with low rates. They are speculative instruments. You can only make money if yields go negative.
- Stocks are priced toward the top part of the range. Signs of speculation are vivid.
- We can see the bond market is anticipating some increase in inflation.
Financial markets are less about numbers and more about popular psychology
Once inflation gets underway, central banks get trapped because if they diminish of the end the money printing, then the next thing that will happen is a crash or a deep recession. Central bank policy around the world has stored up this false confidence. If the growth doesn’t match or look like the performance from 2010-2019, it’s probably because real inflation and cracks in global bond (or equity) markets.
There’s no such thing as sitting passively. A bunch of pressures that have to go somewhere. Say inflation breaks out to 2.5%, 3%, 3.25%: Where does the pressure go? Perhaps the value of the dollar relative to other currencies; or the major currencies may fall against gold, silver, commodities, and real estate.
That’s why I refer to 2010-2019 as ‘where they (the central banks) got away with something’. They engaged in something radical, and it only had good effects.
You’ve got this insane MMT. (HA! I don't disagree).
The central bank debts are unpayable. I’m not talking nominal, I’m talking about purchasing power. You won’t get what you put in plus a rate of return on that value. (We, the millennials, already knew this).
One solution is inflating your way out of it. The reason that saying ‘we can inflate our way out of it’ is preposterous is because of investor psychology. Will investors have confidence in central bankers? No investors will front-run or attempt to front-run inflation.
You do that by selling bonds. Is the fed going to own all bonds? (Seems difficult).
If people lose confidence in money, it’s going to be an interesting fight between investors trying to get out and governments at least at the beginning helping them to get out by holding up the prices.
It’s a ball game because confidence and citizen psychology is the key. That has been what policymakers are relying upon. They think that confidence is infinite. The damage they can do is stunning. (I wonder when the market will lose confidence. But I've been wondering that for a while).
The complexity of the economy is way beyond the abilities of central bankers.
As you know, you can obtain the minutes of Federal Reserve Board meetings. So people published what went on in 2005 and 2006. What you can see clearly is they had no idea of what CDOs, CDO squares, subprime CDOs, etc. were. Central bankers had no idea what was going on in the structuring desks in the banks. The risk departments of the major financial institutions in the world didn’t have a clue either. That's the same today.
As I said, uh, bleak.
Two books for further reading:
- Dying of Money: Lessons of the Great German and American Inflations
- When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany
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