Laid To Rest
(Note: The post was written before the ECB’s rates decisions)
Another week of the year has passed, but the most discussed topic within financial markets did not change. Primarily because of the coming US CPI numbers (Friday) and the ECB meeting (Thursday), inflation remained in the focus of markets.
There is no end in sight for the uptrend in yields as the oil prices continue to push upwards. WTI is slightly above 120 US dollars/barrel, which means it is about 20 dollars away from its 2008 all-time high. However, differently than last time, the dollar also appreciates further. As a result, oil prices have already reached new all-time highs in other currencies, resulting in further inflation pressures for those countries.
Despite the price gains, oil demand remained high, as producers either could not or were unwilling to expand supply. Even the release of the US’s SPR only dampened the price gains but failed to achieve a price drop.
While the Federal Reserve and the Biden administration have already taken steps to fight inflation, the ECB is expected to lay out its plans further to normalize monetary policy at this week’s meeting. With inflation at elevated levels, the ECB continues to be between a rock and a hard place.
An article by Martin Arnold in the Financial Times perfectly sums up the dilemma of the ECB. High inflation rates in recent months led to the fact that even the doves within the governing council are now saying they will support the normalization of monetary policy.
The ECB’s asset purchase program will end this month, and a first 25 basis points rate hike shall follow next month. In her blog post, published on May 23rd, Christine Lagarde wrote that the ECB would likely end its negative interest rate policy (NIRP) in September. The question remains if acting gradually and step-by-step will bring inflation down without tipping the eurozone economy into recession or causing a rise in peripheral bond spreads.
In the article, Arnold is very critical of Lagarde, mainly since she relies heavily on the expertise of her chief economist, Philip Lane because she has no fundamental knowledge in the field herself. The article quotes Klaus Adam from the University of Manheim, who sums it up perfectly:
Who can she rely on now? She is no expert herself and her chief economist has been so wrong on inflation.
The hawks within the governing council, like Austria’s Robert Holzmann and Germany’s Joachim Nagel, are pushing for a more aggressive tightening path than Lagarde or Lane. However, the risk is, as mentioned prior, that risk spreads of highly indebted eurozone countries widen and will result in refinancing problems at some point.
Financial conditions are getting tighter within the eurozone, mainly because the ECB plans to end its special discount rate on TLTROs (Targeted Longer-Term Refinancing Operations). Currently, banks could borrow from the ECB at an interest rate of -1 %, which is 50 basis points below the deposit facility rate. According to Oliver Rakau (mentioned in the FT article), a possible hike by 50 basis points could mean pressure on the economically weak countries in the eurozone.
However, not only the southern countries in the eurozone might be overwhelmed by an interest rate hike, the whole eurozone is already close to recession and will likely fall into recession because of the complex economic environment that supply-chain problems and the Russian invasion have created. Weak numbers for German factory orders this week, similar to the Ifo-Index, are pointing to a coming recession in Germany.
Anyway, according to its mandate of stable prices, the ECB should keep in mind that consumer price inflation is more important than a (very) possible recession. In my opinion, the recession is the bitter medicine the economy needs to swallow to get rid of all the economic imbalances that the ECB created due to the policies of negative interest rates. The question remains whether the ECB will stick to the tightening plan because, as Christine Lagarde's appointment shows, many steps that the ECB takes are also political.
On the other hand, if the ECB is acting too soft on inflation, that would put pressure on the euro, which has devalued significantly against the dollar already this year and hence would mean further problems on the inflation front. While the ECB did nothing, the Fed and the Bank of England have already started tightening. Bloomberg Economics estimates that inflation in the eurozone likely will reach its top in Q3 this year and will not fall back to the ECB’s goal of 2 % until 2024.
Nevertheless, the Fed seems determined to bring consumer price inflation back to its 2% goal. The Fed is already planning to hike by 50 basis points multiple times, so it is tightening much more aggressively than the ECB. The discussions in the US seem to be different from those in Europe. While in Europe, the debate is about whether hiking by 50 basis points or not, the discussion in the US is if hiking by 50 basis points is enough to fight inflation.
European Keyesians mostly say that the ECB shall not act too aggressively, but US Keynesians are going in another direction, urging the Fed to act more. This month, Harvard economist Larry Summers and his colleagues Judd Cramer and Marijn Bolhuis published a paper where the authors compare the current inflation with past inflation.
As former chief economist of the World Bank (1991-93) and former director of the United States National Economic Council under President Obama, Summers is one of the most prominent economists in the US. Apart from that, as a Keynesian, he is unsuspicious of being a neoliberal. Summers is also known for supporting the theory that interest rates have fallen because of a savings glut, although this is not supported by scientific evidence.
Summers was one of the few Keynesian economists who warned that inflation was likely not transitory last year. In contrast to his monetarist colleague from Johns Hopkins University, Steve Hanke, Summers argued that inflation is coming because of an overheating economy. However, numbers do not support his theory, even though a demand shift from services to goods made inflation more sticky.
In the paper, Summers et al. compare the current inflation with the high inflation of the past, but they do not look at official inflation rates. The calculation of CPI has changed throughout history, so it is not easy to look at the official published CPI rate to compare different points in time. Thus, the authors are recalculating past CPI rates using the current calculation method.
Especially the calculation of housing inflation by the Bureau of Labor Statistics has changed fundamentally. From 1953 to 1983, price changes in homes were calculated due to several input factors, such as price changes and property taxes. Nowadays, housing inflation is calculated by the Owner’s Equivalent Rent. Nowadays, homeowners are interviewed and asked how much they would charge for renting their home to someone else.
The authors argue that the old calculation tended to overestimate rises in home prices and thus led to an overestimation of the CPI rate. Therefore, they say that measured inflation was higher and more volatile in the past (while critics might say that the current method underestimates inflation).
Additionally, the CPI basket changed over time because consumption behavior shifted from goods to services. According to the authors, this is mainly because food and shelter expenses became less critical because of falling prices. Using the BLS data, Summers et al. calculated an adjusted rate of headline CPI and core CPI to compare the inflation rates of different years.
According to their study, the current inflation rate is much nearer the top of past inflation. After all, the new calculated past inflation rates are lower than the official CPI numbers.
Additionally, the authors compare the implications of the adjusted CPI rate to the real fed funds rate (Fed funds rate - CPI) and the policy gap, which means the difference between the real Fed funds rate and inflation. Their calculations suggest that the policy gap is around the same level as during the Volcker era.
They conclude that inflation is closer to the peaks of the 1970s than the official numbers suggest and that the influence of changes in the interest rate was overestimated back when the BLS used the old calculation of housing inflation.
Summers et al. further argue that,
…recent research indicates that housing inflation is likely to continue growing in the coming months (Bolhuis et al., 2022). With private sector rent growth currently still at 16 percent, residential inflation is likely to move towards 7 percent by the end of 2022, contributing almost 3 percentage points to core CPI inflation.
I think that the paper of Summers and his colleagues is exciting. Reading them, let one conclude that even the Federal Reserve would need to tighten much more aggressively than currently anticipated. If inflation is close to levels of the Volcker era, the reaction of monetary policy should be similar.
However, such a reaction would have massive implications for markets because the US economy would fall into a deep recession, resulting in a collapse of consumption and higher unemployment. Already, people are expanding credit card spending to keep current spending constant in this inflationary environment. As a result, the credit card debt they paid off because of stimulus payments is rising again, which is not a good sign in an environment where interest rates are rising.
The US savings rate collapsed and has fallen below its pre-covid trend, and retailers are sitting on full inventories. Target Corporation, the US’s second-largest discounter, warned of too-high inventories this week, which lowered its stock price, although it has recovered a bit since then.
But, as I already mentioned, the Federal Reserve should not take heed, mainly because politicians also want a lower inflation rate. Because the situation in energy markets remains severe, I think the Fed might be forced to be more aggressive (if it wants to bring inflation down). Goldman Sachs forecasts an oil price of 140 US-dollar/barrel in Q3.
But the Fed faces a severe problem: The US’s debt to GDP ratio is much higher than in the days when Paul Volcker was in charge of the Fed. At some point, a too restrictive monetary policy might harm the US household budget. Therefore I believe that QE could make a comeback sooner than most observers might think.
Finally, I want to look into the future to see how a more aggressive Fed would affect markets. While I do not know what will happen at Thursday’s ECB press conference, I assume that the ECB will continue to be much less hawkish than the Fed, and therefore I think it is a question of when, not if, the euro will reach parity with the dollar. In the short run, a very hawkish ECB might push the euro a bit higher in the short term.
If the monetary policy becomes more restrictive, I think that rates have some more room for the upside, although, regarding the long end, it is crucial how soon fears of a recession spread among investors. While inflation fears have the upper hand, I assume that the trend of rising yields continues until the Fed reverses its course.
The situation in the stock market might become more volatile. If the monetary policy becomes more restrictive, I think buying the dip is not a good idea because the market has not priced that in yet. However, in such a scenario, bear market rallies of around 20 % are not unusual, and therefore one should remain cautious.
In the case of a more restrictive monetary policy, gold might also suffer. However, if one has a further time horizon, this might lead to some great buying opportunities. In contrast, over the short term, the price of gold will either trend sideways or have some room to fall, especially if real rates remain positive.
Commodities could also benefit from the current economic environment, as long as demand is steady. Always keep in mind that no central bank can print commodities!
Considering future economic development, it would be good for the economy to swallow the bitter medicine. Personally, I think central banks are already late, and that loose monetary policy should be laid to rest. However, I have some serious doubts that central banks are willing to pull through.
Have a great weekend!
Fabian Wintersberger
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Spot on Fabian. The central banks are both behind the curve and terrified that if they do fight inflation their respective economies will tank and they will be blamed. Truly no good solution for them