6 December 2021
"The misery of being exploited by capitalists is nothing compared to the misery of not being exploited all." ― Joan Robinson
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Last week's brilliant and analytical Marshall's Thoughts were in fact written by Jiong Han Yeo and covered the much-discussed topic of 'Climate Change - and what Economics has to say about it'.
This week’s Marshall’s Thoughts are written by Yuexin Zeng.
Inflation has long been a topic that kept policy makers awake at night, but for different reasons. It wasn’t long ago, prior to the global pandemic, when the debates were centred around whether inflation was gone for good. Now, in light of surging CPI figures in many developed countries, policy makers are trying to solve a problem that they have also been fighting the past decade, which is of too low inflation.
One of the main points of debate is whether the rise in prices is transitory and will fade soon, or whether it may prove more permanent. Supporters of the transitory camp believe that this year’s price spikes are due to a one-off surge in consumer demand bumping against a one-off disruption in the supply chain. Namely, we are experiencing a “pandemic-specific” inflation. The fact that Asia - also an importer of energy and has suffered the same jump in commodity prices - isn’t facing the same extent of price surges seen elsewhere, suggests that the Covid-19 pandemic response mechanism might have played a role in the different inflation outcomes these regions are now experiencing. In Asia, countries have either managed to avoid compulsory lockdowns altogether (South Korea), limit them in scope and duration (China and Taiwan), or delay such measures until deep into 2021 when vaccines were becoming available (New Zealand). The consequence is now playing out: on the demand side, Asia experienced fewer of the dramatic swings in consumption, which in turn resulted in less pressure for supply to respond.
On the other hand, supporters of “team permanent” argue that the surges in price are more fundamental than a supply-chain disruption, as excessive stimulus has been pumped through the economy, and the consequences loom large. In addition, the labour market - especially in the US and UK - may have shifted structurally, which resulted in a higher natural rate of unemployment as labour participation falls. Indeed, as the surges in price have now shown a broadening pattern outside of energy, especially in countries where a shortage of workers is pushing up wages, there is all the more reason to believe inflation is here to stay.
Perhaps it’s too simplistic to divide beliefs around inflation into “transitory” and “persistent”. After all, how long is “transitory” - 3 months, 6 months or 18 months? Nobody can tell for certain. Even among those who believe that inflation will fall next year as supply chain problems ease and consumer demand stabilises, there is an acceptance that the inflationary shock will last longer than first estimated. Economists polled by Consensus Economics, a company that collates the predictions of leading forecasters, have steadily revised up their expected inflation figures for 2022. Market participants are also adjusting their expectations and steadily pricing in a rise in inflation over the next five years in many countries, evidenced by prices of the 5-year inflation swaps.
This begets the big question: what will the central banks do? Fed’s introduction of AIT (average inflation targeting) in August 2020 has given Powell enough ammunition to put off raising interest rates in spite of surging price levels. Christine Lagarde, European Central Bank president, also pushed back on expectations that rates would rise next year despite inflation rising to a 13-year high of 4.1 per cent in October. Similarly, the Bank of England backed away from an immediate increase in nominal rates from their historic low of 0.1 per cent, even though it predicted inflation would reach 5 per cent early next year before falling back. However, should the current pace of price rises persist, it’s only a matter of time until the central bank’s commitment to the price target is put to test, as credibility takes years to gain but can be lost rapidly.
What’s keeping global central banks so dovish? Growth can be a concern, but evidence is suggesting otherwise. In the US, fourth-quarter economic growth is tracking towards an 8% annualised rate, according to the Atlanta Fed’s purely data-driven real time estimate - a stellar scorecard from the 2% from the third quarter. In addition, Citi’s economic surprise index, which had been on a long slide downwards since mid-2020, has been rising since September, and is now well into positive territory, meaning that the majority of reports are now coming in ahead of expectations. Whilst it is still debatable whether the current strength can hold up against a policy tightening on the margin, growth doesn’t seem like a main concern that stops the Fed from raising interest rates, for now.
Rather, debt monetisation seems like the elephant in the room that keeps central banker’s hands tied. In the post-pandemic world, the absolute deficit numbers in many global economies are much bigger, as is the level of debt. The US Congressional Budget Office projects that federal debt held by the public will rise from 103% of gross domestic product at the end of 2021 to 106% in 2031. This compares with less than 40 per cent at the time of the financial crisis. Granted, other developed economies - namely Japan and Europe - have long been battling against a high debt level, but the challenge is now different in an inflationary world, with increasing pressure on central banks to raise interest rates.
The challenge of a high debt level is reflected by the fact that real rates in the US have firmly stayed in negative territory despite consumers and companies that are flush and free-spending. This goes against the traditional intuition that real rates should follow through spikes in inflation, as bond investors respond to high inflation by demanding compensation for the possibility that inflation will get higher still, dragging real rates up. This is not happening now, which suggests the alternative explanation, that we’re in a debt trap. The idea is that debt has piled so high that any increase in rates will make it terribly expensive to service, wounding the economy and leading rates back down again. Thus, whilst the market expects inflation to remain high, US treasury market is unrattled by the prospect that inflation is here to stay and are pricing the Fed to stay dovish for as long as it takes, evidenced by the 10-year TIPS (inflation-indexed Treasury securities) hovering around -1%.
Whilst the prospect of a dovish Fed keeping the nominal rates low suggests that a debt crisis is some away ahead, it is nonetheless interesting to contemplate over the long-run implications on the "safe haven” status of US treasuries, and consequently, the dominance of US dollar as the world’s reserve currency. With excess global savings, there still is an insatiable demand for safe assets in the shape of the enormous outstanding liabilities currently being created by the US. So 60% of central bank foreign exchange reserves are still in dollar assets. As a new paper by Ethan Ilzetzki, Carmen Reinhart and Kenneth Rogoff points out, changes in the dominant global currency are rare. Nonetheless, the authors also note that, while demand for dollar-denominated safe assets has exploded, the tax base backing those assets has diminished. The demand for safe assets, they say, risks eventually overwhelming the US government’s fiscal capacity to back them, adding that there is no guarantee that insatiable demand for such assets will continue.
In this debate the enduring question is, what are the alternatives to the dollar? With China set to overtake the US economy the renminbi, which commands just 2% of global reserves, is clearly a contender. Yet many question whether an authoritarian state with an in-transparent central bank, a reputation for excessive currency intervention, and now a fragile property market can do the job. In practice, the bigger challenge here for Powell will come if China succeeds in making the transition to a more consumer-driven economy, which would cause global savings rates to fall and real interest rates to rise. That is one more reason for markets to wake up and recognise that US government IOUs are very unsafe assets.
What the ‘big quit’ tells us about inflation|Financial Times
An interesting read that puts forward resignation rate as a leading indicator for inflation, as shifts in labour market are often subtle and we might be facing a structural change of natural rate of unemployment before we know it.
A handful of items are driving inflation in America|The Economist
This article provides a unique, data-driven approach on deciphering the inflation trends in the US. It’s often too easy to just look at the headline numbers and draw a too-simplistic conclusion on the current inflationary phenomenon. Contrary to what many believe, the Economist’s new measure - focusing on the concentration of price items - shows that this portends lower inflation, but not enough for the Fed to lower its guard.
The gap between US spending and confidence|Financial Times
Holiday sales have started strongly, but Omicron raises new questions. This is a good forward-looking piece that bridges the gaps between realised consumer spending and future uncertainty over consumer confidence.
That's it from us for now!
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