Imagine you’ve gone to the cinema to see a Jason Statham action movie. There’s lots of rushing around when someone picks up a machine gun, fires it at bunch of people but, alas, nobody falls over. That’s what markets looked like yesterday when the US released its February Consumer Price Inflation figures. Headline annualised CPI rose to 3.2 per cent from 3.1 per cent in January. Annual core CPI, which excludes volatile food and energy prices, increased 3.8 per cent in the same period, below the January increase of 3.9 per cent but above the market forecast of 3.7 per cent. On a monthly basis, the CPI and the core CPI both rose 0.4 per cent. Inflation is not continuing to fall as predicted and yet equity and cryptocurrency markets, which are both supposed to be enjoying huge support from the prospect of imminent rate cuts, looked the other way with the S&P500 closing at yet another all-time high of 5,175.27 pts and bitcoin again knocking on the door of its own record price.
In the Jason Statham movie, it will transpire that some wise guy has replaced the ammunition with blanks, and we must ask ourselves whether the Fed and its friends and relations might not find themselves doing the same. Jonathan Levin, the Bloomberg columnist, neatly summed up the situation in a piece titled “Fed’s Data Dependence Fails When the Data Isn’t Dependable” although I wonder whether one should not be going one step further.
In the earliest stages of the current inflationary cycle when Fed Chairman Jay Powell first coined the phrase “transitory”, I queried whether the nature of inflation might not have fundamentally changed from the last great price cycle, whether this was the same form of cost-push inflation that Dr Fed had treated with shots of higher interest rates. I remember even going so far as to muse on whether cutting rates might not be the better approach. Much water has flowed down the Thames, the Potomac and the Main since then and, although we have learnt much more in terms of data, have we actually broadened our understanding of the underlying dynamics?
Six or eight weeks ago, I took a look back at the great inflation cycle of the 1970s and suggested that our memory of that period might be warped. Economics 101 teaches us that inflation is created by an excess of demand over supply. Tick. The textbooks told us that the oil shock of 1973 launched the period of hyperinflation which the late Fed Chairman Paul Volker took on with some of the most aggressive monetary policy ever seen. Between 1978 and 1984, Fed funds were rarely not in double figures. In 1981, they ranged between 22.36 per cent and 11.83 per cent and for the year averaged 16.39 per cent. Professor Volker has gone down in economic history as the great and fearless inflation buster. What I did was to stand back and take a broader view.
The 1960s saw both the Vietnam war and the NASA moon programme in full swing which, between them, are thought to have generated up to 10 per cent of US GDP. So they produced lots of household earnings while the goods produced did not appear on supermarket and department store shelves. No more classic case of too much money chasing not enough goods. Over time, however, as the war ended as did the great push to put people into space the economy began to self-right itself by manufacturers turning their capacity to producing goods for the market. Capitalism and not a command economy rectified the demand/supply imbalance. If my thinking were to be correct, then half a decade of ultra-aggressive interest rate policy might have looked right but ultimately it was the market and not the Fed that had brought inflation back to acceptable levels. I am old enough to remember having been taught in Economics that 10 per cent unemployment and 5 per cent inflation represented equilibrium and when current cost accounting was not regarded as strange.
Globalisation and the rise of China changed everything. I believe it is now common currency that the West’s central banks missed a trick in the early years of the 21st century when merrily patting themselves on the back for having elegantly managed inflation; erstwhile Bank of England Governor Mervyn King and his naming of the NICE (Non-Inflationary, Constant Expansion) economy marks the high water mark in their misunderstanding. All the while, strong underlying inflationary tendencies in their respective domestic economies were being cornered by cheap and plentiful imports from Asia. The more people borrowed in order to buy cheap imported goods the more inflation fell. Borrowing to consume should be inflationary. It wasn’t. Or by dint of the disinflationary effect of consuming imports, it appeared not to be.
The banking crisis of 2007/2008 which was met with the great government bailouts effected a huge shift of private sector debt onto the public sector balance sheet. Quantitative easing, reflected in the explosive expansion of central banks’ balance sheets was in effect nothing else. I was one of those who for some time had been sitting there waiting for the inflationary effect of QE to kick in. To begin with, this did not happen for the reason that early stage QE simply moved outstanding debt from one pocket to the other. Then, when inflation was beginning to kick in, the pandemic broke out and all bets were off. And by the time that was over, the disinflationary trade flows – or indeed what was left of them as China’s ability to endlessly supply cheap goods was fading – had evaporated. Lots of money sloshing around the system and, don’t forget that China was still in lockdown, not enough goods. Sound familiar?
The answer should have been not higher interest rates but a tighter control on money supply. With President Biden, however, intent on pumping US$ 7 trillion of supplementary deficit spending into the economy, what chances did the Fed stand?
Did the markets’ response, or lack thereof, to the higher-than-forecast February inflation number reflect traders and investors alike deciding that central banks, by insisting that they are data dependent, are themselves firing blanks and that a more holistic approach to interest rate setting is to be expected? It has always been difficult to take decisions with not enough information. Having too much of it, so we are learning in this so-called information age, makes it no easier. Surely most of us would admit if pressed that the majoirty of the decisions we take, we take based on gut feeling, usually politely referred to as educated guesses, only to then arrange the available facts in order to justify ourselves. There is always enough data out there to explain post-factum why what happened did in fact happen.
Here in the UK, there is an ongoing debate with respect to unemployment figures. The authorities are finding it increasingly difficult to deny that they really don’t have a clue. The UK is rare amongst European countries in that citizens are not required to register their presence with local authorities. We have no mandatory identity card scheme. Sure, in order to benefit from “the system”, we are required to have our National Insurance and National Health System numbers but ultimately there is no central registration which guarantees that the person who gives the number is and always has been the same one. Some suggest that up to 5 per cent of the people living in this country are not officially accounted for. But that’s also a guess. It might be 3 per cent. It might even be only 1 per cent although that would appear to be illusory. I digress.
The monetary policy committee of the Bank of Japan meets on Monday and Tuesday and the Fed’s FOMC meets Tuesday and Wednesday. The odds are going on 80 per cent that the BoJ will raise rates and similar odds are on the Fed doing nothing. Although Fed rhetoric now increasingly points towards only two or maybe only one rate cut in 2024, the futures market is still resolutely pricing in three. And given the way stock markets are performing, one might be led to believe that the equity geeks are still tacitly hoping for more.
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