Ebb and Flow, Flow and Ebb

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Getting a bead on inflation is a bit of a mug’s game but nevertheless unavoidable for the cross-border risk-taker. You have to have an opinion, right? The current US administration’s fiscal activism, and skewing of the US energy markets may have primed inflation; the Russian invasion of Ukraine certainly exacerbated things. But how durable will the current spate of inflation prove to be? Therein resides the risk and the opportunity. Global lenders and investors should manage leverage accordingly, making sure to choose from ready and durable facilities over ones more feckless and demanding. This is important since volatility does jump and asset prices correct, when people get surprised and get things wrong. That said, there are disinflationary forces that could prove stabilizing, yet policy decision-making and geopolitics could turn things pear-shaped. Just on its own, inflation numbers as another catalyst for geopolitical risk. As if it’s not obvious enough, eyes should be wide open.

For such a mild-mannered guy, Jerome Powell can sure dominate a room. A week-ago this past Friday, Chairman Powell declared that, under the auspices of the annual Jackson Hole event, the Fed was prepared to tighten monetary policy until US inflation was irrefutably subdued. No matter what the impact. US fixed income and equity markets promptly cratered and continued to lose ground during the ensuing week. The Fed Chair’s admonition poured more gasoline on some of the worst US financial markets over the past 70 years. No matter.

So, US inflation stands at an annual rate of 8.5% as of this July, a little slower than that of the preceding month but still high. In an earlier piece, we took license to supplement the adage that inflation is anywhere and everywhere a “monetary phenomenon”, by noting that it’s probably a “political” one as well. Elections – and chosen policies – have consequences, as different pundits note. With recent legislation understood as caveat, the question arises whether the dramatic fiscal measures brought on by Covid may be receding in their impact, much like a kind of Doppler effect on the economy. Some monetary data may be indicating as much.

One thing to think about is the annualized rate of growth in US credit and the monetary aggregates. These express demand, action and liquidity – they articulate the “too much money chasing too few goods” condition to the extent it’s there. For reference, a handy resource on this is the “Credit Creation: Cause & Effect” insert in the bi-weekly Grant’s Interest Rate Observer (GIRO). As of this past June, over the last three months reported growth in M-1 and M-2 aggregates were negative, at -2.9% and -1.3%, respectively. Over the past six months, the two aggregates crawled at respective rates of 1.1% and 1.7% on an annualized basis. Year-over-year rates per the June Federal Reserve data show respective M-1 and M-2 rates at more animated clips of 6.3% and 5.9%.

Of note though, the rates of growth are much slower than those posted last year. As reflected in October 2021 Fed data, M-1 and M-2 grew at respective clips year-over-year of 15.7% and 13.0%. As the Fed numbers indicate, there is less liquidity sloshing around in the economy, which shows Fed tightening has been working and the fiscal impulse may be ebbing. Something to watch.

Mr. Powell is reminded constantly of the resolve Paul Volcker showed. Volcker tightened and would not quit until convinced, thereby expunging worsening inflation from the US economy and ushering in the forty-year fixed income bull market. Jerome Powell must do the same, and he has told us he will.

But think about it for a minute. Human nature, sadly, is a constant, and risk-takers must remind themselves of that. And yet, circumstances are different from what they were in the 1970s and 80s. That could be material. Taking a tremulous pause, one might say, “this time is different…”

In their brief piece posted on May 5th, “Lower Oil Reliance Insulates World from 1970s-Style Crude Shock”, IMF economists note that this time may indeed be different. In their comment, the IMF profiles the efficiency of energy utilization since the 1970s. The economists show that the number of barrels of oil required to produce USD 1.0 million in global GDP – what the IMF describes as “global oil intensity” – has declined sharply.

From 1970 to 2022 to date, global oil intensity has declined from roughly 800 barrels to just above 200 barrels of oil. This is a tangible disinflationary development. The authors also draw this additional labor market distinction, citing the “…generally lower prevalence of wage setting mechanisms that automatically adjust worker pay based on inflation. This reduces the upward pressure on prices…” It also helps preclude the advent of an inflationary spiral path – a dynamic exhibited during the inflation prone seventies.

Different commentators highlight poor demographics and the pull back from globalization as forces that will precipitate more global inflation. But the disinflationary forces endure:  improving technology, enhanced communication and better process development continue to make things better and frequently cheaper.

More efficient use not only of fossil fuels but of other raw materials has been manifest throughout the global economy since the 1970s. The author Andrew McAfee, a principal scientist at MIT Sloan School Management, describes this in his book, “More from Less: The Surprising Story of How We Learned to Prosper Using Fewer Resources – And What Happens Next” (New York, NY: Simon & Schuster, Inc., 2019).

So, the things that have made price stability more tangible for much of the world – innovation, technology developments, better means and ways of doing things – are potentially all “renewable” or rather inexhaustible. They represent human ingenuity and, critically, they can prove to be disinflationary.

The thing to watch will be that other forum – politics, and related geopolitics. Russia’s invasion of Ukraine is one such realized example. A further negative ramification may be Russia’s seeming ability to turn EU and US sanctions on their head. High global energy prices have emboldened the Russian Federation, which has recently opted to shut its Nordstream 1 pipeline shipments of natural gas to Europe – so more potential for price shocks in that regard.

So, disinflationary forces notwithstanding, bad geopolitics and poor public policy missteps can still mean inflation risk or shocks.  But, long-standing forces could be helping things mend.

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