Bigger Mistakes
Doug Nolan
August 27, 2021: Bloomberg Wall Street Week’s David Westin: “Larry, you saw, you read what Jay Powell said [in his Jackson Hole speech]. What was your reaction?”
Larry Summers: “I was glad to see him moving towards beginning tapering this fall.
I still think he’s operating within the same paradigm that he’s been operating in – which… I don’t think is quite right.
He made a whole set of arguments on the serene side with respect to inflation.
And obviously, he may turn out to be correct in those arguments – and there are a lot of people who agree with him.
But I was struck, for example, that he didn’t say anything about the housing sector.
That’s the largest part of the consumer price indices.
I saw a statistic… that said, on average, when a tenant moves into a rented residence, they’re paying 17% more than the old tenant.
That suggests a lot of rental price inflation.
If you look at owner-occupied houses, the prices are taking off.
None of that has been reflected yet in our price indices.
And yet, on any commonsense definition, that’s surely inflation.
And, so, my guess is you’ll start to see the housing component of inflation show up as rising pretty rapidly.
Or if you don’t, it will reflect defects in the way we create the price indices.
The Chairman mentioned, rightly, that we’ve got record levels of job openings, and workers are turning over very fast.
Workers are quitting their jobs.
I’d have thought that all of that would be a signal that in a labor shortage economy, you’d be starting to see much more rapid wage increases than you’d seen historically, but that that was a process that would take a certain amount of time.
He was more serene about all of that.
He was referencing that we had had 4% unemployment before covid without rapidly accelerating inflation.
He was right about that, of course.
But I see that we’re having far more structural change in the economy, as businesses rethink their business models – when people aren’t going to be coming into the office, as people rethink their lives after a year without commuting – as the whole structure of the economy changes.
And I think with all that structural change, you’re likely to see some substantial increase in the level of unemployment that the economy can sustain without excessive inflation.
So, there're no certainties, but I think the inflation risks are graver than those that the Chairman recognized.
I think that the toxic side effects of QE are rather greater than the Chairman recognized.
So, in the range of places where this speech seemed likely to come down, I think it came down in a relatively good place from my point of view – pointing towards a taper this year.
But in terms of the issues I’ve been concerned about for quite some time - that we’re kind of making a bit of a paradigm error, I didn’t expect that the speech was going to represent a deviation from the paradigm, and I don’t think it did…”
“If you think it’s a good idea in order to stimulate the economy – I think the risks are more on the overheating side – but if one thought that it was a good idea to stimulate the economy by printing interest-bearing money, the question would be what you should spend the money on.
Out of all the things you could spend the money on, the thing that it seems to me that would help the wealthy most and do the least to promote demand, is buying up financial assets.
And that’s what QE is.
I’d rather see us – to the extent we want to do this – use fiscal policy.
Again, I don’t see the problem now as stimulating the economy.
I see the risk is overheating the economy.
But if we want to provide stimulus, I don’t think QE is the right way to do it.”
One cannot overstate the critical role played by central banking, especially now that their policies so dictate market excess.
History informs us that sound “money” is fundamental to stable economic development.
Moreover, monetary stability is elemental to social and political stability.
Because we entrust such momentous responsibility to a small group of unelected central bankers, we should at least expect they maintain a cautious approach to monetary management.
Their decisions can cause great harm, so they should act accordingly.
That they can be so dismissive of inflation and Bubble risks is deeply troubling.
We’re now into a third decade of experimental central banking, of which I have chronicled the past two.
The experiment has failed.
Monetary disorder has spiraled completely out of control.
I am reminded of the “rules vs. discretion” policy debate that dates back to the Currency School vs. Banking School debates in nineteenth century England.
It was recognized generations ago that the risk inherent in discretionary central banking was that one mistake would invariably lead to a series of Bigger Mistakes.
I appreciate Larry Summers’ insight, and he’s clearly more diplomatic than I could ever be.
This is an unmitigated fiasco.
Federal Reserve credit has now inflated $4.154 TN over the past 77 weeks – and is up $4.597 TN – or 123% – in 102 weeks.
Let’s not forget the current QE program began months before the onset of the pandemic.
After beginning 2008 at $850 billion, Federal Reserve assets have inflated almost 10-fold to $8.33 TN.
Inflationary pressures are the strongest in years, asset markets are conspicuously manic, and much of the labor market faces the tightest conditions in decades.
And after doubling its balance sheet in less than two years, the Fed is poised to add another Trillion over the coming year.
Why?
Are the risks not obvious?
August 23 – Bloomberg:
“China’s central bank chief vowed to stabilize the supply of credit and boost the amount of money supporting smaller businesses and the real economy, after both credit and economic growth slowed in July.
The People’s Bank of China will keep monetary policy stable with a good cross-cyclical design and will support high-quality economic expansion with ‘appropriate money growth,’ according to a statement…”
August 24 – Bloomberg:
“Promoting the common prosperity will be the focus point of PBOC’s financial work, the Chinese central bank says…, after a meeting on Friday chaired by its party chief Guo Shuqing.
PBOC calls for strengthening financial infrastructure in rural areas to promote common prosperity among farmers.
PBOC reiterates not to flood economy with liquidity, will use various monetary policy tools to keep liquidity at reasonably ample level.”
August 26 – Bloomberg:
“China’s central bank signaled it may reduce the reserve requirement ratio for banks to spur rural finance, a targeted move that would help cushion the economy as it slows.
The People’s Bank of China said it will use monetary policy tools including the reserve ratio, and relending and rediscounting measures for rural development…”
Beijing followed up last week’s Huarong recapitalization with a string of dovish pronouncements from the People’s Bank of China (PBOC).
Haurong CDS sank 105 bps this week to a four-month low 453 bps, with an eight-session decline of 380 bps.
Fellow “asset management company” (AMC) China Orient CDS dropped 46 bps to a four-month low 156 bps – down 70 bps in eight sessions.
And AMC China Cinda CDS fell 47 bps this week (63bps in eight sessions) to a four-month low.
August 23 – Bloomberg (Rebecca Choong Wilkins):
“China Huarong Asset Management Co.’s credit rating was cut by Moody’s… to Baa2 from Baa1, and the borrower remains on watch for a potential further downgrade.
The ratings firm cited the deterioration of the asset manager’s capital and profitability, after Huarong forecast a 2020 loss of nearly $16 billion last week.
While a capital injection by a group of state-owned enterprises indicates Huarong’s systemic importance, the plan’s exact impact remains unclear, Moody’s analysts wrote…”
The AMCs pose a major dilemma for Chinese leadership.
Belatedly, Beijing recognizes the need for some market discipline.
But China’s now massive $12 TN credit market essentially trades with the perception of implicit central government backing.
A Beijing move to counter moral hazard with even a modicum of market discipline risks a bursting bubble.
Chinese officials moved to buy some time by orchestrating a Huarong recapitalization, a move surely in response to rapidly escalating credit instability.
And then Monday, the People’s Bank of China announced they would be “promoting the common prosperity.”
Chinese and global markets surged on hopes for further Beijing stimulus measures.
The Shanghai Composite rallied 2.8% this week, with the tech-heavy ChiNext recovering 2.0%.
Hong Kong’s Hang Seng Index rose 2.3%.
Taiwan’s TAIEX Index surged 5.3%.
South Korea’s Kospi recovered 2.4%, and Japan’s Nikkei was up 2.3%.
Major indices rallied 4.8% in Malaysia, 3.7% in Thailand, and 2.3% in the Philippines.
Chinese Credit instability was at the cusp of spiraling out of control.
A crisis of confidence in “AMC” debt would likely push the system over the edge.
As Moody’s pointed out with its Huarong downgrade, the recapitalization plan’s “exact impact remains unclear.”
But it does in the near-term likely take a potential highly-destabilizing catalyst off the table.
That coupled with the typical PBOC emollient was enough to spur a market rally.
Greed and Fear.
“Oh no, Beijing is no longer willing to underpin the markets, and this could really start to unwind!” to “Of course they have everything under control - buy the dip and squeeze the shorts!”
It’s easy at this point to dismiss the role China developments are playing in U.S. markets.
Isn’t it all about the Fed?
But in a world of highly correlated markets, it’s worth noting the performance of riskier U.S. stocks at the “Periphery.”
Last week, when the Shanghai Composite dropped 2.5%, the small cap Russell 2000 also fell 2.5%.
This week, the Shanghai Composite rallied 2.8%.
The Russell 2000 surged 5.1%.
U.S. high-yield spreads (to Treasuries) and CDS have also turned more closely correlated to Chinese Credit developments.
The Bloomberg Commodities Index rallied 5.7% this week, after sinking 4.2% the previous week.
Global bonds and currencies also whipsawed.
I struggle to believe this is all a coincidence.
While Beijing did buy some time with the Haurong bailout, Chinese Credit is not out of the woods.
August 26 – Wall Street Journal (Xie Yu):
“Cash-strapped developer China Evergrande Group said its flagship property business incurred a rare loss in the first half of 2021, after slashing prices of many apartments to boost sales.
The… property unit’s loss, equivalent to around $618 million, was its first since at least 2009…
Evergrande, China’s largest developer by contracted sales, warned in a regulatory filing that its reported net profit for the six months to June 30 would be substantially lower than a year ago…
Since the early months of the coronavirus pandemic last year, Evergrande has discounted sale prices of some of its apartments by as much 25% to lure buyers…”
Evergrande has over $300 billion of debt.
It’s bond (4-yr) yields traded to almost 45% in Friday trading.
The “AMC” catalyst may have been pushed somewhat out into the future.
Meanwhile, Evergrande and the faltering apartment Bubble remain a clear and present danger.
August 25 – Bloomberg:
“Beijing’s unprecedented determination to curb the property sector could be China’s ‘Volcker Moment’ as it will cause a ‘significant’ slowdown in economic growth, according to Nomura...
Unlike in previous economic down cycles, Chinese authorities look set to tighten property sector policy and tame prices this time, in order to reduce wealth inequality and boost the falling birthrate, economists led by Lu Ting wrote...
Policy makers will be willing to sacrifice near-term economic growth to tame house prices and divert financial resources out of the property sector, which accounts for a quarter of China’s gross domestic product, they wrote.”
They won’t admit as much, but Beijing is determined to finally bring its Bubbles under control.
The PBOC and “national team” will be employed to try to keep things orderly.
I don’t expect this to go smoothly.
It’s fascinating to watch Beijing and the Fed attempt to manage their respective historic Bubbles.
At least Chinese officials recognize they have a major problem.
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