Deflation and Policy Mistakes
Doug Nolan
Hotter-than-expected August CPI and quarterly options/derivatives expiration made for a toxic mix.
“Core” CPI was reported up 0.6% for the month (7% annualized!), double estimates.
With the peak inflation narrative having received the blessing of the markets, sinking gas prices, a negative headline print, and rapidly declining y-o-y CPI were the bullish focus heading into the report.
The reality was persistent and broadening pricing pressures – good and services.
Two-year Treasury yields surged 17 bps on CPI Tuesday – and rose 31 bps for the week to the high (3.87%) since October 2007.
Market expectations for the Fed funds rate at the December 14th FOMC meeting spiked 31 bps this week to 4.19%.
Benchmark MBS yields jumped 26 bps to 5.07% - the high since November 2008.
While relatively contained in the face of Tuesday’s equities downdraft, general “Risk Off” dynamics gained momentum through the week.
U.S. High yield CDS surged 57 bps, trading intraday Friday (545 bps) back to highs since mid-July.
Yet high yield CDS only reversed the previous week’s 58 bps drop.
Investment-grade CDS jumped eight to 89 bps, reversing the majority of the previous week’s 11 bps decline.
Bank CDS prices were up strongly, but in most cases only reversing the previous week’s move.
The VIX (equities volatility) Index traded to 28.5 in Friday trading (high since July 13th), before ending the week up 3.5 points at 26.3.
Not that big of a deal.
For the most part, global “Risk Off” was not overly vigorous.
European CDS rose less than the previous week’s decline.
German and French equities indices were down more than 2%, but most European equities declines were unremarkable.
EM CDS surged 25 bps, just reversing the previous week’s drop.
EM currencies and bonds were under moderate pressure.
Yields were up 30 bps in Brazil, 24 bps in Thailand, 24 bps in Mexico, 22 bps in Poland and 21 bps in Turkey.
The most notable yield surges were in dollar-denominated EM debt.
Yields were up 65 bps in Turkey, 39 bps in Peru, 33 bps in Panama, 30 bps in Chile, 26 bps in Mexico, 24 bps in the Philippines and 22 bps in Brazil.
The Shanghai Composite sank 4.2%, with the growth-oriented ChiNext Index falling 7.1%.
China sovereign CDS jumped seven to 75 bps, reversing the previous week’s decline.
Chinese bank CDS were little changed, while developer bonds were mixed.
Disappointing CPI data pushed at least a couple analysts to forecast a 100 bps rate hike in next Wednesday’s FOMC meeting.
As of Friday’s close, rates markets were pricing in an 80 bps increase.
September 14 – CNBC (Yun Li):
“Cathie Wood, Wall Street’s most vocal proponent of deflation, is getting a few high-profile supporters even as price pressures continued to surprise to the upside.
Jeffrey Gundlach and Elon Musk recently joined Wood’s camp in calling for a decline for prices, expressing worries that the Federal Reserve might go too far.
The so-called bond king warned of deflation risk on Tuesday, urging investors to buy long-term Treasurys.
Meanwhile, the Tesla CEO called falling commodity prices ‘neither subtle nor secret’ and tweeted to his 100 million followers that ‘a major Fed rate hike risks deflation.’
‘We are getting some loud voices now accompanying us on this deflation risk,’ Wood said…”
Jeffrey Gundlach - September 13, 2022:
“In spite of the fact that the narrative today is exactly the opposite, the deflation risk is much higher today than it’s been for the past two years.
I’m not talking about next month.
I’m talking about sometime later next year, certainly in 2023.”
September 12 – Fortune (Prarthana Prakash):
“What a difference five months can make.
In April, Elon Musk told analysts that he believed inflation was worse than was being reported at the time and would likely continue through 2022.
Now he’s singing (or tweeting) a different tune.
The Tesla CEO is now worried that a major interest rate hike by the Federal Reserve could kick off deflation.
‘A major Fed rate hike risks deflation,’ Musk tweeted…”
I recall the vociferous deflation talk following the 1987 stock market crash.
In 1990, after the crash of the late-eighties “decade of greed” Bubble, deflation fears became only more entrenched.
Championing new reflationary doctrine after the bursting of the “tech” Bubble, Bernanke invoked lessons from the deflationary spiral and Great Depression.
Deflation risks were priority one following the mortgage finance Bubble implosion.
It seems that the “Inflation vs. Deflation” debate also dates back decades.
I’ve long argued that most inflation v. deflation discussion is too simplistic.
There are various key price levels in a system that don’t necessarily move in concert.
Understandably, Cathie Wood and other Wall Street operators are deeply concerned about sinking stock prices – or, more broadly, asset price deflation.
They’re worried about an unfolding “policy mistake,” while myriad mistakes unfolded over the past three decades.
It should be noted that collapsing asset prices are an inevitable facet of speculative Bubbles.
I have consistently argued over the years that the greatest systemic risk was not deflation, but instead Credit and speculative Bubbles.
It has been nothing short of a monumental misdiagnosis of the problem and administration of precisely the wrong medicine.
Accommodating historic Credit and speculative excess in the name of fighting supposedly insufficient inflation - and even deflation - has been an epic failure of runaway Bubbles.
The Federal Reserve and the global central bank community today confront the nightmare confluence: myriad faltering speculative Bubbles concurrent with multi-decade-high consumer and producer price inflation.
Moreover, consumer price inflation has accelerated even after months of speculative Bubble deflation.
The Fed’s hope for transitory price inflation proved wishful thinking.
What’s more, Fed expectations for tightening market financial conditions to presage a return to 2% inflation have been deeply flawed analysis.
Last week’s CBB highlighted ongoing robust Credit growth, as evidenced in Fed Q2 Z.1 data.
Bank lending, in particular, is booming, while government deficit spending is unrelenting.
The economy is demonstrating powerful and pervasive inflationary biases.
This being the case, a major slowing of Credit growth is now necessary to tame runaway inflation.
The U.S. is certainly not alone in suffering the ill-effects of years of monetary inflation.
China’s Aggregate Financing (AG) expanded $348 billion last month, up strongly from July’s $108 billion, and almost 20% above expectations.
Yet AG was still 19% below August 2021.
After eight months, y-t-d AG growth of $3.467 TN is running 10.7% ahead of 2021 – while only 8% below 2020’s historic Credit onslaught and fully one-third higher than pre-Covid 2019.
Bank Loan growth of $179 billion almost doubled July’s production, but was still about 15% below estimates.
Y-t-d growth of $2.236 TN was almost 4% above comparable 2021, with one-year growth of $2.935 TN, or 10.9%.
Corporate Bank Loans bounced back strongly, from a weak July ($41bn) to $125 billion, 26% ahead of August 2021.
At $1.796 TN, y-t-d growth was 32% ahead of comparable 2021 – and even 30% ahead of 2020 (74% above 2019).
One-year growth ticked up slightly to $2.157 TN, or 12.8%, with two-year growth of 25.6% and five-year growth of 72.5%.
While somewhat recovering from a dismal July ($17bn), Consumer (chiefly mortgage) Loans increased only $66 billion, 20% below August 2021.
This put y-t-d growth at $395 billion, 50% below comparable 2021 growth and 44% below pre-Covid 2019.
One-year Loan growth of 7.4% was the weakest in decades.
Government Bonds expanded $44 billion, down from July’s $57 billion and August 2021’s $140 billion.
Yet y-t-d growth of $768 billion was 48% ahead of 2021, and only 6% below comparable 2020 (48% ahead of 2019).
Analysts were generally unimpressed.
Bloomberg sources have suggested that some loan growth is due to banks lending to other banks, often simply to meet lending quotas.
There was also a $70 billion increase in shadow banking last month, according to Bloomberg “the biggest increase since March 2017.”
The bottom line: Aggregate Financing inflated a massive $4.825 TN, or 10.5%, over the past year to $48 TN.
Over 30 months, AG surged $12.094 TN, or 72%, in one of history’s most spectacular Credit expansions.
Private sector Credit, especially Consumer, has slowed markedly, while government and banking sectors rapidly inflate.
Ominously, the gap between Credit and economic growth has only widened further this year.
Credit must slow in China, the U.S. and globally - and many will wail "deflation" and "policy mistake."
I also believe a comprehensive reexamination of contemporary central bank doctrine is long overdue.
I was thinking this week of prescient insight offered some 17 years ago by German economist (former Bundesbank and ECB Chief Economist) Otmar Issing.
Dr. Otmar Issing (from his 2005 paper “Monetary Policy and Asset Prices - Crisis: Time to Ponder on Traditional Wisdom"):
“We have learned on many occasions that excess liquidity can show up in excessive asset valuations and not only in consumer price inflation.
Sooner or later, then, unsustainable asset price trajectories may translate into sizeable risks to price stability -- in either direction -- and often much further down the road as the long-run fallout of the Japanese bubble of the late 1980s has shown.”
“To my mind the risks associated with asset price inflation and subsequent deflation are an important additional reason for paying close attention to money and credit, over and above the regular and well-established link between money and consumer prices.”
“Thus, a monetary policy strategy that monitors closely monetary and credit developments as potential driving forces for consumer price inflation in the medium and long run has an important positive side effect: it may contribute at the same time also to limiting the emergence of unsustainable developments in asset valuations.
In other words: as long as money and credit remain broadly well-behaved the scope for financing unsustainable runs in asset prices should remain limited.”
“The tendency of modern textbooks on monetary theory and policy to relegate money and related concepts to inconsequential footnotes can be no comfort.
What is the role of liquidity, financial frictions and the flow of funds for the real economy and the relation of money vis-à-vis a broader range of asset classes?”
The Fed faces another important meeting next week.
The FOMC is, of course, poised to push ahead with its aggressive tightening cycle.
Meanwhile, global crisis dynamics fester.
I appreciate that our central bank is resolved to get inflation under control.
Unfortunately, each week seems to confirm “hike until something breaks.”
A 100 bps hike would be a first since Volcker was resolved to aggressively tighten until money supply growth slowed markedly.
At least he had a sound analytical framework for attacking the inflation problem.
Without at least some focus on money and Credit, the Fed has been flying blind.
I’m anxiously waiting for Powell’s press conference.
It would no doubt be a cold day in hell – the Chair mentioning Credit growth.
A couple timely headlines from the week: FT: “Fed’s Faster ‘Quantitative Tightening’ Adds to Strain on Bond Market.”
NYT: “Fed’s Exit Puts World’s Biggest Bond Market on Shakier Ground.”
While the focus has been on rates policy, I expect liquidity issues to increasingly pressure the Fed to provide the market with some QT relief.
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