From Pantomime to Farce

This time last year we wrote an article entitled ‘Pantomime Monetary Policy’ where we mocked the denial and inaction of central bankers in the face of rising inflation, especially high asset price inflation. For much of 2022 central bankers bleated that inflation was ‘transitory’, but with consumer price inflation now tagging 8-10% across the Atlantic, they  are now of the view that ‘there are few signs that inflation pressures are easing’ to quote the latest Federal Reserve meeting minutes. Now they may get it badly wrong again.

As the central banking chorus grows, an array of macroeconomic indicators are dropping sharply like fizzing meteorites to earth – components of the Conference Board lead indicators, Philly Fed Survey and Empire State Manufacturing indicator – have all fallen to levels only seen during the 2008 recession. Financial liquidity is contracting rapidly (this has proven a good indicator of where inflation goes, with a lag). Note that if inflation doesn’t fall, then liquidity must contract even more.  

Economic sleuths will have noticed the recent drop in the price of oil, welcome from an inflation watching point of view, but a move that also tells the story of weaker growth ahead. Together with the drop in some of the above-mentioned releases, this suggests that a recession is not far away, if not upon us (curiously the Fed economic forecasts and those of the White House exclude such a scenario). More compelling evidence comes from the bond market where there is an epidemic of steeping if different calibrations of yield curve.

Yield curve steepening occurs, in very simple terms when longer maturity bond yields (10 year for example) fall well below shorter term ones (2 year), essentially forecasting weaker growth in the future. Unlike equity markets, which have predicted nine of the past five recessions, the yield curve has a better record, predicting six of the past five recessions. Another important indicator is the health of housing markets. In the rate sensitive and generally over valued and over leveraged markets (Canada, Sweden, Australia and New Zealand for instance) aggregate prices are dropping

Many economists are now sounding the alarm, and readers should brace for a media debate on whether we get a W, V or U-shaped recession. As it stands, unlike government bond markets, corporate bond and equity markets are not pricing in a recession and may well be vulnerable.

But, the outlook is however more complex than that.

Notably, different elements of the business cycle are behaving in odd ways. While lead indicators and more speculative indicators of inflation (lumber, used car prices for example) are dropping, labour markets are very strong and in general business activity seems to be healthy. Many of these elements may disimprove with time, or a lag as economists say, but these strands of strength make for several dilemmas for central bankers.

Do they for example bludgeon the cash rich consumer and healthy labour market in order to force inflation down or permit a higher level of inflation to stay in place with many unforeseen consequences for companies and asset prices. As it stands, there is a risk that interest rates run high for too long – thus discovering hitherto hidden pockets of risk and leverage. This will be a key story for 2023 and we will come back to it. An additional strand of this story will be the acute social and wealth inequality related aspects of this.

There are two more things worth saying about the business cycle.

The first is that it has been distorted and vandalized by a range of factors – lengthened and prolonged by both globalization and low interest rates (the three business cycle expansion phases during the period of globalization were the longest on record) and then the effects of COVID on labour markets, consumer preferences and fiscal policy. The commercial rupture between the US and China will also skew it and most likely the large outstanding debt load across many countries and companies will produce shorter, staccato’d business cycles.

Second, and finally there are not enough policy makers with a vision for the structural improvement of their economies. Liz Truss managed to identify a low trend rate of growth as a problem, but her response to it was hopeless. Since the global financial crisis, policy making across different countries, notably Europe, has been about crisis management. As such there are few large economies that are targeting gains in productivity and build infrastructure in new economic areas. When that happens we will be free of unconventional business cycles.

 Until then, we are in the hands of the central bankers.

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