Do No Harm

An unusual but non surprising cameo in the response of the UK to the burgeoning energy crisis that is resulting from the Iran War, was the inclusion of Bank of England Governor Andrew Bailey in last Tuesday’s emergency COBRA (Cabinet Office Briefing Room) meeting. The prospect that inflation and a cost-of-living crisis could further derail the fledgling economic recovery in the UK, has struck fear into politicians (the OECD reckons that the UK will be the worst hit country), though monetary policy purists won’t like the appearance that the independence of the ‘Old Lady’ (the Bank not Bailey!) is compromised.

What is more interesting is that this is yet another datapoint in a trend where finance, war and politics are becoming interwoven. In peacetime, central banks were the only game in town, the monetary battleships of the 2010’s, keeping the peace in bond markets and tilting currency moves in their country’s favour.

That was not always the case, books like Liaquat Ahmed’s excellent ‘Lords of Finance’, show the key role that central banks played in maintaining the stability of war time economies.

Now, the world order that is unravelling before our eyes is more like that of the 1910’s than the 2010’s, and a particular concern for central bankers is the extent to which economies have become frictioned.

By this, I mean the extra costs and inefficiencies that are bubbling up because of the end of globalization (a period associated with intense commoditization of prices and low inflation), a pandemic of supply chain disruption, and great power competition for ‘rare’ things (from rare earths to rare places like Greenland to rare technologies like quantum computing).

In general, these frictions will tend to bump up the rate of inflation. A famous example is the way in which the side effects of the war on Ukraine combined with short-sighted energy policy in Europe to produce a prolonged rise in inflation from 2021 to 2022.

From the point of view of central bankers, inured to a decade of stubbornly low inflation, this was a surprise, and prominent members of the central banking community were badly caught out by their view that this burst of inflation was ‘transitory’. Their difficulty is that the economic context of the 2010’s was characterised by demand weakness whereas the main policy problem of the 2020’s is supply constraint.

We now live in an economy of ‘atoms’ (energy, commodities, deeptech), where historically huge amounts of investment capital expenditure is/are being deployed amidst supply constraints to build a new (AI) economic infrastructure. About half of this will be financed by different forms of credit. Within this model, the debate on the productivity benefits of AI, which has produced a wide range of estimates of the potential impact of AI on the economy, illustrates what a demanding environment it is for central bankers to read.

The potential energy shock from the Iran war complicates matters even more and raises the prospect of a policy error. Echoing the schoolboy mistake by Jean-Claude Trichet to raise interest rates in 2006 when a spike in the dollar helped trigger a spike in oil prices, current ECB President Christine Lagarde has stated that the ECB was ‘ready to raise rates’. This may be a pre-emptive move to push markets to do the ECB’s job, and to warn companies and unions off raising prices. If not, Lagarde and other central bankers should do no harm. A rate rise from the ECB will do nothing to re-open the Strait of Hormuz (good note on the disruptive effects from the Kiel Institute), nor to rebuild refining capacity in the Gulf states.

The dilemma for central bankers is in distinguishing between an energy centric rise in prices and an eventual generalised rise in inflation expectations.

In my view the economic consequences of the Iran War can be short lived, but as long as it endures, amounts to a tax on consumers, a hit to risk appetite and a blow to confidence in US financial assets. Furthermore, the many costs of the war (see our note of two weeks ago, ‘It will be over by Christmas’) include a rise in the debt burden that countries like the US and UK will suffer, and an elevated level of uncertainty as the world’s former policeman turns bully.

It could be worse for central bankers, they could be politicians, who now must contend with another cost-of-living crisis, with little money left in the fiscal jar.

Have a great week ahead, Mike

Grasshopper

I had intended to write about universities this week but, strolling through the City of London, I was surprised, shocked even, to find myself on Trump Street, and then amused to see that it is joined by Russia Row.

My first thought was that this was part of a grand plan by the British establishment ahead of President Trump’s visit to London in September, the idea being to stage an event at the nearby Guildhall and to then tell the president that a nearby street had been named after him. Trump Street was apparently named so because several trumpet makers lived there in the 18^th century, but let’s ignore that for the time being.

Yet, the far more meaningful coincidence of Trump Street is its proximity to Gresham Street.

Sir Thomas Gresham was a trader and financier in 16^th century London, at a time when coffee houses in the lanes around the Royal Exchange formed the basis of what is known as the City. Gresham was an important player in Queen Elizabeth I’s economy, and his emblem – a grasshopper – is still present in various parts of the City (there is a giant-sized golden grasshopper on the roof of the Royal Exchange….if you can dare to make it up there).

While Gresham’s imprint can be seen across the City, he is remembered by Gresham’s Law which was named after him and states ‘bad money will drive out the good’. Gresham’s Law which echoes similar observations from Copernicus and other scientists through the ages is founded on the idea that in an economy where coins with the same face value but that are made from different base metals (say nickel and copper) there is a tendency for traders to hoard the coins made of the more valuable metal and to circulate lower quality coins. Bad coins stay in circulation, good ones are re-commoditized. From an economics point of view the law is conditioned on all the coins (of variable quality) having the same face value.

Unlike the 16^th century, today, coins have the same physical consistency and in general there is little incentive for people to shave bits off coins (historically coins have serrated edges to prevent this) but broadly the Gresham’s Law is applicable in different domains.

Think of how cheap goods (made under questionable labour conditions) have forced quality players out of markets, or how in the run-up to the global financial crisis, low quality financial institutions offering generous loan conditions caused better quality banks to step back from lending. In both cases, regulation or policing of markets is necessary to ensure that ‘bad’ actors do not gain an advantage over good ones. Social media is another example, where it seems a lot of nonsense thrives at the expense of information.

Additionally, the idea of Gresham’s Law is applicable to politics, where in many countries it appears that political actors with extreme views and extreme modus operandi are forcing out ‘good’ ones in the sense that most normal people would be terrified of a career in politics.

Readers will guess that my argument is leading back to Washington. Bad behaviour, bad ideas and bad policies are infesting themselves in public life, the economy and markets – to the surprise of many ardent supporters of President Trump. What is not clear is whether this will result in an evacuation of capital and talent from the US, or whether there will be a counter-reaction. Gresham’s point in describing how bad money drives out good was to avoid the debasement of the currency (schilling), which when Elizabeth I came to power, was already in a bad state. She appointed Gresham as a finance minister of sorts in 1560, and within a year he had ‘bad’ coins taken out of circulation and replaced them with money made from precious metal, the result of which was a dramatic improvement in Britain’s status as a trading and economic power.

The lesson of this should be very clear today. As a final point, it is interesting to note, from the point of view of coins and money, that the ratio of gold (precious metal) to a cyclical commodity (copper) is the most stretched it has been since at least the 1980’s, suggesting that markets at least are thinking of Gresham’s Law.

Have a great week ahead

Mike

Samuelson vs. Sahm

Next week the Federal Reserve will very likely cut interest rates, for the first time since the COVID related rate cutting cycle. Recall of course that at the end of this speedy sets of cuts, most of the leading central banks had declared inflation to be ‘transitory’. The Fed cut will come on the back of a series of rate cuts from ‘elder’ central banks – the Bank of England, Riksbank and the Swiss National Bank, as well as the European Central Bank from whom we had another rate cut last week.

The anticipated move by the Federal Reserve is instructive in several respects. Market based interest rates are lower than Fed rates and many investors expect (or rather crave) the Fed to make a 50 basis point cut, as opposed to a ‘standard’ one of 25 basis points. At the weekend, the lead headline in the Financial Times read ‘Investors raise bets on bumper half-point Fed rate cut’.

This is yet another sign of monetary addiction – the result of the conditioning of investors to financial liquidity. In mid-August, following a dip in the stock market, I wrote that the idea of the ‘Fed put’ – the notion that the Fed would react to a fall in asset prices by cutting rates – is very much alive in markets.

The market dip led several seasoned and apparently credible investors to call for an emergency cut in rates. However, the Fed has only ever taken such dramatic action in the thick of deep crises (LTCM/Russian economic collapse, the dot.com collapse, 9/11, the global financial crisis and the COVID crisis). Similarly, it has not begun a rate cutting cycle with a 50 basis point cut, outside of financial crises. There is no financial crisis today (though plenty of mounting financial risks such as very high debt levels), but a crisis of expectations.

That crisis of expectations is at play as investors position for the Fed meeting next week. In my experience, the Fed is, in normal economic conditions, a cautious and slow-moving beast, and it would be untypical for them to begin a rate cutting phase with an outsized rate cut. To do so would suggest that they are in a hurry to correct a mistake of their own making.

To the extent that investor behaviour demands a 50-basis point cut, this recalls the quip from Paul Samuelson, the first winner of the Nobel Prize in Economics, that the market has predicted nine out of the last five recessions.

Set against this apparent concern by investors (do they fear a recession or desire lower rates?) is a debate around a relatively new economic rule of thumb called the Sahm Rule, named after research by economist Claudia Sahm at the Federal Reserve. Her rule states that when the medium-term unemployment rate rises an impending recession is signalled (the three month average of unemployment needs to rise by 50 basis points). It is a surprisingly simple rule that appears to have prefigured eleven US downturns going back to 1953. Sahm’s aim in establishing a reliable rule was that stimulus checks can be sent out at the outset of recessions (as opposed to waiting for GDP data to indicate a recession).

I am tempted to trump the Sahm Rule with two observations.

The first is Goodhart’s Law, named after Bank of England and LSE economist Charles Goodhart which states that ‘when a measure becomes a target, it ceases to be a good measure’, or more colloquially that fame kills a good model.

More seriously, most of the last ten business cycles were conventional ones, whereas this business cycle bears the scars of reversing demographics, the lingering effects of COVID fiscal policy and labour market distortions (work from home) not to mention the contortions of strategic industrial policy (i.e. the CHIP’s Act, Inflation Reduction Act) and the political ramifications of high inflation and immigration. It is anything but a typical business cycle, and very hard to read.

Somewhat unusually at this stage in the cycle government finances are weak (from France to the US) whilst the large corporates of the Western world are in a generally healthy financial state. Of the major economies, China poses the greatest risk to the downside in the near-term.

With different components of the US economy moving in different directions, my expectation is for a slowdown than a deeper recession (this may eventually come at the end of 2025 if inflation rises again). Equally, I expect the Fed to make a series of rate cuts rather than deep cutting cycle. If that view is correct, the interest rates market will be very volatile, as investors periodically over react to data points and price in ‘booms’ and busts’.

Expect a market tantrum next week with investors complaining that the Fed is behind the curve. Samuelson would tell us that the curve has got it wrong.

Have a great week ahead,

Mike