Although the week was a non-event in the markets with bonds and equities generally higher, the PCE Core Deflator, a key measure of US consumer prices, came out at its highest level since 1992 at 3.1 % Year on Year.
As the long term chart shows, US core inflation is clearly coming out of almost 30-years of low inflation and the debate over whether the recent acceleration in inflation is just transitory — as the Fed believes — or becoming entrenched is the most heated in the field of economics at the moment.
The truth is that there is no historical precedent for how an economy reacts to the trillions of dollars of fiscal and monetary stimulus that were injected during the COVID pandemic, but traditional economics teach us that inflation IS, by definition, a monetary phenomenon.
A quick review of the various US inflation gauges shows that they are all sending the same message.
At 4.2 % year on year, the US Consumer Price Index is clearly at the highest since the Great financial Crisis.
The US Core CPI ( excluding food and Energy ) is also at the highest since the 1990s
At 9.5 % year on year the US Producer Price Index is the highest since 1982
Another broader measure of inflation is the US GDP Price Index and there again, the gauge is now trading at levels not seen since the 1980s
Asset markets are clearly ignoring these numbers, trusting the words of Central Banks about their capacity to control inflation and their assessment that these spikes are transitory, but the fact of the matter is that the unprecedented liquidity injected into the system since 2020 is creating inflation, and, contrary to the assessment of the FED, this could well be the beginning of the inflationary impulse and not just a simple blip.
Granted, the FED may argue that the base comparison with the month of May 2020, in the middle of the lockdowns, creates a temporarily unfavourable base effect that will fade away in the coming months, but even when taking into consideration this base effect , what really needs to be taken into consideration is the unprecedented magnitude of the liquidity injection and artificial tweaking of interest rates caused by the Pandemic
Maybe more worrying, even if unnoticed for now because of the appeasing FED talk, is that besides the equity and commodity bubble, the US real estate market is on fire.
US Median Existing Home prices are now almost 50 % higher than where they were at the peak of the 2006 real estate bubble, a bubble that led to the Great Financial Crisis.
And they have been rising by 19 % over the past 12 months, while as the above graph shows, the pandemic had strictly NO negative impact on US home prices 12 months ago, so there is no base effect there.
The 19 % rise is a pure and perfect inflationary phenomenon, and if interest rates do not normalise, there is strictly no reason for home prices to start falling or even plateauing.
What all these indicators are saying is that the excess liquidity created by the FED and other Central Banks is finally finding its way into real prices, sending inflation higher accross the board.
Until now, the markets have refused to acknowledge the phenomenon.
Last week’s muted reaction of the. bond market to the torrid pace of inflation gauges is a worrying sign.
Bond markets are supposed to be wise and predict the future of inflation.
It is clearly hard to discount the collective wisdom of bond traders and their supposed ability to accurately predict where inflation is headed.
However, they are operating in a market environment where demand is artificially tweaked by massive central banks buying and they have never seen the real impact of so much monetary and fiscal stimulus.
But they are operating in an environment where their main barometer – yields – are manipulated and going against the ruler power of the FED is a dangerous leap of faith.
The best illustration of that the current inefficiency of the bond markets is that yields are artificially trading well below inflation, raising questions about the sanity of bond traders, and bond investors. We are in a market where borrower are paid in real terms to borrow money and where lenders pay in real terms to lend money.
This is not a testimony of the insanity of bond traders or of the accuracy of their predictions, but rather of the insanity of Central Banks that have lost their compasses in the face off political interaction and an unprecedented health crisis.
Real yields haven’t been this negative since the mid-1970s and it is actually this state of affairs that triggers inflation, as it did in the 1970s.
Inflation is a monetary phenomenon whatever the FED says …
The US supply of money has exploded in 2020. M2 — cash, checking deposits, savings deposits, money-market funds and other items defined as “near money” — stood at $20.1 trillion as of the end of April, up from $15.3 trillion at the end of 2019. To put that $4.8 trillion increase in perspective, one must consider that the most M2 ever increased in a whole year was $952 billion in 2019. So, in 2020, we had 5 x the most aggressive money supply increase in history.
As this long term graph shows, we have never had such a jump in liquidity creation since data exists, and M2 is still growing at 18 % YOY in April
When looked at in absolute terms, the graph is even more dizzying…
In absolute terms, Money supply is 5 times larger than it was in 2000 and accelerating vertically.
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Since 1982, we have been in a traditional Kondratieff disinflationary environment amplified by four structural factors, global peace, better economic management, globalisation and technological advances.
In the last decade of that winter cycle, the fear of central banks and economists was the disappearance of inflation, or outright deflation. That fear was so prevalent after the 2007 financial crisis that Central Bankers allowed themselves to withdraw from their own analytical frameworks and sort to extraordinary tools such as quantitative easing and bond buying.
This led to a first bout of asset inflation, mainly concentrated in the stock market with the relationship of valuation to corporate profits going hay way.
Economic Growth, market trends and inflationary pressures were suddenly threatened in 2018 by Donald Trump’s ill-conceived trade war with China, so the FED re-injected liquidity and the COVID-2019 pandemic made them much all the way on the monetary accelerator.
In normal times, money injection takes time to filter through the economy as money velocity sometimes counters the effects of additional money.
But when fiscal stimuluses comes on top of monetary stimulus, then the seeds of inflation are clearly sawn.
It is most interesting to note the phenomenal rise of the US stock market – and only the US stock market – in 2019 with the SP500 rising by 29 % and the Nasdaq by 35 % in what was otherwise a truly muted year form the economic or corporate profits standpoint.
These stellar performances – and correlative valuation expansion – were entirely due to the combination of massive injection of money on the back of Donald Trump’s – again ill-conceived – 2018 counter cyclical tax cuts.
Valuation expansion is another form of asset inflation and the CAPE ratio of the US stock market today stands at the second highest level ever.
Over the past decades, many economic studies have questioned the Monetarist theory and demonstrated that the lower nominal interest rates were, the lesser the impact of money supply on inflation was.
However, and as is the case in periods of war, large money supply and large budget deficits do combine to create inflation and so in a massive way.
Some economists today rightly compare the COVID 19 episode as a Wartime period and the language used by Governments and Central Banks resonates in exactly the same way
And our macro-economic case is that far form being a transitory phenomenon, the current bout of acceleration is only the beginning off what could prove to be much more lasting inflation ahead.
So if inflation is a monetary phenomenon and money supply is not being reduced and bond yields are kept artificially low, maintaining exceptional negative real yields, HOW COME THE FED EXPECTS THE CURRENT INFLATIONARY PRESSURES TO BE “TRANSITORY” ?
This is like having a train running at full speed and saying that it will slow down without having to use the brakes…
The US Fed has dangerously fallen behind the curve…
The world G3 central banks are playing a very dangerous game by allowing inflation to run run hot before tightening monetary policy. Inflation is not something that gets under control easily and it took a massive recession and a huge hike in interest rates in 1982 for Paul Volcker to tame it.
Between 1977 and 1981, the FED had to quadruple interest rates from 5 to 20 % to bring inflation under control, sending the US economy in a 5 % recession then. Note how mild that recession was when compared to our current 2020 downdraft
The massive amounts of liquidity that has been created in 2020 has first poured in asset prices, leading to speculative bubbles almost everywhere and is now poised to pour into the economy as the pandemic eases further and people start to travel, shop and eat out again.
The laws of supply and demand are now taking over, forcing prices of goods and services higher.
For the moment, consumers seem content to hoard their money. The Commerce Department also said Friday that the personal saving rate remained at a lofty level in April, clocking in at 14.9%. The rate has averaged 18.4% since the pandemic started in March 2020, more than double the 7.6% in the prior decade.
But with the re-opening of the economies and the hiring of people increasing, consumers are starting to feel more confident and spend again.
Inflation may then accelerate markedly by the end of the year, forcing the hand of the FED.
In fact, form a situation where Central Bankers used to talk about “thinking of Thinking of tapering ” only a month ago, we have already moved to “talking about talking of tapering” at their June meeting.
The FED’s talk oversized importance, and the clear hunch of the current FED in favour ion asset markets has delivered the most dovish FED ever seen in modern history.
But there are a number of signs that economic agents are starting to lose confidence in the system and their economic management.
From the rise of Gold and precious metals to the rationale for holding computer codes in lieu of money, investors are in search of inflation hedges.
May be even more telling is the fact the the Chinese Yuan, the current of the only large economy that has NOT resorted to these dangerous monetary policies is rising against all currencies. The relentless rise of the Yuan against all currencies since March 2020 is a clear sign of flight to quality.
Another sign that the Fed talk might change soon is that for the first time in the past 10 years and in fact since 1980, US high Yield bonds yield LESS than inflation
We see inflation fluctuating marginally at these high levels in the coming few months before accelerating markedly in the 3rd quarter of the year…
But the G3 Central Banks cannot continue to print money as they are now…
And the markets are not priced for a change of attitude …
Watch the Fed talk at their June meeting…
Tapering may be announced sooner than expected by the markets.
Equities were uniformly positive last week, gaining between 1 and 2 % on the back of positive economic and labor news.
As predicted, China took the lead with a 3.6 % advance on the week while Taiwan stocks jumped 4 % and Japan rose by 2%.
Bond yields were generally lower with US 10 year yields stable at 1.60 %
Commodities were strong again last week with Oil prices shooting up another 4 % despite the prospects of a US – Iranian deal and metals still shooting up. Copper added +3.81 % while nickel was up 7 %
To get a sense of the strong inflationary pressures induced by the Fed’s policies, suffice to look at the Year to date performance of the main commodities and the charts of Copper and Lumber
The US dollar was lower this week against the major currencies and made a new low against the Chinese Yuan. Conversely, watch the Japanese Yen that is about to break a major technical level and start its journey en route towards 120.
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