Brendan Brown, PhD, is one of the world’s leading monetary theorists. He is senior fellow at the Hudson Institute and associate scholar at Mises Institute. He is a columnist for Nikkei Veritas and a frequent guest on Bloomberg TV and Radio. Brown is a monetary economist whose areas of special expertise include Austrian monetary tradition, European monetary integration, Japanese monetary issues, the global flow of capital and international financial history. He has developed techniques of market analysis during a long career in international financing including the role of chief economist at Mitsubishi (UFJJ) International Finance. He has published many books on international financial topics including most recently (2018) “The Case Against 2 per cent inflation” (Palgrave). He received a PhD from University of London and MBA from University of Chicago.
Dr. Brown has begun a new publication, "Monetary Scenarios,” the inaugural issue of which is below. To receive further mailings, contact him directly at email@example.com.
Subsiding Inflation and China-US “Truce”: no real cause for celebration
by Dr. Brendan Brown
Two strands of optimism have been filtering through global markets since late December. Both are highly suspect.
The first is that falling inflation in the US and the related pull-back of the Powell Fed (some would say Trump Fed) in its “tightening program” boost economic prospects beyond the likely already started short “growth cycle downturn”.
The second is that a looming “trade deal” between the US and China will provide stimulus to the global economy whilst boosting asset prices via a lowering of uncertainty. Let us take each of these dubious propositions in turn.
US inflation downturn
So yes, the US PCE (private consumption deflator) is up 1.8% year-on-year to November (down from 2.4% in mid-2018); and the core PCE (excluding food and energy) is up 1.9% (virtually the same as at mid-year). Given the weakness in commodity prices, the global cyclical slowdown, overall firmness albeit not strength of the US dollar, and continued “march” of digitalization, most forecasters see some slight downtick in reported inflation in months ahead.
If indeed the US has already entered a growth-cycle downturn in the context of continuing global economic weakness, then reported inflation in the US could match the forecasts. Under the scenario where the slowdown develops into a recession or even depression then in hindsight the verdict will be that reported inflation never reared its ugly head during the 2007-2019 business cycle in the US (measured peak to peak). Radical monetary experimentation under the 2 per cent inflation standard created powerful asset inflation, but digitalization and globalization provided camouflage in goods and services inflation.
Fed puts in auto-mode
There are many investors “out there” who are speculating that the “pause in monetary tightening” re-confirmed at the start of January will amount to another “put”; this would follow in a notorious historical sequence including the Yellen put of 2016 (when all planned rate rises were scrapped in response to market and economic softening) and earlier Greenspan puts (including autumn 1998, winter/spring 1996, and autumn 1987).
On this train of thought, a new economic and market rebound lasting a year or more could well follow.
Fed puts are now pre-programmed given the way this institution now sets policy. Specifically, the Fed pulls back in response to any substantial “worsening of financial market conditions”.
The alternative “sound money” view could be that some significant “worsening” is essential and healthy accompaniment to monetary normalization (away from the radical monetary experiment of the Bernanke and Yellen Feds as extended through the first year of the Trump Administration).
Even some proponents of sound money, though, caution about how to start on the journey to this destination, given the perilous situation resulting from so many years of monetary inflation.
In any case, given the present context of vast accumulated asset inflation (characterized by immense carry trade positions, widely camouflaged leverage, uncritical speculative narrative telling, and much else) any spike up of credit spreads for example or other symptoms of the disease possibly entering its late stage (crash) triggers a Fed put.
Why the Powell put will fail
Fed puts do not always work: if they were sure of success there would be no such thing as market crashes and recessions.
Historical examples of failure go all the way back to the Fed put of March 1937 (short-term rates fell back to zero from the slightly positive level which they reached in the Fed’s attempts starting in late 1936 to putatively exit the then version of QE). That did not prevent the Great Crash of late summer and early autumn 1937 or the accompanying Roosevelt recession (more severe than the 1929-30 downturn).
Typically, Fed puts work best several years into a monetary inflation when there is still a strong current of speculative narratives (which remain plausible at least to investors who have shed normal cynicism in the hot market environment), whilst the camouflage to leverage - still not near peak danger - is still intact and where the hidden extent of accumulated mal-investment does not bear down yet on present overall economic activity. When we are so far into potentially one of the longest monetary inflations these assumptions are implausible, notwithstanding the latest strong US payroll employment report.
Most likely a substantial increase in labour supply (including previously discouraged and inactive persons) occurring in the situation of a tight overall jobs market lies behind the reported strength rather than a new upturn in demand for labour. Hence employment could be more of a lagging indicator than usual.
2019-20 recession and its inflation aftermath
Suppose the pessimists are right and indeed a US plus global recession forms through 2019/20 (and indeed the German recession may already have started in the second half of 2018). This would not justify confidence in a non-inflationary or low inflationary future. In fact, the opposite is the case.
The conversation, both within the Trump-Powell Fed and amongst its fellow-travellers outside, is of “reforming” the 2 per cent inflation standard in ways that mean higher average inflation over time than in the cycle now likely coming to an end. Undershoots of inflation in one period must be compensated for by overshoots in other periods under so called proposals to bring “price level targeting” into the policy mix.
This further radicalism in monetary policy, especially at a time of huge US fiscal deficits (which could easily top 10% of GDP in a serious recession), is cause for long-run inflation concerns.
After all, the camouflage of inflation in goods and services markets during recent years is not permanent in nature. And in the next cycle it is possible to imagine that either new economic dynamism (creative destruction in context of previous mal-investment) or step-rises in government spending could raise the neutral level of interest rates to well above any contemporaneous estimate of this magnitude by the Fed. The result would be acceleration in broad-based money aggregates and ultimately prices.
All of this could get a kick start from a deliberate policy of dollar devaluation (implemented by Washington warning Europe, Japan and China not to undertake further monetary radicalism which would counter the currency market influence of aggressively easy US monetary policy). Under those constraints the way forward to economic stimulus policies in Europe would include first an Italian exit from EU and second German economic reform (alongside tax cuts) – all subjects for another Global Monetary Viewpoint!
US-China “truce” means “deal of the cronies”
Not a subject for another day, but for today, is the widely expected US-China deal.
For a start, the word “truce” is a misnomer.
Last autumn (2018) it seemed that the Trump Administration was serious about seizing the moment of Chinese economic weakness to move forcefully on its agenda of halting Beijing’s economic and wider aggression.
(How weak is the Chinese economy now – more than it seems according to a just published analysis of China data by Derek Scissors in How to Evaluate China’s Economy, AEI January 2019).
Instead, at the (infamous?) G-20 dinner in Rio, President Trump blinked and offered to delay the next round of tariffs in exchange for negotiations. It is plausible that the Chinese dictator and his advisors interpreted this as a sign of weakness.
An old-fashioned and time-honoured “deal of the cronies” – including Wall Street especially private equity, farmers, natural gas producers, and automakers – was again to be concluded. More deep-seated issues would be left unresolved, subject to Beijing making enough concessions and lightly enforceable commitments at best to save face for the Trump Administration. All the talk (and written text) about monitors and automatic kick-ins of disciplinary measures would amount to a big yawn.
If indeed we are headed to this deal of the cronies, is that a cause for global asset market celebration?
The answer is yes and no. Some big US (and indeed non-US) companies heavily invested in the China story (whether as location of production or as source of demand or both) can emit a sigh of relief. In particular the US businesses gaining from the crony deal should rise in overall value. That is very different from saying that there are net gains as a result for the US or global economy.
An increased and broadened tariff on Chinese imports into the US was never going to be anywhere near the most significant influence on the course of the present US business cycle. The numbers just do not add up to that and in any case, there are many gainers as well as losers from tariffs, albeit the latter are more vocal in the media and in K street.
The gainers include producers of goods in competition with those subject to tariffs, whether in emerging markets outside China or in the US itself. Included (amongst gainers) are businesses in competition with the big German or Japanese exporters who fitted China into the latter stages of their assembly line for re-export into the US.
Opportunity lost in the looming Xi-Trump deal
What is the downside of Washington at a moment of great negotiating advantage (such as in autumn 2018) sacrificing this in exchange for a quick re-bout to the failing stock market, or to please cronies, or whatever else?
Surely some of those now joining the pre-event celebrations can see the consequences including enhanced power for the Chinese dictator, loss of opportunity to break Beijing’s economic and wider alliance with Teheran, failure to boost the forces of freedom within China?
It is not certain at this point that this crony deal lies ahead, though in the global market-place and media this seems like the dominant hypothesis.
It is possible that Beijing overestimates Trump’s softening of position. The communist leadership could end up making too few concessions, resulting in no deal and conflict instead. After all, some of the big cronies on Wall Street and elsewhere are not close to President Trump (though possibly to his Treasury Secretary) but rather to the Democrats.
It is a perennial problem of weak diplomacy (such as President Trump pulling back from higher tariffs) that over-interpretation of the pull-back by the opposite side leads to break-down.
Wars come about sometimes from one side overestimating the enemy’s zest for peace. On that line of thought, it would have been better for global economic peace and prosperity if the Trump Administration had remained tough throughout rather than indicating a window for negotiation before action.
Bottom line: market strategy
Given the scepticism here about “the end of the US inflation menace” and the “US-China deal”, how would investors and borrowers modify their strategies in line with that?
First, long-maturity US T-bonds are not a safe-haven; well-grounded inflation concerns regarding the next cycle defy that label. Even so, if recession now develops, T-bond yields would most likely fall well below present levels, with an inverse yield curve arriving first (before the recession well-recognized).
Second, the US dollar is vulnerable to US recession risks and to longer term inflation concerns. Even so, the rise of the euro (as a corollary to dollar weakness) would be highly volatile, subject to serious shock from credit and related political events to a destination where a re-incarnated Italian lira would feature. The virtually zero yield on long-maturity German government bonds takes this scenario into account.
Third, pursuing short position in the Canadian dollar against the US dollar offers potential gains from global asset deflation and economic downturn. Overindebted households (already pulling back according to recent data), real estate speculative fever already moving into reverse, weak commodity prices, and domestic political risks are all promising factors from a short perspective – together with a continuing positive spread in favour of US rates over Canadian.
Fourth, the Japanese yen is a safe-haven in the short-run, but don’t ignore the dark clouds which may gather (loss of confidence in Japanese corporate sector, export sales slump, exposure of high leverage in US technology bets, and an ultimate political quake powered by revulsion amongst ordinary citizens at the loss of wealth after years of stealth taxation via sub-zero interest rates). Mal-investment under Abe-economics could prove to be colossal.
Fifth, the Powell “put” and the prospective China-US deal are not strong pillars on which to build global equity market optimism. Regression to mean for record profits, question marks over the length of profits bonanza for the new monopoly capitalist, vulnerability of earnings to economic downturn, and a potential unmasking of leverage (whether in emerging markets, US private equity, or real estate), the road ahead for the equity bulls is full of potential shock.
Sixth, the tide of concern that US economic slowdown and possible recession ahead could be the catalyst to a dollar devaluation policy coupled with lack of serious confidence in any fiat money alternative continue as powerful plus factors for gold.