The U.S. Economy: Why There is No Ground for Optimism
Regulators seem to have few tools left to suppress inflation.
The current inflation is due to the excessive expansion of the money supply in 2020-2021, when about 20% of GDP was injected into the economy in various forms: QE, social programs, direct lending, etc. This money caused a significant increase in agents’ monetary incomes amid a decline in consumption caused by the lockdowns.
In the second half of 2021-early 2022, this money poured into the market as a result of the lifting of restrictions. This caused a significant increase in consumption amid a clear stress of supply, suffering from broken supply chains, shortages of components and labor, and regulatory and fiscal tightening.
An important contributor to the imbalance was commodity inflation, which, in turn, was driven by an extraordinary influx of investment, secured by zero credit rates, extremely low yields in risk-free instruments and geopolitical tensions.
In addition, two things should not be forgotten.
First, rising prices are occurring against a backdrop of rising corporate profits in general and an increasing share of corporate profits in GDP.
The population has significant means to consume without saving and saving – the savings rate is declining while consumption is rising.
Companies are actively earning on this through higher prices, especially against the backdrop of lagging production from demand. On top of this, the population’s willingness to work has declined substantially, and thus wage demands have risen, creating a shortage in labor supply and affecting the growth of production costs, becoming another component of inflationary expansion. Thus all of these factors of margin persistence and expansion, among other things, mediated the inflationary spike.
Accordingly, inflation, as always, is ultimately the result of monetary and fiscal expansionism, not energy price increases at all. Inflation in commodities, particularly energy commodities, is for the most part also the result of monetary inflation in assets in a zero-rate environment, when excess liquidity was looking for yields above zero.
Second, there is the important point with rate hikes. There is clearly great difficulty in achieving success in controlling inflation because in the previous case, in the late 1970s and early 1980s, when inflation peaked at 16%, rates were raised by more than inflation, up to 20%.
Of course, this is impossible to imagine right now, because with inflation at 8%, a rate increase to 10% would mean smashing the economy to the ground and depressing it all at once. Such an increase in the cost of money would block both supply and demand, tear up bank balance sheets and drop markets, causing extraordinary losses for pension funds and insurance companies. Against a backdrop of geopolitical turbulence and growing social tensions, such a decision would be fatal for political elites and would be likely to cause a dramatic change in electoral preferences, up to and including social unrest.
At the same time, raising the rate to 3-4% with inflation at 8% still does not solve the problem and does not provide the soft landing desired by the government.
An adequate and effective policy in such a situation would be to continue careful monetary absorption and simultaneously stimulate supply by reducing the regulatory overhang and tax burden, i.e. to focus on GDP and economic growth in the first place, and inflation neutralization in the second…
Despite the impossibility of avoiding the painfulness of the bailout process and the recession itself, it would bail out a credit-depleted economy, eliminating destructive leverage and giving impetus to a healthy recovery.
The inflationary wave that swept through the economy after the unlocking of the lockdowns appears to promise to subside, and supply chain problems and component shortages should end, which will even out the supply-demand ratio. In addition, there are two other factors with positive potential to soften the blow: low unemployment at 3.6% and relatively low household indebtedness – about 78% of GDP.
However, in the current environment dominated by the left-populist policy discourse of the ruling elites, one cannot count much on such a “right-wing” U-turn. This means that the probability of either a painful recession, possibly in a stagflationary mode, or another credit expansion of the state continues to grow intensively.
Markets as a whole, being a leading behavioral indicator of the state of the economy, in fact, already praise recession and deterioration of prospects: the value of both commodity and stock market assets has declined significantly.
Rising bond yields are the most important indicator of fears about inflation, which is eating into nominal yields. Investors are moving away from long maturities and staying or increasing positions in cash and short duration.
Cash and short duration are all the more in demand as the FED tightens monetary policy and raises the cost of money to reduce inflationary growth.
As a result, an increase in the fed funds rate and a corresponding increase in government bond rates increases the discount rate on the cash flows that form the valuation of productive assets. This means that it becomes more expensive to borrow, and real cash flows are reduced by inflation. Consequently, investment premiums to risk-free assets decline and the cost of capital rises. All of this reduces asset valuations – in both stocks and bonds – and markets decline.
For the second time since March 2022, we are seeing an inversion of the 2/10 Y Trsrs yield curve.
The curve inversion is simply a reflection of investor behavior driven by expectations and assessments of risks and opportunities. Accordingly, the inversion means that expectations about the prospects for inflation easing are negative, just as expectations about the FED’s ability and capacity to curb inflation and not send the economy into a prolonged recession.
Thus, the sell-off of the long duration and its rising yields with a simultaneous rise in the cost of money are the result of negative expectations of the overall economic outlook: investors expect cash flows to decline due to the contraction of economic activity of agents and go into protective quick liquidity – cache and short duration.
As a result, the current stagflationary vector speaks to the worst expectations of economic agents – producers and consumers who are investors at the same time.
Nevertheless, a recession is a necessary bailout process that will allow the economy to cleanse itself of overvaluation and the effects of government leverage, to balance supply and demand, and the capabilities and needs of market agents. The extent to which this purification will be widespread, deep and long depends on the position of the government and its economic policy.
And markets are just a reflection of the expectations and assessments of economic agents, formed as a reaction to the actions of the government. And the less government interference in the market mechanism of economic balancing, the smoother and less volatile will be the expectations of economic agents.
The bad news is that President Biden’s administration knows this, but will apparently continue to break the market, trying once again to “borrow from tomorrow”-that is, from the next generation.
Populism and fear seem to be the only fundamental and interrelated reasons for the decisions of the current administration.