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U.S. economy: it is going to hurt with no alternative – Paul Tolmachev

There seems to be no doubt that the general trend of the U.S. economy is recessionary.

It is the result of a fatal error, or rather, populism and short-term political interest in the government’s economic policy, which has been repeated over and over again.

Soft fiscal and tight monetary policies stimulate production and savings, encourage competition and value-added growth, limit the growth of government spending and the debt burden, level out inflation, and ensure that the cost of credit matches production and consumption capacity.

Instead, the government, having long ago and finally shifted into the expansionist paradigm of political populism and irresponsibility, does exactly the opposite and solves the problems of today without thinking about tomorrow. It cheapens money and stimulates the growth of consumer demand ahead of production, i.e. it inflates the state’s leverage, tightens conditions for production and expands government spending, obviously within the flawed Keynesian paradigm of economic policy.

This means that the money supply is not matched by appropriate output, an obvious and dangerous disequilibrium. In the case of any trigger, imbalances lead to crises, which are essentially balancing the economic system and trying to find equilibrium.

But the government buys the crises with an additional expansion of the credit advance, which allows it to leapfrog the threat of a crisis today, but exacerbates the volatility and criticality of the inevitable balancing tomorrow.

Meanwhile, inflation continues to hold a rising trend.

Raw material prices, coupled with logistical disruptions and component shortages, significantly inflationize manufacturers’ costs. An important component is still low labor participation and recent labor market shortages, which have also contributed to the overall rise in production costs.

Finally, inflation in asset valuations, driven by ultra-soft monetary policy, also contributed significantly to inflating imbalances in the economy.

At the same time, low interest rates, accumulated savings, and the removal of lockdowns led to a surge in consumer demand. However, against a backdrop of stressed production, disequilibria increased significantly as producers faced constraints caused by external nonmonetary factors.

The problems were exacerbated by fiscal and regulatory tightening and the expansion of government programs that worsened the competitive business environment at a time when demand was maximally stimulated.

Thus, demand was stimulated by cheap liquidity and consumer sentiment after the opening of the economy, while supply, on the contrary, was stressed by inflation of assets and raw materials, logistical blocks, expansion of budget spending and fiscal tightening.

This is the unfortunate result of economic and social policy along the lines of expansionary Keynesian discourse.

What’s next?

Instead of improving supply-side conditions and providing the impetus for a good equilibrium, the government wants a linear monetary tightening solution to a multifaceted problem.

In fact, the government is trying to balance the situation through deliberate man-made degradation, worsening demand-side conditions so much that they become consistent with poor supply-side conditions. At the same time, supply-side conditions are not improving in any way. On the contrary, the trend of tightening conditions persists amid geopolitical tensions and reduced credit availability for producers.

But then the concerns and words of government representatives about measures to prevent hard stagflation, recession and soft landing look like a mockery of common sense at the very least, especially considering how even recently the finance minister and head of the FED dismissed the inflationary threat as non-existent.

As a result, we have entered the territory of de facto stagflation, where the slowdown in consumption and production, i.e. economic activity, is accompanied by rising prices due to the permanent stimulus of credit expansion.

So what is now indicative of a stagflationary cycle?

Overall, we can clearly observe a slowdown in the economy through the performance of a wide range of indicators. This can be seen in the slowdown in manufacturing orders, declining construction applications and consumer mortgage terms, slowing retail sales and rising inventories.

Meanwhile, inflation continues at extremely high levels, with manufacturing inflation (PPI) significantly outpacing consumer inflation (CPI) amid consumer primitivization – a shift in consumption toward simpler goods and foods. This is a typical situation of the classic stagflationary cycle.

  1. CPI and PPI are at record levels.

PPI, which shows the dynamics of production costs, is a leading indicator and suggests a transmission of production inflation to consumer inflation. At the current moment, we can observe the persistence of high inflation with declining retail sales, output and simultaneous growth of inventories. Moreover, core inflation – the consumer inflation curve excluding fuel and food – is flattening, which indicates a slowdown in inflation in durable goods, simplifying consumption and reducing economic activity.

  • Inventories have risen, especially wholesale and retail, which also suggests a stagflationary environment where, despite slowing production, consumption, and inventory growth, prices continue to rise.

This is also partly explained by the fact that in an environment of low interest rates and high inflation it was profitable to borrow cheaply and expand production in order to then increase the margin on rising prices.

In addition, it should not be forgotten that amid expanding money supply and rising demand, production and investment flows in the real sector were shifting to the production of consumer goods closest to the end consumer as a way to monetize output as quickly as possible and to obtain the most substantial margin.

All this led to a significant filling and expansion of inventories, oriented to outpacing consumption growth, but not realized due to the slowdown in retail sales.

C). Retail sales are declining.

Demand begins to sag, caused by intense inflation and the transit of rising production costs into selling and consumer prices.

As a result, we have a slowdown in consumer demand in capital-intensive industries, rising inventories and declining production, while cost inflation persists and producer prices rise amid expensive raw materials, overheated labor markets, logistical gaps and geopolitical tensions. This is a classic picture of a stagflationary cycle.

The situation is exacerbated by the general indebtedness of agents under the current tightening credit conditions for consumers and the fiscal and regulatory pressure on producers.

So what are the expected consequences of delayed monetary tightening?

FED’s monetary tightening will have three main consequences:

– lower demand and reduced consumer power;

– a revaluation of assets due to rising rates and a correction in markets;

– increased pressure on businesses due to higher costs of credit and increased costs.

An important negative result will be a worsening of conditions for banks: first, there will be a decline in lending due to rising costs of credit, and second, rising delinquencies on existing loans, withdrawal of demand deposits and declining value of collateral assets will be triggers for deterioration of banks’ balance sheets.

Under such conditions, it is impossible to talk seriously about the prospect of a soft landing. Of course, a significant level of liquidity remains in the market, as evidenced by the growing reverse repo rate.

But now the government will increase the cost of money to the last, until it becomes critical for social stability, and, above all, until the balance sheets of pension funds and insurance companies begin to burst at the seams.

The depreciation of assets and a deep decline in markets will reduce the level of pensions and increase the cost of insurance products, which could be a trigger for social discontent as the most important factor in the stability of the current power elite.

In the current environment, the position of the FED is extremely difficult, as there are virtually no options for a soft outcome. Recall that the productive assets in which pension funds and insurance reserves are invested are valued through the ratio of the cash flow that the asset generates to the rate of capital raising (i.e., the cost of credit anyway), which in the final outcome is determined by the federal funds rate.

In a stagflationary cycle, rising rates and persistent inflation worsen conditions for producers, reducing profits, reducing the numerator of the fraction and increasing the cost of credit, the denominator. Accordingly, a deep correction in the markets has a very tangible risk of turning into a sustained bearish trend.

Certainly, monetary compression is necessary for the economy to deflate a leverage that can no longer be managed. However, as can be seen, firstly, this will be a painful process, as the situation has obviously gone beyond manageability, also due to the fact that the FED started the cycle of anti-inflationary measures too late. And second, it is not enough: fiscal offsetting of the negative effects of monetary tightening is needed which hits producers and increases their costs.

Meanwhile, 10-year Treasuries rates continue to rise.

With inflation expectations inevitable in the face of a sharp tightening of monetary policy, treasury rates should fall and demand for government bonds should rise, thereby helping to restore valuations in productive assets.

Yet rates continue to rise. It is obvious why: the Fed is not just increasing the value of money through rates, but it is absorbing liquidity and reducing the money supply, including by reducing the balance sheet. This means that the supply in the government bond market goes up, so its price goes down, pushing rates up.

Among other things, this neutralizes the risks of an inversion of the curve, since the demand from institutional investors for low risk is offset by the expansion of supply from the shrinking balance sheet of the FED, which neutralizes the risk of an inversion.

There is a possibility that the government will be forced to deviate from the usual and accepted Keynesian expansionism: it will begin to cut spending and stimulate business in the current extreme conditions, sacrificing immediate electoral goals.

Liberalizing conditions for business while controlling inflation and limiting consumer leverage could, on the one hand, self-correct the hard landing and expansion of two decades of accumulated problems, and on the other hand, give impetus to a new healthy expansion of the economy. An expansion based on productivity, efficiency, competition, and savings, rather than on consumer acceleration through unsecured and forced expansion of the money supply and endless government leverage.

Strange as it may sound, the current cycle of geopolitical turbulence and rising risks may be a good stimulus to get rid of ethical illusions and to change the preferences of political elites toward more responsibility and less populism.

The historical examples of the early 1980s suggest that

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The Russian-born Paul Tolmachev is portfolio manager at BlackRock (London, UK) with more than $500 million in personally managed assets. He also is a visiting scholar at the Stanford Institute for Economic Policy Research, where he researches institutional and political economy, decision science and social behavior. Paul Tolmachev is a Certified Professional in Philosophy, Politics and Economics (PPE Program), Duke University. Having 20 years’ experience on the financial markets, Paul Tolmachev held management positions in leading Russian and international investment and wealth management firms. As a research scholar for the past few years, he has also specialized in the analysis of macroeconomics, politics, and social processes. Paul is a columnist and contributor to a number of international think tanks and publications, including Duke University, Mises Institute, Eurasia Review, Investing.com, etc.