BRIAN KANTOR: Will the Fed wake up to deflation ahead of a recession?
Fears of inflation and the Fed drives the markets
Last Thursday in New York was one of those days to be fondly remembered by everyone with skin in the game — that is, all of those at the mercy of the capital markets, which is surely just about everyone with a retirement savings plan. The key S&P 500 stock market index had added 5.54% to its value by the close of trading; the more IT-dependent Nasdaq even more at 7.35%.
That is more in any one day since the world’s nations came to realistic terms with the damage caused to their lockdown economies late in 2020. Government bonds, which typically make up 40% of any conservatively managed portfolio, also became significantly more valuable as longer-term interest rates receded sharply.
The yield on the key 10-year US Treasury bill fell from 4.14% a year to 3.82% on the same day, the largest such daily move since 2009, with the dollar value of the bond moving higher as the yield fell. The next day the JSE all share index had gained 3.2% by 11.15am, and the mighty rand was up 2.67% to R17.27 to the dollar by midmorning. On November 1 a dollar had cost about a rand more.
The source of all the good news for wealth owners was unusually obvious. US inflation for October turned out to be surprisingly low. Simply put, less inflation expected in the US implies less aggressive US Federal Reserve (Fed) policies, and lower than previously expected short-term interest rates. An improved probability of the US avoiding recession added present value to stocks and bonds.
The trend to lower inflation was further confirmed this week with similarly favourable market reactions. Producer inflation also surprised on the downside, with prices declining by 1.3% in October. The index is now no higher than it was in April.
Having been so completely surprised by the surge in inflation in 2021, the Fed seems determined to march the US economy into recession to eliminate inflation it seemed at a loss to forecast with any degree of confidence. Monetary policy has become data-driven, guided by the view through the rear window and accompanied by the fear that persistently high inflation could become a self-fulfilling tragedy for the US economy.
If recession is the price to pay for avoiding permanently higher inflation, then recession it will have to be, the Fed seems to be saying, much to the discomfort of the US equity and Treasury bond markets. In the year to November 15 the S&P 500 was 17% weaker and the Bond Index about 12% lower.
But should the Fed and markets have been so surprised by inflation? Surely not, if they had been following recent trends in inflation and spending by households and firms. Similarly, they should know why inflation has come to a screeching halt since its peak of 9.1% in June. A year can be a long time for an economy.
The US consumer price index (CPI) was 9% higher in June than it had been a year earlier, but has flatlined since, and producer prices are now no higher than they were in April. The month-to-month percentage increase in prices was 1.37% in June, -0.01% in July, -0.04% in August, 0.21% in September and 0.41% in October. The increase in consumer prices over a rolling three-month period has slowed to 2.3% a year.
If this flat trend in the CPI continues, the annual inflation rate will still be a high 6.9% at year end, but if it continues thereafter, inflation (year-on-year growth in prices) will fall away sharply to less than 1% by June 2023. US headline inflation is apparently on a path to zero.
Not just the market but the Fed too, should be acting accordingly. That is, recognise that aggregate spending in the US by households and firms has already slowed down markedly and does not threaten higher prices in the future. The weakness of aggregate demand is restraining price increases. Higher prices to date have largely absorbed the spending power that was so boosted by a vastly increased money supply and Treasury handouts in response to the Covid-19 lockdowns.
Higher prices have their demand and supply side causes, but higher prices also have negative effects on spending power. They absorb disposable incomes and sap spending power. Wage increases, even given full employment in the US, have not fully kept up with higher prices, further restraining spending.
Inflation cannot perpetuate itself unless accompanied by continuous increases in the demand for goods. This has not been the case in the US or Europe. The notion — endorsed by the Fed and many other central bankers, including SA’s Reserve Bank — that higher prices and wages can simply perpetuate themselves is a false notion. Inflation expectations soon run aground on the rock of deficient demand and unintended excess inventories.
This theory is self-willed and does not pass the test of evidence. The Fed and markets should be following the weak trends in spending closely. Ever higher interest rates could in these circumstances turn minimal growth in spending into spending declines — truly the stuff of the recession they so fear.
The Fed and markets would also be well advised to play close attention to the trends in money supply growth. Inflation may be defined as a continuous increase in prices caused by an increase in the supply of money over the willingness to hold that extra money. All inflations are associated with excess money supplies, and the recent inflation in the US is no exception. It is a well-established rule.
A money supply explanation of the weakness of aggregate spending in the US also helps explain why demand for goods and services is growing so slowly. The important monetary facts are that money supply, broadly defined as M2 in the US, is now no larger than it was at the beginning of 2022. M2 amounted to $21.62-trillion in January. By September it had declined to a mere $21.46-trillion. The year-on-year growth in M2 that had peaked at an extraordinary 27% in early 2021 has slowed to a barely positive 3%, with the three-month growth rate now negative.
Growth in commercial bank credit has also slowed down markedly. Annual growth in bank credit was 7.6% in October, while annual growth in bank credit has slowed to 1.6% over the past three months. Monetary, credit and price trends are all pointing strongly to deflation rather than inflation by the end of 2023. The market can only hope the Fed recognises this in good enough time to avoid recession.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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