The state of macro: A nuthouse with no hope?
Fixing inflation means getting deficits down. Rate cuts will therefore be disinflationary. When will the Fed understand that and act accordingly?
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
When I built my roadmap for 2024, I predicted that we will likely see an inflation echo this year.
It was a far out of consensus call. More than 90% of respondents in the December 2023 Bank of America Fund Manager survey expected a soft or hard landing. Inflation/central bank hawkishness was still considered the second most important tail risk, but it had lost its top spot to recession fears after being in the top spot for almost all of the time since early 2021, the longest time a risk factor has ever reigned all other ones.
My prediction aged pretty well surprisingly quickly, didn’t it? Everyone is talking about inflation again subsequent to the third abysmal CPI print in a row. March core CPI came in at 0.4% month over month, the same it was in February and January. This confirms inflation has de facto reaccelerated to almost 5%! Wow!
Let’s put this CPI print into perspective for a moment. Two years have passed since the Fed and many other central banks launched the most ferocious hiking cycle ever. They went from 0% to 5% in record time. Most people would have thought that this economy can’t even take 200 bps worth of rate hikes before crashing down.
But what has in fact happened since then? In 4Q21, US GDP was $24.7tn. Two years later, in 4Q23, it was $27.9tn, 13.3% higher or 6.5% annually. In real terms, growth has been 1.9% annually over this period. And now CPI prints are accelerating! Maybe rate hikes don’t work the way people think they do?
Many pundits don’t reflect upon such a question. They are quick to claim the path to rate cuts is dead. Some are even suggesting more hikes are necessary to finally kill inflation. Frankly, this reminds me of a scene in the Simpsons where Abe (the Fed) tries to help Jasper (the inflation problem) with the pencil sharpener (rate hikes).
Insanity is famously defined as trying the same thing over and over again and expect different results. The opposite of that would be a coolheaded scientist who observes the world around him to derive hypotheses how it works and then tests them. Much of the macro research out there does not care at all about this last step. It’s always trapped in the theory that sounds nice, irrespective of whether it’s true.
How the economy actually works
The prices of all goods, services and assets are a function of the liquidity circulating in the economy. This liquidity is equal to the amount of outstanding credit. All credit matters for this purpose, not just what is defined as money.
When liquidity rises, it can serve as an impulse to prices of any kind. Private borrowing is the credit impulse to liquidity. Public borrowing is the fiscal impulse to liquidity (it's also credit, but it deserves its own term because of its importance).
The idea of monetary policy is to manage liquidity by manipulating interest rates to encourage or discourage borrowing. For that matter, quantitative easing (aka buying and selling financial assets) is also first and foremost yield curve manipulation. By definition, monetary policy can therefore only target the credit impulse. The public sector does not desire to generate profits and it has an indefinite lifespan. There is no limit to public borrowing for a fiat currency issuer (as long as it happens in its own currency). Its inclination to borrow is therefore not impacted by rate manipulation. There is in fact a reverse sensitivity because rate hikes increase the Treasury’s funding costs which sends borrowing up even more.
Deficit spending creates private sector savings. And in aggregate, it does not matter whether that spending happens via interest payments, infrastructure investments or social security payments. It does not even matter whether the beneficiary is a domestic or foreign entity. And it does not matter whether the beneficiary is rich or poor. All deficit spending is liquidity that will find its way into the economy by being consumed or invested.
The higher the public debt burden and the higher the public deficit, the more the fiscal impulse matters for liquidity creation. This is exactly what has happened during the last 18 months and that is exactly where most people get this macro framework wrong with their Fed obsession. There has been a very strong fiscal impulse because tax receipts faltered from the inflation shock and rate hikes jacked up Treasury outlays.
And in terms of the credit impulse: Whoever can be discouraged from borrowing and consuming has already been discouraged at an overnight rate of 5%. Hiking to 6% or 20% won’t do much further discouragement. In fact, due to the extreme long duration in the liabilities of US households, many of them do not even care about rate hikes for the time being. They simply enjoy rising interest incomes. Rate hikes may even devalue their liabilities to the extent they cause inflation.
Additional rate hikes are utterly useless as a monetary policy tool.
You want evidence for these claims? Let’s check out some data points on private sector credit creation.
The pulse credit impulse
Anyone without much rate sensitivity is raining the money. Everyone else is suffering hard. The Fed’s rate hikes have put firm brakes on consumption of goods and investment in assets that require financing. Let’s check out a few example of industries that I personally have come across during my research.
The sales volumes of autos and light trucks are currently at an annualized run rate of 15m units. They still have not recovered back to prepandemic levels and they are lower than during many periods in the 2000s and 1990s when the US population was much smaller. These are clearly cyclically suppressed levels that are below sustainable levels.
Used car sales volumes are even more depressed. 2023 is trailing 2019 by about 30%.
RV shipments have finished 2023 with just over 300k shipments, about 30% below its long term growth (although there was admittedly some pull forward of demand during the pandemic which would have caused a decline even without hikes).
Existing home sales are currently at a seasonally adjusted annualized rate of 4.4m units, which is close the the bottom of the GFC and where the trend was in 1995. In 1995, the US population was 20% lower and US households were significantly bigger, i.e. less homes were needed per citizen.
Real gross private domestic investment has recovered a little bit, but it is still 2.5% below its 1Q22 peak and about $300-400bn below its prepandemic trend.
Do any of these charts look cyclically extended to you? Do you think any of these need to be reigned in by monetary policy action to avoid economic overheating?
This time is indeed different. Normally, a hiking cycle concludes with cyclical industries near their peak. This time, those industries are close the lowest levels they could possibly be at. That's dormant economic potential that they can wake up with a few rate cuts whenever it pleases them.
Conclusion
Rate hikes have fueled the inflation problem. Frankly, why is this so hard to acknowledge for many people? It’s not just a provocative claim to make a splash. It’s rooted in sound theory and there is plenty of evidence for it to be true.
If this statement is true, it follows that rate cuts will be disinflationary. Again, this is very simple and straight-forward reasoning. I don’t care if it’s unorthodox. I care about what is true.
Now, will rate cuts cause a credit boom which may intensify the inflation problem temporarily? It’s absolutely in the realm of possibilities. Two years of manic hiking have created huge pent-up demand in some industries. When the Fed cuts rates what will happen to auto sales given the average age of the US vehicle fleet is sky-high?
What will happen to housing sales given that many millennials are still in the household foundation stage? What will then happen to mortgage originations? What will happen to the sales of home improvement businesses?
What will happen to private investment volumes? And what will their productivity be considering that the hurdle rate for profitability is still quite high?
The risk for excesses is real, especially considering that private sector pockets are full to the brim due to a cumulative deficit spending of $9.5tn since this nonsense began in early 2020. But the risks of those excesses materializing is in fact increasing with every day that passes without getting rates back to normal. Every day that passes with a huge fiscal deficit fills up private sector savings even more and thereby loads the spring even more.
In one of my last articles, I hypothesized that the Fed has perhaps finally understood that. Why else would the keep signal rate cuts in the face of terrible CPI prints? How likely is it that they will keep missing such an easy takeaway that even a nobody like me can figure out? Rate hikes are clearly not working which makes it likely that they will eventually stop them and turn to rate cuts. We must do something. This is something. Therefore we must do it.
The longer they wait, the better it is for stocks. But once they happen, it will be a good thing. It’s a win/win regardless how it plays out.
There is a saying in (German) soccer, namely that the best referee is the one nobody talks about. I consider the Fed in particular and all policymakers in general the referees of the economy. They have unnecessarily put themselves into the spotlight after years of erratic policymaking. They have amplified economic volatility instead of smoothing it. Their actions will keep echoing through time. The next crisis will be such an echo. But for now, it’s boom time.
Sincerely,
Your Fallacy Alarm
Ok, your point is valid, but cutting rates with the current inflation backdrop is still a bit like stepping on the brake and gas simultaneously. Plus, reducing the government’s interest expense could lead to EXTRA Federal spending, negating the benefit of lower rates for both deficit and inflation control purposes.
Now the Fed would never do this, but if we insist on cutting rates here, we should still do true QT by outright selling long bonds from the balance sheet. Then you eliminate excess interest income on the short end for rich savers AND you crush risk assets with higher long-term rates (since the government is heavily weighted to short term debt, the higher interest paid on the long end is less consequential from a deficit standpoint). You hopefully get some deficit reduction, more rational risk asset valuations, and most importantly, lower inflation. If you get a recession, you could just end the QT. Instead, the Fed is already reducing fake QT (roll off), a defensive measure to protect the treasury market. They are all turned around at the moment.
I agree that rate hikes can’t fix the inflation the US currently faces because households and corporations have termed out the debt and treasury interest is enough to generate excess income for the richest people, which enables outspending those with fewer resources. But the solution is NOT to cut rates which would stimulate the economy beyond capacity, compounding the inflation problem. The most logical solution is to withdraw the fiscal. Since DC won’t cut spending, the second most logical solution is true QT, which means selling long bonds, not just roll off. This would more directly hit borrowing rates, which are pegged off the ten year, not FFR (FFR is closer to the income the rich people get from the Treasury as excess income). This approach would lead to a bear steepener in the yield curve, crush risk assets, and reduce inflation through the reverse wealth effect.