Self Fulfilling Prophecies

The discussion about price inflation will not stop, but not because those who warn about central bank policies talk about them. Instead it is central bankers who talk about it everytime and try to calm markets. Transitory inflation is the mantra, which is repeated daily.

This week Fed-officials Barkin and Williams have come out and said that price increases will be transitory and all will be calm again next year. From the ECB side there has been Philipp Lane, who said that inflation will get back to low levels after a temporary rise. I don't see it. I just don't see it, Lane said at the Official Monetary and Financial Institutions Forum.

Besides endless repeating that inflation will be transitory, the other topic that central bankers talk about these days is the job market, where we are still far, far away from full employment. According to Barkin, Williams, Lane and others only a tight labor market can create substantial inflation...

I wrote about the current phenomenon a lot in the past weeks: Even though the US far into the reopening-stage, many businesses struggle to find workers because no one is attending. 

Stimulus checks from the Biden administration keep people away from the job market, especially if they used to work in low-paying jobs. And this is already visible in the data: Wages for low-paying jobs are on the rise. As low income groups usually consume all of their income, this will definitely be able to become an inflationary factor.

Further all around the economy we experience supply shocks, for example there is a big problem within the semiconductors' market.

The Wallstreet Journal writes: At the same time, Ford Motor Co. and other auto makers are halting some production because of semiconductor shortages, Caterpillar Inc. and other manufacturers are working to counter rising prices and short supplies of needed materials, and Domino’s Pizza Inc. and other chains are struggling to find enough workers. “I get it that the Fed doesn’t want to recognize inflation, but there is inflation,” Dover Corp. CEO Richard Tobin told investors on April 20.

Although the unemployment rate is still way above full-employment levels, employers struggle to find employees. The National Federation of Independent Business Index is on its' highest level ever. Following chart shows the NFIB in panel 1 and the unemployment rate in panel 2. At such unemployment levels, it is unusual that businesses struggle to find workers.

The market is partly skeptical about all this and at least does not seem to agree totally with the claims of central banks and economists. Inflation expectations see US-inflation at 2.5 % on average for the next 5 years.

On the one hand, markets are not always right too, and on the other hand, 5y5y inflation breakevens show that - despite all worries - the market is counting on the Fed to solve the problem if inflation really picks of.

John Authers correctly notes: So, it looks as though Powell can claim with a straight face that expectations don’t require the Fed to act. However, much more important in my opinion is the following: If commodity prices or breakevens rise much further, that could soon get very hard to sustain.

To sum it up, it seems that markets are anticipating a possible rise in CPI on the one hand, but on the other hand they rely heavily on central banks that they will make the right calls.

This is a narrow balancing act for market participants because a not foreseen, sharp rise in inflation developments could be dangerous and needs perfect asset allocation. 

Personally, as you may already know, I am very critical of the Fed & ECB appeasements and see it in a way that they are trying to influence markets in a certain direction. If this works out - we will see. Price increases for commoditites in this year have been spectacular though and definitely a point, as I would argue, against the transitory inflation case.  

Those price increases have been initially caused (at least that is how I see it) because of a huge imbalance between supply and demands  because of the measurements to fight the global pandemic. 

The implemented transfer payments in the US and the german 'Kurzarbeitsmodell' in Europe have limited the damage at the beginning. But it also has driven people into dependency from the state, especially in the US. Dependency on government transfer payments has risen enormously there with no end in sight.

Now back to the implications for financial markets. If inflation is surprisingly higher than expected, this will lead to another leg upwards in government bond yields (in my opinion). Additionally I would argue that even though central banks always whine about that the rise in yields will hinder the recovery, rates are still at ridiculously low levels. If you compare them to nominal GDP, the current level in yields looks - still - too moderate. 

In Europe there is another point that I would like to briefly discuss when we are talking about future inflation expectations: The EU under Ursula von der Leyen, the EU is fully committed to climate protection and wants to become a model for the world. 

Von der Leyen, who never shied away from ambitious goals (although she nearly always failed to reach them), is fully in belief that the shift to renewable energies will lead to a new European Wirtschaftswunder. 

I am skeptical about that because of two things: Firstly, we know that there is hardly any successful example for central planning and secondly, the European industrial sector is far away from being climate-neutral. Recently, CO2-emission prices have risen sharply and have roughly doubled.

Altough Fatih Birol, Executive Director of the International Energy Agency in Paris claimed in an interview with the Financial Times that this would be excellent because it would push businesses to switch to clean energy much faster than otherwise. 

I am not so sure if a higher CO2-price will lead to the effects that Birol suspects. On the one hand, because businesses may have to pass price increases to the consumer, e.g. through higher energy prices or higher prices within CO-2 intensive industries, and on the other hand because higher energy/CO2 prices create an incentive to move the industry out of the EU, where energy is cheaper. 

It should be noted, that the seeds for inflation have been sown, especially because of expansionary debt-policies by western governments to fight the crisis. After all, price inflation is a monetary phenomenon and thus the monetary expansion will not be without consequences, and the expansion is much bigger than after the 2008 financial crisis.

I see another problem on the horizon: The stock market has fully priced in an amazing recovery, the greatest recovery of all recoveries, to be specific. Every disappointment can cause trouble and bring markets back to reality. 

Global Market Cap of all equities is 27 TRILLION dollars higher than before the pandemic. Richardson Wealth is asking the right question: Is the globe that much better off?

The strong gain in market cap has been caused mainly by interventionist (central bank) policies, that is broad consensus. The question, if this was good or bad is different (most think that it was the right call).

Furthermore there is another market, apart from equity markets, that has absorbed loads of liquidity: The crypto currency market. I will not even imagine where equity-prices would be, had the 2 trillion dollars from cryptos flown into equity markets as well. 

There I see the greatest danger for equity markets, although not now. The dow has made another all time high this week and I claim that it will not be its' last. Growth rates are high because of strong fiscal support and loose monetary policy. If the EU does not screw up the European reopening because of a total failure when they implement the Green Passport, this trend is likely to continue for a while. 

Although, that we have accomplished such growth rates through exponential spending is pretty disappointing under this point of view. More debt does not necessarily mean more growth, as the diminishing returns from US debt show in the following chart.

Janet Yellen has caused equity markets to turn red when she said that the Biden stimulus may lead to rising interest rates. She corrected herself about six hours later and pointed out that this was not a prediction. 

Yellen has been a master in bluffing markets into the wanted direction during her term as Fed-chair already, which makes it a little astonishing that she made a mistake that usually one would expect from Christine Lagarde. However, when she was asked about inflation, she was her old-self again and said: I don’t believe that inflation will be an issue. But if it becomes an issue, we have tools to address it. A dangerous threat?

Have a great weekend!

Fabian Wintersberger

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.