It has not been a great week for central bankers, which is already saying something. By standards of recent developments, so long as a seven-day period goes by without major banking news, for them it would be considered a good one. Adding to the now-typical woes over financial “turbulence”, first the Bank of England’s top Economist told the Western world to suck it up and accept being poorer before it was announced the Fed’s Chair had been pranked by Russians into admitting a US recession was a good bet.
Ironically, both were for the same general reason.
BoE’s Huw Pill was speaking on Columbia University Law School’s Beyond Unprecedented Podcast. In the episode titled Inflation: Not Dead Yet, Mr. Pill clumsily tried to explain how the massive pandemic and post-pandemic distortions had put many places - indeed placed many people - in a bind of hardship.
For the UK like many emerging market economies, it imported increasingly expensive natural gas, food, and energy while at the same time exporting mainly services that were also difficult to deliver given restrictions. In his view, this was responsible for the pound’s pounding adding to the surge of consumer and producer prices.
But, he warned, having become impoverished by all that, businesses and consumers must now make peace with having been made the fool. Never mind the windfalls among the oiled elite and shipping magnates, quite naturally people will attempt to claw back some purchasing power largely through asking more for whatever it is they do. For consumers as workers, demanding wages. Companies will raise the prices on their products.
No, Pill demanded. This will only make things worse. In his Keynesian worldview centered straight upon an expectations-biased Phillips Curve, the damage has been done so any attempt to make it right will make it even more wrong. We can only heal if we all just agree to take one for OPEC.
“So, somehow in the UK, someone needs to accept that they're worse off and stop trying to maintain their real spending power by bidding up prices whether through higher wages or passing energy costs on to customers etc.”
Pill then acknowledged how there was and would be a, “reluctance to accept that, yes, we're all worse off.” Well, not all of us.
By insisting on higher wages and pay, or companies outside of energy and shipping who raise prices attempting to regain lost profits sunk into unnecessarily huge input costs, the world risks igniting what these Economists fear most of all. Not deflation and banking crisis, rather a wage-price spiral.
The same is true anywhere mainstream Economics infests. Mr. Powell over at the Federal Reserve is of the very same mind as Mr. Pill. Sure, he’ll acknowledge that SVB failed and we’re still talking about First Republic, but his mind remains fixed on the same Phillips.
Labor remains way too hot for his liking, therefore by whatever means it needs to be cooled down before it pushes the whole system into that spiral.
Back in January, thinking he was speaking with Ukrainian President Zelensky, instead being pranked by a couple Russians, Powell reportedly admitted (the Fed has only acknowledged the prank and the fact there is a recording of the call, however they imply it has been altered therefore have refused to confirm its accuracy) that an economic contraction here was “almost as likely” as slow growth might be.
Besides, he told fake Zelensky, a recession might really be a good thing, “so the labor market can cool off, so that wages can cool off.” What better way to interrupt the wage-price spiral than to Volcker it?
Honestly, it wouldn’t matter if those statements really are fake. The Fed’s very own models are now forecasting the same thing. According to the minutes of the prior policy meeting, simulations run by ferbus and the other DSGEs show there is a good enough chance of a “mild” recession to make one their base case.
How things change. It’s already a big reason to consider the direction we’ve been traveling since last year.
Sparring with Senator Elizabeth Warren last June, the Fed Chair reiterated his same stance, “We're not trying to provoke — and don't think that we will need to provoke — a recession. But we do think it's absolutely essential that we restore price stability, really for the benefit of the labor market as much as anything else.”
Nearly the same moment he was making this claim, the entire “inflation” dynamic had already shifted. Look at a chart of the US or other CPIs and you’ll see June 2022 stick out in nearly every one as the top, the maximum for the supply shock effect. Rates of change for consumer prices didn’t immediately drop back to 2% as everyone is shooting for, nor should that ever have been the expectation, yet there is a very clear inflection in the trend which has seen substantial slowing ever since.
It is even more pronounced in producer prices, an important consideration given how much business “thinking” plays a central role in central bank thinking. Many PPIs including the one for the US (more importantly China’s) have already flipped to outright deflation.
At exactly the time Powell was arguing with Warren, and the general course of our CPI was about to be altered, yield and money curve inversions accelerated wildly. They had themselves flipped from small but notable inversions to unmistakable proportions.
And policymakers like the Fed Chair were quick to dismiss them, thus why he assured Senator Warren that while recession might be possible it wasn’t a good one according to his view. Instead, Powell like nearly all Economists pointed to something else called the near term forward spread (NTFS).
This other only begins with the yield curve, in this case the 3-month T-bill rate comparing it to the calculated forward 3-month rate out eighteen months ahead. Basically, what the market is expecting 3-month rates to be a year and a half down the road. If the latter is less than the former, then, said Powell, there is something to worry about.
In truth, this forward projection behaves almost exactly the same as the spread between the 3-month bill and the 10-year UST note (3m10s). Economists love to overcomplicate things because in very simple and straightforward terms markets so often contradict their every position right down to their deepest beliefs.
Last June, both of those were enormously steep, so Chair Powell certainly believed he was on solid ground. But as the CPI and PPI began to bend lower in July, those two spreads abruptly collapsed. By August 1, the 3m10s was just barely positive (+4 bps), though the NTFS a bit more (+35 bps). Either way, a huge change.
After flirting with zero for several months in between, early in November both succumbed. Though Powell had specifically promoted the NTFS, I can’t find a single reference in any speech or statement since it went negative. Just before it did, on November 2, he was asked about it but quickly dismissed the concern because, for the moment, it was still positive.
“CHAIR POWELL. Well, so we do monitor the near-term forward spread—you’re right. And it’s—that’s been our preferred measure. We think, just empirically, it dominates the ones that people tend to look at, which is 2s, 10s, and things like that. So it’s not inverted. And, also, you have to look at why things—why the rate curve is doing what it’s doing. It can be doing that because it affects—it expects cuts or because it expects inflation to come down.”
The gymnastics here are rather childish, as is the complete blackout on the topic ever since this. They told us not to bother about the yield curve unless this one concoction corroborates any others, but once it did complete silence. You’d think if it was as he tried to claim at the end there, inversion forecasting Fed victory over “inflation”, officials would be all over this thing trotting it out on every occasion because it’s supposedly on their side.
No one seriously believes that, nor does the market price inflation success. In fact, it doesn’t price inflation – at all.
Since that time, both the NTFS and the 3m10s (as I said, they’re close proxies despite the silly claims otherwise) have absolutely collapsed. Not all at once – never all at once – unnervingly steady all the same. There was hardly any notice of SVB or Credit Suisse in mid-March, just another deflationary milestone on the journey toward ultimately further global impoverishment.
Just this week, the 3m10s sank to -173 bps, the worst it has been in its modern era (dating back to ’81). The NTFS had plunged to around -150 bps last week, and is right now sitting at roughly -140 bps. We haven’t seen anything like this since the deep recessions of the 70s and early 80s.
But there is a key distinction then to now. While the inversions might be of the same nominal proportions, the nominal levels each one starts from could not be more different. Back then, nominal yields were solidly double-digits. So, when, for instance, on May 4, 1981, the NTFS plummeted to -192 bps, it did so starting from the 3-month T-bill yield of 16%! The lower forward rate was above 14%.
Today, the 3-month bill is just higher than 5%. That’s not just a huge mathematical difference, it is a categorical one.
As interest rates were so high for the Great Inflation, the inversion in various spreads at the time had signaled stagflation, or the combination of recession plus painful (legit) inflation.
The same level inversion today only from way down around 5% and nearing 3% forward rates, that’s recession without the inflation risk. To be that much inverted this close to zero!
What that means is at the same time Huw Pill demands we all accept having already been made poorer, the world in reality has only halfway paid for the damage caused and imposed on us in the name of the pandemic. Contrary to both Pill and Powell’s views on labor, what’s ahead is not inflationary wages creating a wage-price spiral, rather markets are as near to certain as ever it will be massive unemployment and highly impaired long run growth as deflationary money wrecks too much of everything.
Again.
Pill is wrong in believing the damage is already done and even wrong-er thinking we can get out of this just by coming to terms with it. There is far more left to be done whether he or Powell wishes to accept the markets’ vehement determination.
Basically, something like another 2008 including the aftermath which from here really does risk making the 2010s seem enviable by comparison. Rates “want” to go back to zero even after not having gotten far from it because the market understands safety and liquidity will soon be the most prized characteristics.
Labor use is going to have to be adjusted for this.
The only question really left at this point is whether we do just accept it. Pill thinks we have to as a means to save ourselves from any worse when savings ourselves went out the window with lockdowns. The global economy had been increasingly impoverished already over the last decade and a half such that I shudder to think of what so much more might truly mean.
One thing is for sure: it won’t mean inflation. And that’s truly the bad news.
