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We're not going to ignore the Ukraine situation, but we figure you've probably seen plenty of coverage of that. Everyone's guessing, and we may well be living through historic shifts in the geopolitical sands. It's too soon to draw conclusions.
Incredibly, there's plenty of commentary doing the rounds that this means the Fed won't hike and the return to easy-money policy means BTFD.
JP Morgan are turning into permabulls...
“If one is selling on the back of the latest geopolitical developments now, the risk is of getting whipsawed,” Matejka and his team wrote in a note to clients on Monday.
“Historically, vast majority of military conflicts, especially if localized, did not tend to hurt investor confidence for too long, and would end up as buying opportunities.”
This may well be true, but if the geopolitical risks don't increase, then the focus should shift, so what will the Fed do?
@doejistar sent me his thoughts and challenged me to prove him wrong...
Over to you Doe! 👇
Having seen a lot of comments and contemplations to the idea that the Russia-Ukraine conflict will cause Central Bank's to revert back to easy policy, thought I'd share a few axioms on why that is very unlikely to be the case.
Let's start by taking stock of why we are seeing wide-spread inflation.
The Pandemic caused a surge in goods demand as consumption shifted from services to goods while causing strains on goods production.
To add further fuel to the growing supply and demand imbalance from a pandemic induced demand and supply shock, the unprecedented levels of stimulus to aid the pandemic recovery gave massive rise to 'demand-pull' inflation.
Wiki defines demand-pull inflation as “when aggregate demand in an economy is more than aggregate supply” and lists some causes:
- quick increase in consumption and investment along with extremely confident firms.
- sudden increase in exports due to huge under-valuation of the currency.
- a lot of government spending.
- expectation that inflation will rise often leads to a rise in inflation. Workers and firms will increase their prices to 'catch up' to inflation.
- excessive monetary growth, when there is too much money in the system chasing too few goods. The 'price' of a good will thus increase.
Should sound familiar! To combat the so-called 'demand-pull' inflation, it should follow that policymakers must attempt to reverse those causes. And while that doesn't paint a pretty picture for what lies ahead, let's consider what could happen if policymakers don't take steps to address it.
The history lessons that come to mind are that of 'hyperinflation'. Not the base case, as this is a fairly extreme illustration with some definitions being “the rate of price increases measuring more than 50% per month”.
To be clear, hyperinflation is EXTREMELY unlikely.
The economic mechanisms however are somewhat the same. Hyperinflation is the spiraling up of prices causing depression of ‘purchasing power’ or the ‘real value of money’.
Again, I'm not suggesting that we'll see anything like hyperinflation. It's just a good illustration of how inflation can take hold and spiral.
Basically, the longer these price pressures persist, the worse it is, and the more likely they continue to persist for longer if not addressed.
Which is why central banks cannot be complacent.
In extreme cases, rapid inflation can cause capital flight to safe haven assets and currencies which can further exacerbate the depreciation of the domestic currency and its denominated assets.
To make matters worse, Governments get sucked into this negative feedback loop by attempting to stimulate the economy by increasing spending and money supply at the expense of increasing government debt. The inevitable rise of interest rates only increases further pressure on the Government’s debt burden.
Once that feedback loop starts, it is a near impossible scenario to come back from if the easier policies don’t amount to economic stabilization and growth.
South American countries such as Brazil and Venezuela, are probably among the best modern day examples of this.
Now that isn’t to say that the major economic powerhouses like the US and Europe are anywhere near that level of catastrophe, but it goes to show how quickly the problem can spiral out of control to becoming virtually unmanageable.
The more these hard to quell inflationary pressures persist for reasons outside the control of Central Bankers, the greater their most trepid fears might soon be realized should they not act upon it, no matter how reluctant they may be to do so.
Thus it is unimaginable Central Bankers would dare revert to easy policy anytime soon.
These are all excellent points.
There's little doubt that Russia's decision to invade Ukraine, and the retaliatory sanctions put in place by the West will have huge implications for global trade and energy prices in the future.
Governments HAVE been tempted into cushioning households from high energy prices already, and likely would do so again.
The risk of high inflation persisting is very hard to ignore.
Europe is likely to bear the brunt of the Russian sanctions spillover. The hit to Eurozone growth and relatively low wage pressures could delay any hawkish moves from the ECB. Back to the status quo of never hiking and infinite QE a la Japan for Madame Lagarde.
But what about the Fed?
They just don't have that luxury.
US GDP growth is still expected to be double the pre-pandemic trend this year.
St Louis Fed president Jim Bullard expects Core PCE to be at 3.5% by the end of the year. Core PCE is the Fed's preferred inflation measure because it strips out food and energy price volatility.
If he's right, there's no arguing that this inflation is "all food and energy". It would mean that core inflation remains way above the Fed's flexible 2% inflation target at the end of 2022..
On Friday, Bullard was still calling for 100bps of tightening by July 1st and balance sheet runoff in Q2. 👇
Governor Waller said similar on Thursday... 👇
It's very hard to believe central banks will flip to easy policies while inflation is rampant and asset values are still highly-valued.
The Ukraine conflict may take the edge off any lingering desire to hike by 50bps at the March meeting. Beyond that, it's hard to see them going slow...
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