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"We Now Understand How Little We Understand About Inflation" said Jerome Powell, Chair of the Federal Reserve, central bank of the largest economy in the world.
The same central bank that sits at the heart of the global monetary system, issues lots of that greenish coloured paper that everyone always needs when sh*t hits the fan, no matter how many times it's pronounced dead by economic commentators...
Yeah THAT Federal Reserve.
Powell dropped this bombshell on a panel yesterday with the head of the ECB, the Bank of England, and the Bank of International Settlements. Everyone had a little chuckle at his joke, the host Francine Lacqua replied "that's not very reassuring" and the conversation quickly moved on...
Now, I LOVE these gatherings. Not because I'm a monetary policy nerd or anything like that (I am a bit). It's because they let their guard down.
In the company of other central bankers, they can all confirm their priors, get fully into groupthink mode and sometimes... They say the quiet parts out loud.
The new consensus was confirmed in the usual places...
Under normal circumstances, this would be the perfect time to take the opposite trade. By the time policymakers are changing tact it's already in the price. Peak inflation!
Five year inflation expectations are falling everywhere at the same time as central bankers are signalling a brand new world of higher structural inflation. 👇
But the current situation just isn't that clean. Even as we head unerringly towards recession...
It's really not clear what kind of recession it'll be. The only thing that seems 'certain' is that a return to the old, low-inflation regime isn't on the cards any time soon.
See, the old regime was driven by a combination of Disinflationary forces such as new, efficient technologies, high Debt and ageing Demographics. Triple D.
As much as any of that though, it was driven by abundance and stability.
An abundance of cheap energy (US shale, Russian gas), an abundance of cheap labour (Eastern Europe, China) and a stable, globalising world economy, where expanding trade was the over-riding goal.
The lesson? A world of abundance and stability is one where it's hard to generate inflation.
Powell think that world's gone for now 👇
“The last ten years were so far the height of the disinflationary forces that we faced. That world seems to be gone now at least for the time being.
We are living with different forces now and have to think about monetary policy in a very different way.”
We'll come back to the bolded points near the end. Lagarde echoed the sentiment:
“There are forces that have been unleashed as a result of the pandemic as a result of this massive geopolitical shock we are facing now that are going to change the picture and the landscape within which we operate”
Powell summed it up:
“What we don’t know is whether we’ll be going back to something that looks more like or a little bit like what we had before -- we suspect it’ll be kind of a blend. We’re learning to deal with it. We’ve lived in that world where inflation was not a problem.
So how did they get inflation sooooo wrong? I mean, it wasn't just their response to it, the models and forecasts were all way off.
“If you want to know the lessons to be learned of the last ten years, look at our framework. Those were all based on a low inflation environment that we had. And now we are in this new world where it is quite different with higher inflation and many supply shocks and strong inflationary forces around the world.”
Powell even pointed out that something was missing in their data for the past 40 years: "a collapse of the supply side".
BIS head Agustin Carstens had the final word: "As economists, we need to do better at understanding aggregate supply. We were trained under understanding aggregate demand, and we know how to respond to demand."
Here's the clip 👇
Despite acknowledging the supply side issues, central banks are going to aggressively tighten to destroy demand anyway, because what else can they do?
Which is why a recession is practically inevitable.
But what if they take it too far? 👇
Dario Perkins: Reading the BIS, the odds are stacked towards policy over-tightening. Would you rather have a recession now, which happens even to the best central bankers. Or a once-in-a-generation "paradigm shift", which is reserved for the few & will become a case study in monetary failure?
This is especially ominous: "Central banks fully understand that the long-term benefits far outweigh any short-term costs. And that credibility is too precious an asset to be put at risk".
So, let's presume they can successfully destroy demand and put economies into recession. What next?
If inflation remains above target (it probably will), do they keep hiking?
A recession won't fix supply side issues. Arguably it would make them worse. Business investment/CAPEX typically reduces as the economy shrinks....
Going right out on a limb here, could central banks look to fix the supply side by working in tandem with governments?
Look at the earlier quotes in that context 👇
"Going to change... the landscape within which we operate”
"We are living with different forces now and have to think about monetary policy in a very different way.”
"we suspect it’ll be kind of a blend. We’re learning to deal with it."
So, here's how it plays out. Governments get it in the neck from the citizens for high inflation. They blame the central banks who respond that they can't affect the supply side and that's the governments job.
Governments: "But we don't have any money, can't raise taxes in a recession and borrowing costs are getting higher and higher..."
Del-Boy enters the room 👇
"Wotcha! You need some of them extraordinary tools bruv! Right, listen up! What we do is finance the governments DIRECTLY. Lend at zero interest, but we'll only do it for the important stuff like energy so that people don't get annoyed. We'll call it green financing or an emergency transition fund or summink. No need to pay it back, just stick it on the balance sheet and forget all about it yeah? Everyone's a winner. Cushty."
I used Powell purely because of that jacket. It could happen in any country, but the eurozone is clearly most in need. This is from the Macrodesiac discord earlier today 👇
The eurozone is also the least likely to do anything before a proper, PROPER crisis. On that note, this is the only anti-fragmentation plan so far... 🤦♂️👇
Donors?! There was no better name than DONORS?! Can tell this plan was made by academics. Zero marketing skillz.
Summing up, now that central bankers are becoming more aware of the supply side issues and perhaps the potential need for domestic capacity to be increased as globalisation retreats, I think it's only a matter of time before the fiscal and monetary branches join hands to 'fix' the recession they're about to create.
The immediate issue is undoubtedly energy. There'll be no return to a low inflation world unless energy supply increases. And that'll need investment, stable policy and government backing, whichever form it takes.