The Default Setting

By Michael Every of Rabobank

Wouldn’t it be great if we could hold down a button and reset the world back to the default setting we thought was normal before our present mishigas? Boy, could we do with it!

Neoclassical economic models think we constantly mean-revert anyway, ignoring the role of credit, supply chains, political-economy, and geopolitics. It’s like a Google Maps that only does straight roads, not bends: worth following for long stretches when nothing is happening, but wrong every time we turn left or right. In the real world, sharp bends are all around us.

The Financial Times’ Gideon Rachman today warns: ‘Xi Jinping’s Taiwan ambitions threaten China’s rise’, not the first op-ed warning of the risk of war. The same paper reports that shipping groups are increasingly seeking break clauses in contracts with Chinese businesses to make it easier for them to walk away from any deals if sanctions are imposed on China: why the sudden concern, and wouldn’t that imply massively disrupted supply chains? Elsewhere, Iran seized a third oil tanker, and nobody seems to have even noticed. There is also not much coverage of Special Counsel Durham’s report into Russiagate concluding the Department of Justice and FBI “failed to uphold their mission of strict fidelity to the law.” Will we now reset journalism to the default setting of bipartisan honest-brokers? Right after we dump neoclassical economic models.

US Treasury Secretary Janet “No financial crisis in my lifetime” Yellen is warning there are only days left until the US defaults on its debts, as President Biden and House Speaker McCarthy ceremonially rip the steering wheels out of their cars today in a pre-2024 game of chicken. We can expect things to get worse before they get better, but that we aren’t seeing wholesale selling of Treasuries down the curve, or the US dollar suggests nobody sees this is an existential issue – yet. However, as Yellen failed to take advantage of the lowest rates in history to refinance the public debt to limit pain from the rates re-set higher which the Fed she still speaks as if she runs is inflicting, the question will linger. And note the interest on the US federal debt is set to exceed spending on the Pentagon soon, as military spending is set to be higher for longer. Something is going to be reset. It’s just a question of what.

The Fed’s Bostic just stressed the “longer” in “higher for longer” rates too despite the New York Fed manufacturing survey collapsing to -31.8 from 10.8 prior and vs. -3.9 expected. Dovish Vice-Chair Goolsbee says he is getting “vibes” of a credit squeeze beginning. Yet some think that squeeze is what the Fed wants to see if the lending is frivolous rather than anything productive. Indeed, are the Fed trying to return the US economy to its historical default setting of low inflation, high production, not financialisation, and military strength in depth? The question is then how the liquidity keeps flowing to anything productive when it dries up to anything frivolous. I’ve made that point repeatedly because there isn’t any other policy that works: it’s just a question of how this is done and when. Meanwhile, the market obviously thinks the US default setting is very low inflation, very low rates, and very low domestic production of everything except financial assets (“Who needs HIMARS, we have CDOs!”).

In China, production is not matched by domestic demand outside services, for now: see ‘Recovery on shaky legs?’ from Teeuwe Mevissen, who thinks USD/CNY will test 7 again. Indeed, today’s China data were mostly big misses, with industrial production 5.6% y-o-y vs. 10.9% consensus, 3.6% year-to-date (y-t-d) vs. 4.9%; retail sales 18.4% y-o-y vs. 21.9% consensus, 8.5% y-t-d vs. 8.2% – which doesn’t match the trend of lower imports; fixed asset investment 4.7% y-o-y y-t-d vs. 5.7%, and property investment -6.2% y-o-y y-t-d vs. -5.7%. Overall, this looks deflationary.

Yet the European Commission just raised its Eurozone inflation outlook and warned of “persistent challenges”. CPI is now seen at 5.8% y-o-y in 2023 vs. 5.6% before, and 2.8% for 2024 vs. 2.5% – and that is despite the sharp fall in energy prices. Core inflation is seen much higher than in the last projection, and only declining slowly, remaining above the 2% target in 2023 and 2024. So, “Länger höher”, even as March industrial production data were -1.4% m-o-m.

In the Antipodes, the chatter is the RBNZ may hike Kiwi rates to 6% and the RBA to 4.35%, a message broadly backed by its latest set of minutes, which noted upside risks to sticky services inflation and the fact that strong population growth combined with low rental vacancy rates could see rents jump even higher than the RBA’s own elevated forecasts. So higher rates….which will then be passed on directly to renters by landlords! Meanwhile, headlines are still of properties next to sewer vents going for millions of dollars as multiple families bid to buy themselves protection from an unofficial political-economy default setting of ‘neo-feudalism lite’. As one US presidential candidate flags removing the right to vote for those under 25 unless they perform national service –welcome to ‘Starship Troopers’, where service guarantees citizenship: “Would you like to know more?”– an Aussie Twitter wag says every Australian should be subject to military service until they buy a home. Which is how thinks used to work once, of course.  

Like I said, it would be great to be able to reset everything – but it just isn’t going to happen. Or at least not in the way that most people expect.