“If We Again See Deflation Ahead, It Requires Fiscal AND Monetary Fusion”

By Michael Every of Rabobank

Shulman, Nosov, Tyulakov, Watford, Melnikov, Avayev, Protosenya, Krukovsky, Subbotin, Voronov, Rapoport, Maganov, Pechorin, Sungorkin, Gerashchenko, Pchelnikov, Petrunin, Mushegian, Taran, Makei, Kochenov, Zelenov, Bidenov, Buzakov, Antov, Maslov, Abdulaev, Pawochka, Makarov, Yankina, Rovneiko. The list of prominent Russians who mysteriously died since the start of 2022 has grown in exponential fashion. Does a market analyst think that’s randomness, prominent Russians being suddenly unlucky, or the Russian political-economy working? I raise the point because our metastasizing metacrisis should force us to look for patterns in our own political-economy even if it means reaching some uncomfortable conclusions.

After all, we just passed the 20th anniversary of the 2003 Iraq War, started over either a terrible error or a lie, which destabilised the Middle East and undermined US moral authority and military strength. Everyone I knew in 2003 knew there were no Iraqi WMDs but that the war was going to happen anyway. The logistics had been set in motion. All the nodders were nodding. I also distinctly recall being on the trading floor when the statue of Saddam came down: everyone turned off the TVs and went back to their desks as if it was all over, rather than the broader problems starting.

The same logistics were clear ahead of the Ukraine invasion in 2022 if one bothered to look. The problems are also still just starting there, even if markets are again trying to ignore them.

Markets can do so only because the US political-economy since Carter is that the labor share of GDP mysteriously dies while capital’s rises; and since Greenspan, that a Fed Put is always there to save investors. To underline how deeply this mentality is built in, even in a week where Credit Suisse became UBS, equity holders were smashed, and AT1 holders crushed, Bloomberg reports the ‘Biggest Fear for Trillion-Dollar Managers is Missing Next Rally’:

“Some of the world’s biggest investors are looking beyond interest-rate hikes, bank failures, and the threat of recession to one of the greatest fears of money managers – missing out on the next big rally…. They’re convinced that an impending slowdown in the US and elsewhere will prompt central banks to switch back to looser policy, triggering a renewed surge higher in markets.”   

Of course, there is still room for a surprise from the Fed tomorrow, perhaps not in terms of an expected 25bps, but in the dot plot of what they think comes next. In a technical paper on the US yield curve, Philip Marey shows Dynamic Nelson Siegel model scenarios for the US 10-year yield for end-2023: 5.31% if inflation is sticky; 4.28% in the Fed’s December dot plot; and 1.53% in case of stagnation. That’s quite a range: then again, the US 2-year yield just traded an 40bps intra-day range yesterday. That would recently have been a safe projection for an annual trading range!

That predicted ‘DM = EM’ shift isn’t a surprise when you see the other names falling out of windows and off yachts or pedestals: Barnett; Bates Clark; Friedman; Jevons; Krugman; Samuelson; Walras; Wicksell, etc. – i.e., the collective reputation of neoclassical and neoliberal economics. Those shilling Goldilocks fantasies ten weeks ago sold linear, first-order, not non-linear, second, third, nth order thinking – like the above economists. If the number of people, or reputations, falling through windows goes 2, 4, 8, 16, I adjust my view of political-economy rather than of glazing.

In the real world, writing in the Financial Times, Gillian Tett notes the treatment of AT1 bonds in the Credit Suisse affair could contribute to an “insidious sense of investor doubt” about the neutrality of laws underpinning capital markets, with suspicions the Swiss authorities ensured the powerful Saudis got their money first. Likewise, SVB was not just a start-up bank but a national security issue, says the Pentagon, and Signature Bank was about dollar-rival crypto. The expansion of Fed swaplines excluded EM, again. Yes, the average Fed governor, like the average market analyst, may not even be able to spell geopolitics, let alone say it, but that doesn’t mean there isn’t a parallel reality to purely market perceptions of events.

Which brings us back to the view that it’s if not when we get a Fed Put. Let’s try to frame this in broader political-economy:

Covid-era inflation was never going to be “transitory”. That’s what happens if you finally use fiscal *and* monetary policy, having failed with only monetary, supply chains buckle, and entrenched oligopolies raise prices because they can. Oh, and war.

Nominal wage inflation was always likely to rise. Covid saw excess deaths, long illnesses, early retirement, lifestyle changes, and labor hoarding in ageing societies where fewer younger workers must produce the same volume of goods and services, while immigration came to a halt. Workers needed pay rises to try to catch up to inflation: and firms can afford to let them to some degree because profits are so high. Governments have to for political reasons.

Interest rates were always likely have to be ‘higher for longer’. What else were central banks supposed to do – argue for higher taxation and anti-trust action?

Raising rates in a financialised economy breaks things. Yet some things getting broken aren’t useful to the Pentagon, and others are more useful broken.

Risks of a credit crunch and deep recession are higher without more state action – which is why after suspending mark to market, the US is now studying extending deposit insurance universally. The state might need to step in even more. If so, will it be for free-wheeling Greenspan get-rich-quick schemes,… or China-style, centralization, re-regulation, and making banking as exciting as the civil (or military) service?

Sustaining state spending will be hard, but voters are in no mood for cuts. More so as defence budgets must surge now “production is deterrence”. On which, US ‘60 Minutes’ just nodded about how many more warships China builds each year than the US. The CSIS says in ‘Reviving the Arsenal of Democracy: Steps for Surging Defense Industrial Capacity’:

“If there is a future conflict, the nation will have to go to war with the industrial base that it has at the time. The WWII model of engaging the industrial base in five years may not be sufficient for a conflict with a highly capable adversary with a strong industrial base, a strategy of onshoring all the components of production, and near-monopoly power over critical subcomponents, including critical materials used in defense production across the world.”

Cutting rates back to zero is not a viable strategy because of high inflation; low unemployment; the need for more production, not asset bubbles; the politics of selling asset-rich-income poor to an already furious public; and the fact that IT DOESN’T WORK. If we see deflation ahead, then we *know* it requires fiscal and monetary fusion – and then we know we get inflation again.

If the US does have to cut hugely again, every other DM is in deeper trouble. Worse, large EM are saying “No more 2003 or 2008!” as gold and crypto rise. I said Bretton Woods 3 Won’t Work, but also that if you want EM to set up CBDCs and use barter or gold for clearing, then let the Fed, ECB, BOE, BOC, RBA, etc., follow the BOJ. Look on as geopolitical sides are taken: as Xi visits Putin ahead of a visit to Beijing from Lula, Kishida is visiting India and making up with South Korea, floated as another Quad member.

Ideology is back as a justification for state action, as flagged in 2020. As we rush to restructure market architecture in a zero-sum, high-inflation, highly-geopolitical atmosphere, more technocratic or FTX-on-the-Forbes-front-cover Bloombergery is unlikely. History and logic says we will instead see new (old!) political-economy fusions of monetary, fiscal, industrial, and regulatory policy: like rate hikes and QE (or, some say, higher inflation targets); suspending or intervening in markets; and/or financial repression.

The logistics of this are starting to emerge if you can join the dots. The nodding heads are starting to nod. Clearly, however, most in markets don’t grasp how their political-economy is changing and don’t see the exponentially rising number of bodies and reputations falling out of windows.