Come Hell or Highwater? Central Bankers and Inflation

Inflation in the UK reached 5.5 percent in January 2022, according to the Office for National Statistics. Victoria Jones/PA

Commentary 

Many are currently baffled on the path of the economy and markets, and for a good reason. Stock markets are nearing a bear market, while the U.S economy seems to be doing ok. Retail sales came in as expected, rising by 0.9 percent (MoM) and the U.S. industrial output rose more than expected (1.1 percent) in April. Is the economy really coping with higher inflation and rising rates?

I think not. What we are likely seeing is a front-loading of purchases by consumers and firms ahead of expected and possible even steeper price rises, i.e., faster inflation. The coming interest rate hikes and QT will also start to bite in a matter of months.

We explained the blurry situation of the U.S. economy in our Deprcon April World Economic Outlook:

“The U.S. GDP produced a surprise decline in the first quarter. It’s only a first (advance) estimate, which means that the final figure may change even to positive. The decline was mostly driven by sharp drop in exports caused, most likely, by the war in Ukraine and the appreciation of the dollar. Outlook for Q2 looks somewhat rosy, though.

“Many of the manufacturing indexes notched clearly upwards in the U.S. in April. For example, the Empire State manufacturing general business conditions index shoot [sic] up close to 35 points to 24.6. The new orders index climbed 36 points to 25.1 and the shipments index by 42 points to 34.5. These are all strong signs of a rebound, but the question is what is driving it?

“It is possible that the current boost in activity is driven by firms and consumers front-loading their orders to get ahead of further price rises. That is, firms and households may have stepped up the pace of their purchases so that they get what they need in the medium-term at lower prices. If this is the case, then we will see a sharp drop in economic activity in the U.S. during the summer. The figures from the Fed manufacturing surveys lend support to this view.

“In the Fed Dallas manufacturing survey, the general manufacturing index as well as indexes for new orders and shipments rose notably. However, the company outlook index fell to -5.5, which is the lowest figure in two years, while future general business activity fell to 1.8, the lowest since May 2020. The outlook uncertainty index rose from 20.8 to 29.8, the highest figure since April 2020. In the Empire State manufacturing survey, the index for future business conditions fell 21 points to 15.2, the lowest since early in the pandemic. In the Richmond Fed manufacturing survey, the expectations of business conditions was negative, which is only the third time that the index has been negative since its inception in 2010’s. These all tell a story of a weakening outlook. Companies also reported very high rises in prices and wages in the Texas, New York, and Richmond Fed manufacturing surveys.”

So the U.S. economy seems to be going through a kind of a mini-boom, at least in manufacturing, but it’s likely to be short-lived (if not already over). The outlook of the manufacturing sector is dire and the housing market is cratering. The leading index of the Conference Board also posted a decline last month. Risk appetite and leverage are falling, while credit conditions are worsening (see, e.g., this).

If consumers are also front-loading their purchases, which seems likely, the U.S. economy will hit the wall in a matter of months. This means that during summer, fall at the latest, we could see a massive decline in economic activity. Asset markets flirting with the bear market are a direct reflection of this.

I think that those arguing that the Federal Reserve should not over-react or that the economy (and inflation) is already “correcting itself,” do not really grasp what is at stake here. We have described the other option, or scenario, in several of our Q-Review forecasting reports under the titles “The Great Inflation” (2018), “Hyperinflation and authoritarianism” (2019), and “The Global Economic Dystopia” (2020).

The point is that either we allow the economy and markets to truly correct themselves by pulling back the over-whelming central bank support, or then we enter something that can only be called a “socialistic authoritarian dystopia,” where central banks and governments rule the economy and fast inflation is the norm. There, quite simply, are no other options left.

We have been arguing for a while that the market bailouts by central banks only end after political and/or economic pressures force them to stop. This could basically happen through an audit ordered by Congress (in the United States) or the European Court of Justice ruling against the policies of the ECB, or through an inflation outbreak.

The latter has now manifested, and thus it’s no surprise that central bankers are taking a tougher stance towards inflation, on which we warned in June/July. Ominously, we stated that: “If inflation continues to accelerate from here, they [central bankers] basically have no other option left than to try taper asset purchases and start to raise rates. But with the current state of super-highly levered financial markets, the mere expectation that financial conditions may become less loose will start ‘fire sales’ in the most speculative corners of the market.”

And, there’s more to come.

Fed Chair Jerome Powell stated in a CNBC interview that the Fed “will not hesitate” in bringing the inflation down, which will also bring some “pain.” Kansas City Fed President, Esther George, stated that policy makers are focused on inflation and not on the stock market. ECB President Christine Lagarde stated that it looks “increasingly unlikely” that the dynamics that drove inflation down during the past decade will return and that it’s “critical” for the ECB to demonstrate their commitment to price stability.

Alas, come hell or highwater, central bankers seem determined to bring inflation down. The only problem is that at the same time they will bring down their own designs, that is, the massively inflated asset and credit markets as well as highly indebted corporations and governments.

Will they be able to stomach that? I am skeptical, but mistakes can happen.