Market expectations of rapid disinflation and a soft landing remain, but January has contributed a few new risks to the optimistic estimates of disinflation with no impact on the economy.
Furthermore, the December inflation figures in the eurozone proved that the base effect was an uncomfortably large driver of the consumer price index’s annual decline in November. In fact, all of the components published by Eurostat in the December advance came significantly above the European Central Bank target.
The second risk comes from the significant bounce in net liquidity and effective money supply, both in the United States and the eurozone. Thus, the following three months will be critical to understanding the real disinflation process and whether market estimates are too optimistic. Unless the money supply declines again, the path to reaching the Federal Reserve’s target of 2 percent inflation may be challenging. The minutes from the meeting of the policy-making Federal Open Market Committee came as a surprise to many when, like the European Central Bank, members maintained their commitment to wait and see rather than implement immediate rate cuts.
We’ve been discussing too much about rate cuts and too little about net liquidity, sometimes forgetting that rising net liquidity has driven markets higher in the fourth quarter, and that the first quarter likely will be more challenging considering the estimated volatility in the reverse repo figures. In addition, massive deficit spending by the U.S. government may keep inflationary pressures above the level that broad and base money reductions would suggest.
The third risk comes from the inflationary impact of government protectionism. As trade barriers continue to build, the monetary disinflation process may be decelerating because of governments implementing trade wars, barriers to commerce, and tariffs. Unfortunately, governments in the eurozone and the United States are tightening protectionist measures disguised sometimes as “environmental policies,” making competition more challenging and prices of food and shelter more expensive, by slashing access to land and farming as well as limiting building projects.
Interventionism and trade wars make goods and services more expensive for citizens by placing a floor on prices even when monetary aggregates decline.
We need to be careful with excessive optimism about inflation and even more aware of the perils of expecting disinflation with no economic harm. Many market participants are suddenly surprised that January has started with a negative trend, but this is explained by the excessive expectations of aggressive and immediate rate cuts.
