Will a recession kill inflation?

There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.

MacroAlf: CPI & Recessions

A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.

CPI, Average Hourly Earnings & Recessions

Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.

Fed Funds Rate & Unemployment

In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.

A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.

Unemployment(U3) & Average Hourly Earnings Growth

Conclusion

We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:

(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).

An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.

A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.

The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

Robert Shiller’s warning

Nobel prize-winning economist Robert Shiller warns that cracks are once again surfacing in the US housing market.

“We have had a strong housing market for pretty much all the time since 2012. Just after the financial crisis, the housing market didn’t recover, maybe because banking was in disarray and people were still expecting declines after the event. After 2012, it started going up at more than 10 per cent a year nationwide in the US, and has been slowing down since.”

Shiller says that a worrying pattern emerging in house prices is reminiscent of the property market in the run-up to the Great Recession.

The bursting of the US housing bubble in 2006-07 was a key trigger of the financial crisis…… “I have seen this happen before, we’re like back in 2005 again when the rate of increase in home prices was slowing down a lot but still going up.

Case Shiller Index

Growth in the Case Shiller National Home Price Index is clearly weakening but we need to be careful of confirmation bias where we “cherry-pick” negative news to reinforce a bearish outlook. I would take the present situation as an “amber” warning and only a drop below zero (when house prices fall) as a red flag.

Shiller has an enviable reputation for predicting recessions, having warned of the Dotcom bubble in tech stocks and the housing bubble ahead of the 2008 global financial crisis. He is correct that narratives (beliefs) can become self-fulfilling prophecies. If the dominant view is that the economy will contract, then it probably will — as corporations stop investing in new capacity and banks restrict lending. Geo-political tensions — US/China, UK/EU Brexit, and Iran/Saudi Arabia — combined with massive uncertainty in global trade and oil markets, could quickly snowball into a full-blown recession.

Sahm Rule: Sweden tips into recession

Sweden: Sahm rule

What is the Sahm Recession Rule?

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm uses the following rule as a timely indicator of recessions:

Sahm RuleSahm RuleSahm Rule Graph

S&P 500: Treasuries warn of a bear market

10-Year Treasury yields plunged Friday, to close at 2.45%, warning of a decline to test primary support at 2.0%.

10-Year Treasury Yields

The yield curve is now likely to turn negative. The 10-Year/2-Year yield differential has already fallen to 0.13%. Below zero signals a negative yield curve, a reliable predictor of oncoming recession within the next 12 to 18 months.

10-Year minus 2-Year Treasury Yields

The S&P 500 retreated Friday and is likely to breach its new support level at 2800. Follow-through below 2600 would warn of a bear market.

S&P 500

Odds of a recession appear low | Bob Doll

Sensible view from Bob Doll:

…The odds of a recession appear low, but so does a significant acceleration in growth. The regulatory environment is loosening, consumer spending appears solid and jobs growth remains strong. As such, we do not expect a recession any time soon. At the same time, however, we see no catalyst to push the economy into a higher gear unless the White House and Congress make progress on their pro-growth agenda.

Progress on tax reform would revive the bulls.

Source: Weekly Investment Commentary from Bob Doll | Nuveen

The Threat of Inflation

From the Trading Diary:

I received a message from a US reader suggesting I should “stay out of politics”.

I would love to stay out of politics. Frankly, I find it tiresome. Unfortunately, politics and the economy are so intertwined as to make the study of one meaningless without consideration of the other. I say “unfortunately” because a lot of the damage done to the economy is caused by the political system.

As for Donald Trump, I am a conservative but do not support him. He is not another Reagan who can lead from the center and inspire his country. If anything he is a polarizing force, more ego-driven than Nixon and just as unpredictable.

I hope I am wrong. Trump has many sound policies and has made some solid appointments to his team. Don’t believe everything you read from a hostile media. They could do a lot of good. Provided they are able to manage the elephant in the lifeboat — the destabilizing side of Trump’s nature.

Now that I have offended at least half of all US readers — slightly less than half if you listen to bleating about the majority vote — let me explain why politics and economics are so intertwined.

Apart from trade wars, which I will discuss at a later date, I see the main threat to the US economy as inflation.

Before I start, let me say that these dangers are not immediate and the present boom is likely to continue for the next 12 to 18 months. But they could quickly materialize, bringing the boom to a premature end, so it is best to keep a weather eye on them.

Inflation

Earlier this week I discussed why the inflation outlook is so important to stock market performance:

From Tim Wallace at The Sydney Morning Herald:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

Harvard scholar Paul Schmelzing points out that inflation is starting to rear its head in both China and Germany, with producer prices rising. This may in part be a result of the falling value of the Yuan and Euro against the Dollar, resulting in higher domestic commodity prices.

The opposite, however, is true for the US, with a rising Dollar lowering import prices and acting as a headwind against inflation.

The consumer price index (CPI) is rising because of higher crude oil prices but core CPI (excluding food & energy) has remained fairly constant, around the 2.0 percent target, over the last five years.

Core CPI and CPI

So why the concern?

Well the Fed is more concerned about underlying inflation, best reflected by hourly wage rates, than the headline CPI figure.

A sharp rise in hourly earnings rates would force the Fed to respond with tighter monetary policy to take the heat out of the economy.

The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure. And tighter monetary normally leads to recession.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth is currently at 2.5 percent, so the Fed has some wiggle room and is only likely to react with tighter monetary policy when the figure reaches 3.0 percent.

Recent rate rises are more about normalizing interest rates — not taming inflation — and are not cause for alarm.

But Paul Schmelzing warns that the combination of a tight labor market and fiscal stimulus could fuel inflation and lead to a bear market in bonds similar to the 1960s.

That is exactly where Donald Trump is headed with a major infrastructure program likely to hit the ground next year. In a tightening labor market, the Fed would be forced to tighten monetary policy, slowing the economy and leading to another bear market in stocks as well as bonds.

Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.

~ Stone Gossard

High public debt impedes recovery

This graph from a FRBSF paper Private Credit and Public Debt in Financial Crises, by Òscar Jordà, Moritz Schularick, and Alan M. Taylor, perfectly illustrates how high public debt levels impede the ability of an economy to recover from a financial crisis:

Figure 3……. shows that high levels of public debt can be a considerable drag on the recovery. The figure displays the path of per capita GDP in a typical recession compared with the paths under three scenarios following a financial crisis resulting from excess growth of private credit. Each of the three scenarios corresponds to a specified level of public debt at the start of the recession. The dotted line represents a low level of debt of about 15% as a ratio to GDP; the solid line represents a medium level of debt of about 50% of GDP, which is the historical average; and the dashed line represents a high level of debt of about 85% of GDP.

Recessions and Public Debt Levels

Read more at Federal Reserve Bank San Francisco | Private Credit and Public Debt in Financial Crises.

Hat tip to Barry Ritholz

High credit growth prolongs recessions

Research by the Federal Reserve Board of San Francisco shows how high credit growth prior to a financial crisis can prolong the recession by three or more years. The graph below compares the average recovery time for a normal recession to recessions preceded by low credit growth [blue or red] and recessions preceded by high credit growth [green or orange].

Recession Recovery Time

Differences in public debt growth appear to have little impact, but public debt levels are another matter.

Read more at Federal Reserve Bank San Francisco | Private Credit and Public Debt in Financial Crises.

Hat tip to Barry Ritholz

Recession time for Russia | The Market Monetarist

Lars Christensen at The Market Monetarist writes:

….. sharply increased geo-political tensions in relationship to Putin’s military intervention on the peninsula of Crimea has clearly shocked foreign investors who are now dumping Russian assets on large scale. Just Monday this week the Russian stock market fell in excess of 10% and some of the major bank stocks lost 20% of their value on a single day.

In response to this massive outflow the Russian central bank – foolishly in my view – hiked its key policy rate by 150bp and intervened heavily in the currency market to prop up the rouble on Monday. Some commentators have suggested that the CBR might have spent more than USD 10bn of the foreign currency reserve just on Monday. Thereby inflicting greater harm to the Russian economy than any of the planned sanctions by EU and the US against Russia.

By definition a drop in foreign currency reserve translates directly into a contraction in the money base combined with the CBR’s rate hike we this week has seen a very significant tightening of monetary conditions in Russia – something which is likely to send the Russian economy into recession (understood as one or two quarters of negative real GDP growth).

Read more at Recession time for Russia – the ultra wonkish version | The Market Monetarist.

China ‘hard landing’ could trigger Australia recession: Standard & Poor – The Economic Times

“Australia’s exposure to commodity demand from Asia, and China in particular, was a saving grace during the global recession of 2009. But by the same token it has become Australia’s Achilles’ heel,” the ratings giant [Standard & Poor’s] said.

“Particularly while mining investment remains such a large share of the Australian economy, and other sectors continue to lack growth momentum, Australia remains highly sensitive to a sharp correction in China’s economic growth.”

Read more at China ‘hard landing’ could trigger Australia recession: Standard & Poor – The Economic Times.