The fight against inflation could break the global economy
By Ambrose Evans Pritchard
The classical signals used by economists over the ages are telling us that Europe and America are sailing straight into a recessionary iceberg at full throttle.
These long-term indicators are nearly all pointing to a deep global downturn, though China may scramble the picture as it comes out of the Great Lockdown.
Yet short-term indicators have been telling us the opposite for several weeks. They suggest that the Atlantic economy is re-accelerating after last year’s recession-scare. A hard-landing has been averted and we are heading into another leg of economic expansion thanks to irrepressible jobs growth, with inflationary consequences to match.
This view, fast becoming the new consensus, has led to a violent repricing of the $US130 trillion ($193 trillion) global bond market, egged on by scorched-earth rhetoric from the US Federal Reserve and the European Central Bank. Yields on two-year US Treasuries have spiked by 80 basis points since early February and are near 5 per cent, which happens to be the peak in mid-2007 just before the international financial system began to unravel.
So which signals should we listen to? The traditional gauges may have been rendered useless by Covid and supply chain convulsions, but that is a risky assumption. The OECD’s composite leading indicator for the G20 has been falling for 17 consecutive months and has not yet begun to stabilise. It clocked a new recessionary low of 98.4 in January. The index anticipates the real economy by six to nine months.
The G7 reading is even lower at 98.1 and is already lower than at any time before or during the dotcom recession in the early 2000s. Italy is dire – lower than during the eurozone debt crisis a decade ago – and the UK is worse yet.
“The big cyclical components of the economy are cycling down pretty darn hard. We haven’t seen it since the Great Recession,” Lakshman Achuthan from the Economic Cycle Research Institute (ECRI) in New York.
Capital Economics said its global trade monitor had yet to detect any sign that shipments have touched bottom. “Not only did the fourth quarter see one of the biggest drops in world goods trade since the 1980s, but leading indicators point to further falls ahead,” it said.
The Fed and the ECB are carrying out the most aggressive monetary squeeze of modern times. This is colliding with public and private debt ratios that have ballooned to 292 per cent of GDP in rich economies (IMF data) and 247 per cent globally – up by 50 percentage points since the pre-Lehman debt bubble.
This has not yet set off serious credit defaults in the West, though a string of developing states such as Egypt, Pakistan, Tunisia, El Salvador, Lebanon, Sri Lanka and Ghana are in trouble.
Companies stretched debt maturities when money was cheap, giving them a buffer. But the effects of last year’s ferocious tightening have yet to feed through and there are already signs of an incipient credit crunch in Europe. S&P Global says US firms have a weaker credit profile than before the Lehman crisis. “Refinancing pressure is building,” it said.
The standard 30-year mortgage rate in the US has doubled to 6.5 per cent in a year. The Case-Shiller National Home Price index of US house prices peaked last June and has since fallen by 4.4 per cent. This is only the second time since the 1930s that prices have fallen nationally.
A new study by the Dallas Fed says the price-to-income ratio has hit levels never seen before in modern US history. It thinks house prices could fall 20 per cent in the US, with parallel falls in Germany, risking a “domino effect” through the global macro-economy.
Every very relevant measure of the US Treasury yield curve is by now steeply inverted. The benchmark 10-year/two-year spread flipped nine months ago and has dropped to minus 88, the lowest for almost half a century. Recessions typically follow a year or so after the start of sustained inversion. That happened nine months ago.
The money supply is contracting across the Atlantic economy. The Institute of International Monetary Research says that broad money fell at a 2.1 per cent rate (annualised) in the eurozone over the past three months, by 3.9 per cent in the US, and by 10.3 per cent in the UK. The fall in real terms has been off the charts.
Yes, this is still draining the monetary overhang created by central banks during the QE orgy during the pandemic. But at the end of the day, monetarists of all stripes agree on one thing: this picture cannot be reconciled with a fresh cycle of economic growth and inflation.
It is certainly possible that these traditional indicators are obsolete in the modern electronic economy, but there are reasons why the winter rebound might be an illusion.
Matt King from Citigroup says central banks have added $US1 trillion of short-term liquidity over the past three months. “It’s basically as though they have been doing QE, even as they told us they were doing QT.”
The longer they keep raising rates into the teeth of monetary contraction, the greater the risk that they will break the global economy in the process.
“The moment you think of it in these terms it paints a much more negative and fragile picture for the outlook. What we’ve seen is quite extraordinary, and you shouldn’t be chasing it,” he said.
The reasons for this bizarre twist are highly technical. The Bank of Japan had to splurge on bonds to defend its yield curve control policy.
The US Treasury has been running down its Fed account to keep spending going until there is a deal in Congress on the debt limit. That has neutralised the Fed’s asset sales. But this is nearing limits and will have to go into reverse, at which point it will double the potency of monetary tightening.
It was the blockbuster US jobs report three weeks ago that launched the reflation story. Non-farm payrolls soared by 517,000 in January. “It was so strong, I don’t believe it,” said Mark Zandi from Moody’s Analytics.
Instant data is always erratic at turning points, and nothing is more erratic than payroll data, a lagging indicator even when correct. Analysis by the Philadelphia Fed said the series overstated jobs growth by a million in the first half of last year.
The January report relied on a 2.9 million “seasonal adjustment” that may be wildly wrong in the discombobulated post-Covid labour market, and amid freak US weather. The February report may prove a very cold douche.
I stick to my unfashionable view that central banks are over-tightening and that the US and Europe are heading towards a serious recession, if it has been postponed by a few months.
What is clear is that the Fed and the ECB have the bit between their teeth. They are trying hard – too hard – to regain lost credibility after letting the inflationary genie out of the bottle. And they are relying on the same lagging indicators that got them into trouble in the first place.
They will certainly break the back of inflation. But the longer they keep raising rates into the teeth of monetary contraction, the greater the risk that they will break the global economy in the process.
Telegraph, London
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