On the Arrival of 70's Stagflation: It's like deja-vu, all over again!

The US Labor Department data on February 19th, showed core Consumer Price Index, which excludes the more volatile food and energy components, increased 0.3 percent in January, the biggest gain since August 2011. The annual core CPI advanced 2.2 percent, compared to the market expectations of 2.1 per cent, the largest rise since June 2012 and exceeded the 1.9 percent average annualized increase over the last 10 years.

This trend would get the Federal Reserve closer to its 2 percent target on the PCE inflation and together with a tightening labor market, provides some impetus for additional rate hikes. According to the minutes of Federal Reserve's January 26-27 policy meeting, policymakers still expected to raise rates and even discussed whether a hike was warranted in that month, but after a lengthy discussion on global risks they said tighter financial conditions may be "roughly equivalent" to further hikes!

It appears, that the U.S. economy is headed for stagflation. Clearly, Fed’s signals with regard to a need for early and modest action toward "normalizing" policy with the ultimate goal of staying ahead of the inflation curve is proving unhelpful and is adding to the current extraordinary uncertainty.  In brief, as we have argued before in this forum, businesses’ capacity planning horizon has shortened in recent times and this is one of the key contributing  causes of the emerging stagflation .

Firms' survival strategy is now determined by their optimization along their short-term cost functions, and this is evident from the lack of investment in capital formation. The reluctance to commit capital to irreversible fixed investment and waiting for uncertainty to abate, stemming from the prevailing global imbalances and their impacts on credits that are rooted in extraordinary amount of global debt overhangs, rising non-performing loans, slowdown in China, and oil price shocks are causing a decline in the potential GDP growth.

Firms caught in these circumstances have resorted  to contingency capital and labour planning to meet any conjectural increases in demand, and this is corroborated by a rise in part-time work and the stagnating wages. These effects are artificially reducing the official unemployment rate. It should be noted that these effects are exacerbating the Not-in-Labor-Force population problem, which based on BLS estimate is 12-times the number of “officially unemployed”, and is  expected to steadily rise.

The use of contingent workforce is increasingly widespread and rising particularly during these uncertain times. Firms use this short-term optimization tactic because it will provide extra flexibility and cut labour costs sharply, by eliminating the need to pay contractual fixed wages, benefits, sick days and vacation days, or overtime. Moreover, it isn’t necessary to withhold taxes, pension plan contributions, or employment insurance premiums and so on, and  payroll, benefits administration, and HR costs are also reduced.

 Although to our  knowledge, the literature on job search has not yet investigated the impact of a greater use of contingent workforce on regular-jobs’ search costs, it stands to reason  to expect that these costs must have risen markedly for the unemployed in particular. This is why many unemployed workers are deciding to provide their services through a temporary agency, or work as intermittent workers, “casual” workers, and other types of works without a standard employer-employee relationship, which are all referred to in the U.S. as “contingent workers”, and are playing a significant role in the stagnation part of the stagflation.

As well, all the needed ingredients are in place to create the inflation part of the stagflation, and in this regard Fed’s policies have become inconsequential from a stabilization policy perspective. Since a hypothetical rise in interest rate would intensify the stagnating part of the stagflation, and on the other hand a reducing interest rate would add to its inflationary part and simultaneously  would aggravate the prevailing macroeconomics’ imbalances.

The underlying reasons for the fact that inflation had remained weak in recent quarters have been articulated quite well by the Fed’s recent release;

“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” 

In other words, because of the mathematics of calculating the annual inflation rate, those parts of the inflation weakness arising from impacts of lower oil price and lower import prices stemming from the US dollar appreciation, which are transitory and normally should be expected to disappear after a year would linger for a while, because of the fact that oil price declines have been staggered and have not occurred all at the same time, and thus  their adverse impacts on annual inflation rate may be enduring for more than one year. Nonetheless, sooner or later, they will disappear.

However, there is no danger of creating memories in the data, arising from the persistence of inflation weakness. Meaning inflation expectations would remain anchored. Obviously then, the inflationary pressures would be reinforced by the above mentioned  lower rate of potential GDP growth rate that would reduce the impact of the notional output gap (measured against the theoretical longer-term cost functions) .

 This stagflation could be exacerbated by the appreciation of the US dollar real effective exchange rate, which has been showing a trend, owing to a kind of currency wars, and a relatively safer haven quality of the US vis-à-vis other countries that entice the  inflow of capital. The February 17th data on the producer price inflation registering a 0.1 percent increase appear to suggest that this process is already started.

Will Banks survive this Minsky Moment?

The global financial imbalances have pushed the banking sector off the cliff edge. On February 11th after yet another volatile day in stock markets, bank stocks crushed amid a selloff that has erased more than $4 trillion from global equities this year -- another Minsky Moment is almost upon us. The global distress embraced industry's titans such as Goldman Sachs, Morgan Stanley, Société Générale, Deutsche Bank, Barclays and Credit Suisse among others. Shares of Goldman Sachs and Morgan Stanley, the two American equity-trading giants, dropped by close to 10% below their tangible book value, a theoretical gauge of how much of their worth they could salvage if liquidated.

American financial stocks are down by 19%. French and German banks like Société Générale and Deutsche Bank saw their shares fall by more than 10%, while Italian banks shares have plunged by 31% and those of Greek by an alarming 60%. The European banking shares have lost around 27 percent so far this year. The index of major banking shares in the UK at one point hit its lowest levels since the depths of the recession. Asian banks were also afflicted, for instance Japanese banks’ shares have dropped by 36% this year. The readers of this blog may recall that this outcome were consistently warned against in this forum. Indeed, in July 2015 we wrote:

While $107 billion dollar Greek debt to European banking sector appears manageable, even a rather modest money multiplier inflate that amount to a quite frightening level. In fact, since the inception of the euro in 2001, the German, French, and Dutch banks bought a huge amount of Greek, Portuguese, Spanish and Italian sovereign debts by leveraging their equity capital—this was European version of the US subprime mortgage fiasco. Thus, the balance sheets of these banks, levered up in some cases by forty to one or more, is in a very fragile state. The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

We are witnessing another financial contagion, where initial deterioration in banks’ balance sheet resulting from a number of adverse shocks such as the oil market predicaments, China's slowdown, and currency wars are rapidly spreading and the risk quality of financial sector’s loans is plunging into a dark abyss. While market anxieties, reflected in increased intra-euro area spreads and higher term premia, were appearing somewhat abated by ECBs policies; it is now clear that its unconventional monetary policies are ineffective and incapable of correcting the fundamental fragilities.

The risk of low market liquidity has reappeared again with a vengeance. Confidence among large banks with respect to their ability to make markets must be collapsing. ECB like a number of other central banks had hoped that its asset purchase program would eventually support nominal growth and as a result banks’ profitability would be improving. It was assumed that by a simulated shrinkage of banks’ balance sheets and some regulatory improvements in various capital and leverage ratios the lingering post-Big-Recession challenges would be behind us.



However, as the above chart demonstrates shares in institutions from Goldman Sachs to Deutsche Bank have endured a serious slide. Central banks may be able to discount the fact that, as shown by Reinhart and Rogoff, at least in the United States, the ex post probability of being in a financial crisis era has been about 13 percent of the time since the country’s independence – i.e., once about every 8 years. However, they cannot deny that the recent intensification of banking stress as net interest margins are being disappeared under the low interest rate environment and flattening yield curves, has created a severe systemic risk. It is quite clear that the legacy of sovereign debt crisis is still haunting and stock of non-performing loans are on the rise proceeding from the plight of the oil and related services sectors, as well as the expected poor performance of companies that are adversely affected by the slowdown in China, or those that have invested heavily on luxury London real estates which hedge funds are beginning to short.

 For much of the last few years various central banks have been performing an extensive set of “stress testing” their balance sheets against a chain of purportedly worst-case economic scenarios, in order to identify which banks do not have sufficient capital to meet the hypothetical shocks, gauging the amount of recapitalisation the banks require. However, policy makers are well aware that no bank can survive these tests when confidence in the banking system has been shattered. As well, nobody knows how the structural parameters of the underlying models for these tests have changed in response to unconventional policies such as negative interest rates. In other words the results of these tests are at best unreliable. The same can be said of calculations that, for instance, show European banks are holding €700m worth of capital more than they were at the time of the last crisis and have disposed of their riskiest assets. These would be misleading if there is a crisis of cofience. Banks’ financial strength is under a question mark and the probabilities of large banks reporting large losses  are not trivial.

The crisis is not just concentrated on the banking sector, negative and very low interest rates are overturning the financial business models of pension funds and insurance companies that must constantly struggle to immunize their long-term liabilities (retirement, long-term disability, nursing home or other long-term care). They do this by financing at a comparable investment horizon with a sufficient yield, so that there would be no interest mismatch or duration conflict. However, now more than US$7 trillion in government bonds (mostly from Europe and Japan)  comes with negative yield, which have caused something of an existential crisis in the global life insurance industry. European regulators have warned that some major insurers may have to be bailed out if the crisis continues, where payout yields continue to outstrip returns in sovereign bonds.

 In the coming weeks we are going to witness more debilitating shocks from the emerging markets, including Saudi Arabia, Venezuela, Turkey, and Brazil. Italian and Greek banks are still fragile. The National Bank of Greece is down 94% this year. In just six weeks, this share has lost almost all of its market value. For many insolvency is just around the corner owing to low oil prices and policy extravaganza. The banking system is in dire need of recapitalization but it is not clear how can this be done? The new "bail-in" rules in Europe mean that senior bondholders and depositors with balances above the guarantee of €100,000 will have to help pay for it, which adds to stress. Of course, North American, and Asian countries will also contribute to various adverse shocks, as the global imbalances and risky balance sheets are interlinked and ubiquitous.

In these circumstances, Italy’s high level of non-performing loans is particularly troubling. Apologists argue that if Italy’s recovery can be sustained they should eventually start to come down, but this is a big if. The fact that over half of the riskiest loans of the country out of €200 billion are covered by special provisions is not particularly helpful. The “bailed in” rules, which have become fully operative for many European countries this year, can trigger a new wave of bankruptcies. As a sign of this many faceted domino effect, it is of note that Goldman Sachs and JP Morgan are now faced with large stakes in Italian oil services company Saipem following their completion of a €3.5 bn (£2.7 bn) share issue with prices that have been falling precipitously.

 The prospect that central banks in Europe and Japan will delve even lower into negative rate territory, and the likelihood that Federal Reserve abandoning its move to normalization are creating further uncertainty and contributing to a more volatile market. It is mind bugling that until now none of the US presidential candidates in the both parties’ presidential debates have not shown even a remote interest on discussing this ominous conditions. Meanwhile, European finance ministers who will meet at the end of February in Shanghai in China have decided to call on the Group of 20 biggest world economies to boost global economic growth. They still do not realize that the culprit is a broken financial structure and as Japan experience has demonstrated no amount of infrastructural investment by itself can create growth.

As we have argued before this crisis is aggravated by global illiquidity arising from sever distortion of credit markets and its incapacitating impacts on supply of bank credit. This illiquidity cannot be expunged unless and until a drastic global restructuring of the enormous global debt overhang is underway. In other words, a comprehensive global strategy is urgently needed which must encompass necessarily a readjustment in valuation of foreign exchange rates based on their purchasing power parity. Furthermore, a drastic overhaul of the operational environment is needed to stop the smothering effects of arbitrarily created rules and regulations that are creating distortionary arbitrage opportunities, moral hazards and adverse selection problems. In this respect, the so-called idiosyncratic tailored approaches would be the most perilous strategy, as no agency can claim to have an in-depth grasp of the various dimensions of the current global imbalances.

What is truly needed is a set of clear principle-based rules that would allow the market mechanisms to do their critical functions of price discovery and determine the efficient allocation of resources. The most important market principle in this approach is the resolution of the Too-Big-to-Fail. TBTF problem. However, a reintroducing of Glass-Steagall separations of businesses without other fundamental restructuring would only exacerbate the impacts of distortions. The main concern is not that banks may lose market share. As, undoubtedly, the “shadow banking” environment is also being affected by the scarcity of liquidity and will be contributing to the severity of the ongoing financial crisis. Other purported policy options such as various macroprudential regulations, “the swap push out rule”, “ring fence” banking activity, and “Volcker rule”, that are supposed to limit or ban TBTF firms’ are also inappropriate in the absence of a comprehensive structural overhaul of the system.

What will trigger the next global bust?

After the first of its eight regularly scheduled meetings for 2016 at the end of January the Fed’s FOMC declared that the U.S. economy lost momentum at the end of 2015. "Economic growth slowed late last year," its statement read, noting that the job market had improved. The positive information about the job market was intended to soften the blow of a disappointing growth. We have seen a similar pattern in the recent press releases of other central banks. It is of note that the February release of the U.S. employment data showed that the January unemployment rate was validating the Fed's median forecast for the long-run sustainable level of unemployment — or "full employment" at 4.9 per cent. But, does unemployment rate measure labor market strength?

As it has been argued before in this forum, the employment growth in the present conditions does not provide any useful information with regard to the vigour of economy, simply because it does not control for the greater reliance of the markets on the contingent labour. In other words, due to the prevailing uncertainty firms are shying away from investment and are aiming to utilize various tactical labour-intensive responses in order to satisfy the increased demand that they do not perceive to be sustainable over the medium to longer run. Thus, they rely on part-time workers to operate with existing machinery and equipment, introduce more overtime if necessary and lease used equipment – in short they are utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technology. By the same token the January rise in participation rate and wage rate are not reliable indicators of the labour market strength at this juncture.

All in all, the sense of panic in the global markets that has been observed since the start of the year, and was predicted in this blog last year, is well-founded. The world is getting much closer to another painful bust, not because of the slowdown in China and its $10 trillion economy, or the fact that the current so-called “recovery” has lasted for 28 quarters (as compared to the average post WW II of less than 20 quarters) or the current fragility of European and Japanese economies, but because of the global economic fundamentals that are afflicted alarmingly by the destructive effects of very low interest rates, exacerbated by other unconventional monetary policies, including QEs .

An increasing number of countries and regions are having negative rates; including Switzerland (-0.75%), Denmark (-0.65%), Sweden (-0.35%), ECB (-0.3%) and  Japan (-0.1%). Others, including the U.S. and Canada have talked about the possibility of moving toward adopting negative rates if the situation warrants. After fueling the expectations of interest rate hikes, in her latest communiqué Bank of England has shown a dovish inclination, with all nine members of the Monetary Policy Committee voting to keep rates on hold. While the U.K. markets now expect the Bank Rate, at 0.5 per cent for more than six years, to remain fixed until well into 2018. The February 4th Bank of England's quarterly Inflation Report, suggested markets expect a notional rate of 1.1 per cent by the start of 2019, while in November it reported that the market expected 1.1 per cent at the end of 2016, 1.7 per cent by the end of 2017 and 2.3 per cent by the end of 2018. Thus, one cannot rule out a negative interest rate in the UK by the mid-2017. The Bank of Japan that surprised markets by adopting negative interest rates at the end of January 2016, a move aimed at boosting a stumbling economic recovery and warding off deflation has maintained that it would cut rates further into negative territory if it needed to push borrowing costs even lower. It said the policy would continue as long as needed to achieve an inflation target of 2%.

It appears that central banks have forgotten a number of basic macroeconomic facts;

i. The liquidity demand will become inelastic around the potential output, and potential output itself shrinks when there is no capital formation and plenty of uncertainty. Moreover, reducing the interest rate cannot affect the growth rate of real output when aggregate demand becomes insensitive towards changes in the policy rate. The conventional theory suggests that the impact of increased liquidity should be translated in higher inflation rates. However, this could be the case if and only if the newly created liquidity can enter into the markets, via consumption and investment which is not the case in today’s economic environment. One can argue that in today’s economy either central Banks have lost their ability to create liquidity, or to the extent that they are able to do so firms’ change of behaviour has offset it. In other words the liquidity created by central banks is hoarded by firms. Businesses are not investing, because they do not see a sustained level of increased demand, and negative interest rates cannot force them to invest because they have invented new instruments and innovative tactics in order to hoard liquidity.

ii. If central banks are aiming at a currency war, to increase their market share of exports, they must have forgotten that these wars worsen the already highly toxic trade environment. In fact, this is the classic case of ‘fallacy of composition”.

In his Marjolin lecture, organised by the Deutsche Bundesbank, Frankfurt, on February 4th 2016, Mario Draghi, President of the ECB, touched upon some of the challenges faced by central banks. Perhaps somewhat optimistically he asserted that “Today, more than 60 years [after its inception,] monetary integration in the euro area is both complete and secure.” Be it as it may, he then divided the challenges into two categories; those “that are common to all central banks in advanced economies, which are linked to a global low inflation environment (read ‘ linked to a global anemic growth’)” and those “ that are special to [ECB] in the euro area”. As for the common challenges to all central banks in advanced economies, he formulated the most fundamental question as “can our price stability mandates still be delivered?” This, of course, is a sanitized way to express the concern about ever-increasing probability of the upcoming bust. He went on to say:

And in several of those economies, long-term inflation expectations, based on market prices, remain below our numerical definitions of price stability. That has led some to question whether it makes sense for central banks to pursue expansionary policies to meet their inflation objectives. Are they fighting a futile battle against forces beyond their control?

In other words, translated into a general equilibrium framework, Draghi's explanation may be reformulated to suggest that the economic growth rates in several advanced economies have remained below their equilibrium level, and this has led some to question the effectiveness of monetary policy to close their output gaps. Mr. Draghi then explored three causes of “too low inflation”, or what others have called secular stagnation.

I. The structural factors that cannot be addressed through domestic monetary stimulus. As a result, 2% inflation target is no longer realistic. Somewhat surprisingly, the conclusion from this line of argument according to ECB is that “Central banks should adjust their objectives downwards accordingly”.

It would have been nice if some references were offered for the reader to enable one to explore the logic of this conclusion. A more rational conclusion would be since monetary policy is ineffective to generate growth (and inflation) there is a need for other policies. In any event, Mr. Draghi, refers to Friedman's edict that “inflation is always, ultimately, a monetary phenomenon” and “It could thus always be controlled in the medium-term by a committed monetary authority”. However, this edict is based on two crucial assumptions that are violated in this uncertain times (a) the edict assumes that the level velocity of money remains fixed and (b) the level of potential output also remains unchanged over medium term. However, when due to uncertainty firms operate below their efficient production frontier and use contingent factors of production one cannot assume that the Fisher or Friedman quantity theory of money can still deliver the edict, as both velocity and potential output subside in response to the option price of waiting for uncertainty.

II. The positive global supply shocks eliminates the need for central banks reaction, as they can simply redefine the medium-term horizon and wait for inflation to hit the target.

Mr. Draghi correctly notes that “a succession of supply shocks, such as the steep falls in oil prices we have experienced recently can cause a downward adjustment of inflation expectations if central banks do nothing."  This is because  a positive supply shock would reduce the cost of production and exert downward pressures on inflation. Thus, a policy response in the form of lowering of interest rate and the resulting exchange rate depreciation would stimulate the aggregate demand, causing inflation to get back toward its target level and allowing the interest rate to return to its natural Wicksellian level, as well the exchange rate would return to its equilibrium PPP levels gradually.

However, Mr. Draghi discounts the argument that “central banks fighting disinflation are inhibited by the lower bound on interest rates”.

We now have plenty of evidence that, if we have the will to meet our objective, we have the instruments. As the ECB and others have demonstrated, the lower bound for policy rates, wherever it might be, is not at zero. And we have also shown how non-standard tools can be used to deliver monetary stimulus even without altering much the overnight rate, and produce equivalent effects. For example, the non-standard measures the ECB has taken since summer 2014 have produced a pass-through equivalent to a 100 basis point rate cut in “normal” conditions.

On this issue, of course, the jury is still out and it would be too soon to celebrate under a “mission accomplished” banner. These are not normal times when central banks credibility would allow them to stabilize a volatile situation, particularly when the volatility is caused by their own action. The fact that QEs have become successively less effective is a clear sign of the restraining impacts of a lower bound. Another sign is the slope of term structure of interest rates. The slope changes when longer-term interest rates do not respond to changes in the policy rate. The central banks’ balance sheets have become far too inflated for them to act as credible provider of contingent funds in central counterparty clearing mechanisms in these abnormal times. This adds to uncertainty and inhibits capital formation, which are direct consequences of the lower bound. The purging of the central banks QE-contaminated balance sheets would not be that easy, and their longer-term adverse impacts on finance are gradually but surely appearing on the medium-term horizon. In particular, the devastating impacts of these policies would exert themselves during the upcoming bust sometime over the next two years. Of course, a bust can be triggered much sooner for instance by a geopolitical shock, rising unrest by the unemployed European youth, or a natural disaster.

III. Central banks do more harm than good. “In particular, expansionary monetary policies at home lead to the accumulation of excessive foreign currency debt or asset price bubbles abroad, especially in emerging markets. And when these financial imbalances eventually unwind, it weakens global growth and only adds to global disinflation”. These imbalances are, of course, part of the concerns in this blog too. In addition to distortions created in emerging markets we are also worried about the sectoral distortions of these policies on domestic economies. Low interest rates are fueling housing bubbles, and hampering the investment in productivity growth.

In response to these concerns Mr. Draghi asks:

what would be the alternative? Would it help emerging markets if advanced economy central banks failed on their mandates? Would that be more likely to contribute to global growth? Clearly, the answer is no. The stability of large economies is vital to their trading partners and to the global economy, and diverting monetary policy away from that aim when our economies are still fragile would not be in their interest.

The problem is that there is no evidence that these policies have been contributing to stability or to a sustainable global growth. The systemic risk has been elevated stemming from a false sense of security, manufactured by central banks, that has given rise to moral hazards and adverse selection risk. However, the markets are not stupid and recent volatility is a clear indicator of such anxieties. The markets are waiting for a trigger to signal makets' bust and this time around no QEs will be capable of providing any help. We have suggested a way out of this predicament in our previous posts, based on Gustav Cassel recommendations of 1937 Brussels conference. That would be the alternative policy.