America’s stagflation


by Alasdair Macleod, GoldMoney:

The accumulation of monetary policy errors by the Fed is increasingly certain to culminate in the credit crisis that always marks the end of the credit cycle. Credit crises are the result of globally coordinated monetary policies nowadays, so the timing of the forthcoming crunch is not only dependant on the Fed’s actions, but is equally likely to be triggered from elsewhere. Candidates for triggering a global credit crisis include economic and financial developments in Europe, Japan and China.

The next crisis is set to be more serious than the global crisis of 2008/09, given the greater level of debt involved, and the exceptionally high rate of monetary inflation since. It is a story I have covered elsewhere.i This article will concentrate on the prospects for the US economy ahead of the next credit crisis, and the implications for the dollar and its associated financial markets.

Other jurisdictions face a similar problem, with domestic consumers being maxed out on their credit cards, auto loans and expensive overdrafts. Rising interest rates after a prolonged period of zero and negative interest rates will increase the cost of mortgages, an acute problem for home-owners, particularly in North America and Britain. In the coming years, economic expansion for all highly-indebted nations will be driven by China’s Asia-wide expansion, in some cases more than by domestic factors. China will even suck in outside capital for the infrastructure development planned in both Asia and China. Demand for non-financial bank credit from all sources will be increasingly allocated to this task, leading to the selling down of the banks’ investments in both dollars and short-term sovereign debt.

It is the single greatest challenge faced by the major central banks in the coming months, and we cannot be certain they are fully aware of the forthcoming dangers. The Chinese currency is already rising, reflecting the start of these capital flows. It is likely to radically change international portfolio managers’ attitudes to their dollar exposure and bond allocations.

We can only conclude that the rise in short-term government bond yields that follows from the reallocation of capital to non-financial activities means the central banks have probably lost control of interest rates already.

Consumer stagnation

Our starting point for describing the outlook for the US economy is to concede that under President Trump, America is isolating her domestic economy from the China-led economic expansion that is revolutionising not only her own economy, but that of the whole Eurasian continent. The US economy now depends for its growth prospects on domestic manufacturing and consumption, financed by yet more bank credit.

The conventional measurement of economic growth, the yardstick used by neo-Keynesians, is changes in real GDP. The statistics that make up this gauge of the state of the economy, nominal GDP and its deflator, are unfit for the purpose. GDP, being a money-total, tells you nothing about economic progress, and how technology and time are improving the average person’s standard of living.

As for the deflator, I challenge anyone to say by how much the general price level is changing, with John Williams’s ShadowStats inflation figures indicating it is rising at between six and ten per cent, depending which of his indicators you use. The Chapwood index confirms the latter ShadowStats figure, finding prices of commonly bought items have risen by an average of about ten per cent annually over the last five years. The Fed targets two per cent for core personal consumption expenditures (PCE), which was up only 1.275{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} year-on-year to August.

It is clear the Fed’s inflation targeting is being set against the most favourable statistic, from the point of view of those who believe in suppressing interest rates. But while the Fed apes the three wise monkeys over price inflation, the rise in prices is creating significant damage to consumption prospects. It is a process that has continued broadly uninterrupted since the 1990s, financed by increasing consumer debt and hardly at all by higher wages. Consequently, the average American consumer is burdened with unsustainable levels of debt, and is running out of an ability to finance continued spending beyond his income. And those who depend on inflation-linked wage increases and subsidies have been progressively screwed down by the CPI’s under-recording of the true cost of living.

Instead of taking the CPI, let us assume Chapwood’s estimate of price inflation as closer to the truth. On this basis, over the last five years, price inflation has been running at an annual average of 10{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}.iiThis means the consumer’s dollar has lost 41{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} of its purchasing power since 2012. Meanwhile, wage increases tied to the CPI have only increased by 7{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} over the same period, while total consumer credit has increased by 32{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}.iii

These numbers confirm our thesis, that it is mainly debt that is financing higher prices. It cannot continue indefinitely. Meanwhile, business is cutting costs where it can, and that requires capital investment. Banks are increasingly prepared to lend to businesses, partly because they perceive lending risk has diminished, and partly because the main alternative use of bank credit, which is investing in short-term government bonds and related financial instruments, is losing them money. And now that the yield on US Government five-year bonds is back above 2{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}, the momentum of bank sales of government debt is set to increase, as will the pace of bank credit expansion in favour of non-financial businesses.

Capital investment at this stage of the credit cycle tends not to lead to higher wages. Rather, it is about producing more through investment in manufacturing technology, as a means of remaining competitive. An article in the current Bloomberg Businessweek on Fanuc, the Japanese robotics manufacturer, revealed that North American manufacturers increased their spending on robotics by 32{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} to the first quarter of this year, compared with Q1 in 2016.

There can be little doubt that without increasing automation, price inflation pressures would be even greater. However, with independent forecasters telling us prices have been rising faster than officially admitted, the combination of capital investment and runaway price inflation can only result in economic stagnation.

The alternative of relying upon stimulative fiscal policies by the government is already restricted by the presence of an intractable and growing budget deficit. President Trump’s tax plans, which are intended to stimulate the economy by cutting taxes, are not going to be matched by cuts in government spending, and will gain no lasting benefit from the more efficient redeployment of economic resources from government consumption to the private sector.

The dollar will weaken

With the American consumer maxed out, there is little apparent reason for the Fed to raise interest rates by much. Inflation is tamed by the statistics, and unemployment likewise. It will be outside influences that upset this uneasy balance, reflected through the exchange rate. Foreign use of the dollar is being challenged by China, which is now driving global demand for commodities, and is increasingly demanding her trade payments be settled in yuan. Redundant dollars in foreign hands will simply be sold.

Therefore, the outlook for the dollar is for it to weaken, the speed of which looks like being partly determined by China’s purchasing of energy and industrial materials for yuan, and partly by the development of international yuan markets to provide currency hedges. There is also a separate problem brewing in the bond markets, and that is over foreign residents’ portfolio holdings of US securities. At June 2016 (the last published date for comprehensive figures) they totalled $17.139 trillion, barely changed from a year earlier. This follows a period of rapid expansion after the great financial crisis, which saw it increase from $9.641 trillion in 2009 to $16.417 trillion in 2014.ivUndoubtedly, the increase in portfolio weightings was encouraged by dollar strength in the currency markets.

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