Viewpoints: February 2022

Figure 1: Flash PMI surveys suggest global supply side congestion may be easing

The Fed has a problem. It's in the business of creating money, but it formulates monetary policy without regard to money itself. So in times when its policy decisions produced a record surge in broad money, policymakers are not attentive or alerted to the negative (inflation) consequences.

From February 2020 to the end of 2021, broad money increased by $6.5 trillion or over 40%. That increase over less than two years is roughly equivalent to the rise over the previous ten years. Yet, policymakers who have long argued that "inflation is always and everywhere a monetary phenomenon" called the surge in inflation transitory, owing to supply bottlenecks. Had policymakers still recognized money as a potential source of inflation, it would not be in the pickle that they find themselves today.

Policymakers now face the unprecedented challenge of dealing with consumer and producer inflation and elevated asset prices ( possibly bubbles.) Policymakers' record on reversing inflation cycles and recognizing asset bubbles is lousy. Policy adjustments have always been late (except for Greenspan's 1994 preemptive strike), resulting in awful economic and financial outcomes, some much worse than others.

As bad as policy decisions were in the past year, it is reckless that policymakers are still easing policy today. Publically saying the monetary policy is "wrong-footed" but not doing anything until the next policy meeting, a month away, is like saying we want the fire to burn some more before being compelled to distinguish it.

Before the preemptive strike against emerging inflation pressures in 1994, Fed Chair Alan Greenspan stated in his semi-annual monetary policy testimony, " if the Federal Reserve waits until actual inflation worsens, they would have waited far too long." It's too late to use Mr. Greenspan's playbook, but policymakers still need to act swiftly. Some policymakers have argued that only a modest adjustment in official rates is needed because of well-anchored inflation expectations. That is short-sighted and wrong. Actual or realized inflation leads to changes in inflation expectations, not the other way around. Persistent inflation will increase inflation expectations over time.

Several decades ago, the Bureau of Economic Analysis (BEA) created the monetary and financial flow index (MFF). It consisted of the growth in broad money (adjusted for inflation), change in business and consumer credit, and liquid assets. BEA stopped publishing this series in the early 1990s, and I recreated the series with assistance from BEA, plus updating the series for new financial instruments, such as new flows into bond and equity funds.

The MFF index was a helpful gauge to predict the peaks and troughs of economic growth cycles and pinpoint excess liquidity situations. The MFF index signaled excessive liquidity growth ( i.e., well above GDP) before the dot.com and housing bubbles. The primary source was explosive private sector credit growth and robust gains in liquid assets.

Over the past year, growth in the MMF index has been more than twice that of dot.com and housing bubbles, owing to record growth in broad money and bank credit. Too much liquidity is the fuel for inflation.

The Fed started this inflation fire by creating too much money. Now, it has to produce less. In January 2022, broad money is up roughly 14% in the past year, down from 25% a year earlier, but still far too fast to kill the inflation dragon. Policymakers have to curtail money growth to a rate well below nominal GDP. That will require a substantial increase in official rates and a sizeable shrinkage in the balance sheet.

Removal of liquidity will appear in asset prices, financial ones before tangible, long before it shows up in conventional measures of inflation. Mr. Market, the biggest beneficiary of Powell and company liquidity bonanza, will soon cry about too little liquidity. Investors forewarned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Now that the cognescenti have judged that goods/services price inflation has transitioned from transitory to something more persistent, the Fed has signaled that it is ready to start raising its main policy interest rate, the federal funds rate, at the mid March FOMC meeting. Moreover, the Fed has suggested that a March interest rate hike will be one of several this year. By how many basis points will the Fed raise the federal funds rate this year from its current level of 0.08%? No one knows, especially the Fed. The federal funds futures market is currently priced to suggest a cumulative 150 basis point rise in the federal funds rate over the next 12 months. But just as Fed policy is "data dependent", so is the federal funds futures market. However many basis points the Fed raises the federal funds rate over the next year, it will have a fiscal effect. That is, it will contribute to an increase in federal outlays in the form of higher net interest payments. Higher Treasury debt-servicing expenses imply higher future federal budget deficits, all else the same.

The blue bars in Chart 1 are the fiscal year values of Treasury net interest expenditures as a percent of total federal outlays. The blue bars in the shaded area from fiscal year 2022 through 2031 are baseline forecasts made by the Congressional Budget Office (CBO) in July 2021. CBO baseline projections of budgetary variables incorporate current laws pertaining to the federal budget and the CBO's estimate of economic variables that would have an impact on budgetary variables. Also plotted in Chart 1 are the actual and CBO-forecast fiscal year average values of interest rates for the three-month Treasury bill (the green line) and the 10-year Treasury note (the red line). In FY 2021, Treasury interest expense as a percent of total federal outlays was 4.8% -- the lowest percentage in the period starting FY 1965. Given that federal debt held by the public increased by $6.2 trillion in the two fiscal years ended 2021, this low ratio of Treasury debt service expense relative to total federal outlays is remarkable. Of course, extremely low interest rates on Treasury debt played a major role in reducing debt-servicing costs relative to total federal outlays. More on this in a moment.

Chart 1

With many Central Banks now more actively tightening monetary policy, financial markets have unsurprisingly been more unsettled in recent weeks. The dilemma for investors is obvious. Should they assume that policymakers are applying a gentle brake to a world economy that is barely breaching its speed limit and will now seamlessly guide it back to a more inflation-friendly speed? Or, are they slamming on the brakes far too hard, and far too early – and to mix the metaphors – now taking a sledgehammer to crack a nut?

To this scribe the risks are tilted toward the second scenario. There is little question that monetary policy is still accommodative and that a slow normalisation campaign is warranted as the world economy normalises in a likely post-pandemic adjustment phase. But a growing number of Central Banks appear to be of the view that inflationary pressures have been building because their monetary policies have been too loose. A more active tightening campaign is therefore deemed necessary in order to squeeze out these pressures. But as we argue in more detail below this strategy carries tremendous risks. And global economic and financial stability are in danger at present of being sacrificed somewhat unnecessarily at the altar of Central Banks' inflation-fighting credentials

This view is based on several messages from the analysis below. Firstly, that the inflationary pressures that have been building in recent months are globally - not nationally - rooted. Secondly, that those global pressures have largely been driven by COVID-related supply side congestion, not by excessively loose monetary policy and overheating demand. Thirdly, and to that last point, credit impulses in most major economies have moved into negative territory in recent months. That's not symptomatic of excessively loose monetary policy. Fourthly, nearly every major economy - including the US - is still operating below levels that would have been expected based on pre-pandemic trends. And that's not symptomatic of an overheating world economy. Finally, wage inflation in nearly every major economy is not yet even close to keeping pace with headline price inflation. Household purchasing power is therefore being significantly eroded even in the absence of tighter monetary policy and igniting recession risks as a result.

Globally-rooted supply side pressures

Let's start with those global roots and those supply-side roots. A recent paper from the Federal Reserve Bank of New York (see The Global Supply Side of Inflationary Pressures) assessed in some detail the recent evolution of inflationary pressures in the US and Euro Area. One of the key findings is that globally-rooted supply factors – including those that pertain to the price of oil - are very strongly associated with the levels of - and persistence of - recent producer price inflation across countries, as well as with consumer goods price inflation (see figures 1, 2 and 3 below). This is noteworthy because all major advanced countries have experienced a large rise in goods price inflation during the initial pandemic recovery phase. Services inflation in contrast has been more muted.

As the paper's authors additionally note if their analysis is accurate and the bulk of many major economies' inflation issues can be traced to global roots and to supply-side roots, it suggests that domestic monetary policy actions could have only a limited effect in containing inflationary pressures.

Figure 1: US goods price inflation has been highly correlated with goods price inflation elsewhere

The Composite PMI and the Service Sector The PMI readings globally are not as comprehensive a set of data as for manufacturing. Still, there is a broad rather representative group of data we can observe to track the overall PMI and the global service sector. In January, among the twelve reporters of service sector data, eight weakened showing that weakening members outnumbered strengthening members two to one. That is decisive. In December, nine members weakened month-to-month. That compared to eight weakening in November.

The service sector globally These monthly changes demonstrate (data not shown separately) that the service sector has been under siege over the last three months with declining sectors outnumbering advancing sectors by a factor of at least two to one for three months running. That is 'impressive' in a negative way.

The chart shows that among the countries and the EMU region whose data are plotted there, the U.S. has been a very different animal with the service sector building to a crescendo while the other service sectors ran either a more restrictive cycle (like the EMU) or simply waffled while moving mostly sideways (Japan shows a bit more uptrend than the EMU or China).

The service sector ranks below its median (on data from January 2018 to date) in eight of twelve sectors with those below their median outnumbering those above their median by two to one again. The relative strongest service sectors are in Brazil (83.7%) and Canada (72.2%). Among the world's four largest economies (the U.S., China, Japan and Germany, the strongest standing for a service sector is Germany at its 36th percentile). Among the twelve global service sectors, eight of twelve have weaker PMI values than their level before the Covid virus stuck in January 2020 (one country, Brazil, is unchanged). The only countries with higher service sectors on that timeline are Canada, France, and the U.K.

The Composite PMIs The service sector usually dominates the composite reading but the composites are more comprehensive, and more countries report a composite PMI than report both individual sectors. Twenty countries report an up-to-date composite PMI in the table.

In January, the composite PMI slows month-to-month in 16 of 20 jurisdictions but dips below 50 (the diffusion boom-bust line) in only six (30% of reporters). The median reading is 51.0, a skinny gap between the median and the boom-bust line.

There has clearly been a worsening in the last two months when the proportion of reporters showing deterioration has risen sharply and stayed high. This is probably a result of the highly transmissible Omicron virus, although some health experts are now concerned that Omicron may not have spread as widely as initially suggested and there may still be a good deal of Delta in the mix. This just points out how much health authorities are stabbing in the dark at a moving target. The U.K. does a great deal of detailed testing. The U.S… not so much, and the tests that the U.S. deploys often only test for 'Covid-19' not for the particular variant. And lot of what we 'know' about the virus is still derived from models and if there is anyone who knows how dodgy depending on a model can be, it's an economist. The initial 'model results' given around Christmas by a U.K. group for the spread of Omicron in the U.S. appears to have been 'overstated.' So, we will have to listen to the health authorities to see what they tell us. Whatever is going around, it is spreading fast and it may be a mix of Omicron and Delta.

A world of 'hurt' Whatever is going on in the world of virus, it is affecting the world of economics and has had a large impact over the past two months. Infection curves are now dwindling (GOOD NEWS!) and although deaths are low relative to infections the infections have been so broad-based that in raw numbers the deaths have been high.

Virus impact on economy Obviously, what happens next is going to depend on what the real virus facts are and where we go from here. The virus has an outsized impact on the service sector since that sector puts a premium on face-to face contact and people who are engaged in heavy mitigation strategies simply avoid as much contact as possible. They stay home. They let other people shop for them. They use the internet, and so on… I live in NYC on the Upper West side of Manhattan, a densely populated area. I see a less grocery store shopping, less traffic on the streets, fewer people on the street, a less crowded subway system. People are mitigating or maybe migrating or even hermitting. Even though they still shop, that behavior hurts growth.

Diffusion data, queue rankings and high-low percentile readings The global composite PMI data show several interesting trends. I just wrote on the deterioration in the last few months. But note the queue standing column in the table…what is going on there? An average standing of 43% means that on average reporters are significantly below their median (medians occur at a queue ranking of 50). Now this is different from the median of the diffusion data which is at 51 and shows a very small tendency to expand (PMI values above 50 signal expansion; values below 50 signal contraction; on the queue ranking data 50% identifies the MEDIAN value of the underlying diffusion value). But these two readings are not incompatible -in fact together they enhance our understanding of events. As a final matter, the column labeled percentile provides the percentile standing of the month's observation in its range- between the sample high and low. A 50% reading on that is simply the middle of the high-low range.

Making the metrics work together One of these metrics, the median, points to a barebones expansion; the other (queue standings) says that countries are posting results well below their historic medians. These two findings are quite compatible; in fact, a barebones 'skinny' PMI level just above 50 is also below most nations' medians (in almost all cases). We can also see that the percentile column shows an average across reporters of 78% and a median of 82%. Again, that is compatible with the other two results. What the table shows is that there is only one reading in the top 10 percentile of its historic high-low range of values (Sweden). However, there are 12 of 20 readings that are in their top 20th percentile on this gauge. While there may be broad queue percentile standing weakness, there is not deep high-low weakness.

Table 1

Manufacturing PMIs have peaked and have been sliding lower for some months. The peaking and slippage are a slightly different horizon for each country, but all of them are now on downslopes.

In January, the deteriorations exceeded the 'better' responses by a factor of 8-to-5. The change from three months vs. six months shows a nearly equal improvement vs. deteriorating trend. The change from 12 months to six months shows deterioration dominating improvements by a factor of more than 2 to one. But over 12 months compared to a year ago, improvement is the order of the day with 11 improvements logged vs. only 2 deteriorations… Longer term, the beat goes on.

Covid rears its ugly head Once again, the Omicron variant seems to be behind the worsening trend in manufacturing as the less virulent but much more transmissible variant has swamped hospitals with infected people despite its lesser virulence. In this case, transmissibility has trumped virulence to create a potent viral attack on the populations globally. While vaccination helps to mitigate the impact of infection, it does not stop it. As a result, Omicron has been very widespread and even quite dangerous. It is a lesson about how one should view danger.

Vaccines to the rescue...oops not... I suppose one thing we should at some point begin to wonder about is the economy's recuperative capacity after a bout with yet another variant of Covid-19. When Covid first struck, draconian measures were taken by health authorities who were more scared than knowledgeable about what to do. Over time the mRNA quasi-vaccines were developed and for a while they became the path to stronger growth. Eventually health officials discovered that the inoculations had a short 'effective life,' and 'vaccine-boosters' were thought to be needed after six or eight months. It is now understood that the inoculation's immune system stimulants begin to drop sharply after just four months. That is probably not a 'New Reality' as much as it is scientists discovering the real reality. Discovery of this reality makes the quasi-vaccines much less of the backbone of a response system and critics of the CDC complaint that the CDC, which tends to lead the Covid fight globally, did not devote enough resources to other potential treatments. If you put all your eggs in the vaccine basket, that basket better carry the day. (This not an opinion-it is a fact. See Scott Gottlieb at the 39-minute mark of Face the Nation 1/16/22 . - here Gottlieb, who is on the Board of Pfizer notes the failure of the vaccines to prevent transmission. He also blames the CDC – a significant statement from a high-profile industry expert and a former FDA Commissioner.)

Damped recovery prospects? In the past after a bout of virus, there were government support programs and some of those are still in circulation in various places. But government assistance and income supports are now much less common. After this round of Covid, manufacturing and services are going to have to rise back based on whatever organic demand has been built up. There is reason to believe that such build-ups in demand occur after a period of disruption. But the snap back may not have the same 'snap' as in previous episodes of infection followed by recovery.

The state of play for manufacturing The queue or rank standings find only China and Brazil below their historic medians, but these two are below by a huge margin with standings below their 5th percentile in each case. The median occurs at a percentile queue standing of 50%. These are readings far from where they belong.

There is more firmness this month than strength. Japan has a 98-percentile queue standing. Russia Vietnam and the EMU have queue standings in their 80th percentile range. But Germany, France and the U.K. -the top-ranking three European economies- have standings in their 70th percentile queue standing. India and Taiwan are in their respective 60th queue percentiles. Turkey and the U.S. tally standings in their 50th percentile decile. Over 50% of the responses are at the 70th percentile standing mark or above. But still 30% are just in the first decile above their median (50

The responses this month show some mixed statistics, but clearly growth remains the operative descriptor. Yes! The growth has been more moderate than strong, and this is due to this survey being conducted in the middle of another Covid episode. Looking at the cumulative gains since January 2020 when covid struck is also illuminating. The EMU area and Germany have gained double-digit diffusion points on that horizon. The next strongest is the U.K. at +7.3 points and Japan at +6.6 points. Then rising by 3 to 4.4 points are France, Russia, the U.S., Taiwan, and Vietnam. Countries with manufacturing readings below their January 2020 levels are Turkey, India, China, and Brazil – sinking like a BRIC?