It’s Too Early to Tell If We’re in a Period of Real Disinflation
Are asset inflation and its bellwether, the euro, really heading into a new spring following a winter marked by the now-fading scare of Fed disinflation (alternatively described as “restrictive monetary policy”)? A computer powered by artificial intelligence might well conclude so, based on reading a million websites.
Yet there are grounds for skepticism. The laboratory of financial history is replete with examples of both Indian summers of asset inflation that fade quickly (so-called bear market rallies) and alternatively of premature celebration about disinflation when in fact a new virulent inflation episode is emerging.
In considering which diagnosis is appropriate to the present global monetary condition, let’s focus on the superlong credit and business cycle that started in the aftermath of the last great recession. This cycle continuously mocks those who predict its coming end. Pessimists announcing the end of the long cycle have cried wolf too often.
Impostor downturns have been lavishly received most of all by the “stimulus makers,” whether by central banks deploying their nonconventional toolbox or by finance ministers pursuing the path of fiscal expansion. Impostors include the “great recession” starting in spring 2020 and then the “disinflation bust” of summer/autumn 2022. Some commentators warn that the true great recession is now emerging.
As of now, late winter 2022/23, it is not fanciful to ask whether there was any disinflation at all. In today’s broken-down monetary system, where “monetary policy” is made by piloting short-term interest rates and the system has no solid anchor (which must be tied to a functioning monetary base), who could be sure whether monetary conditions are tight?
Yes, we might be reasonably sure about monetary tightness if there had been a huge discontinuous interest rate adjustment, as in the famous or infamous Volcker episode of disinflation (1980–82). But when the two-year T-bill yield only rose to 4 percent last July (from below 3 percent in the spring) and is now barely higher than that (having peaked at 4.5 percent in November), it’s difficult to be remotely confident that monetary conditions have been tight.
Yes, the Fed’s so-called terminal rate (according to the “dot plots”) is some 100–150 basis points above the most recently reported quarterly personal consumption expenditures (PCE) or Consumer Price Index (CPI) inflation rates. Under a sound money regime, however, these real rates would move around considerably without signifying monetary inflation or monetary disinflation. In our bad money system, by extension, estimated real rates and their gyrations may say little about the evolution of monetary conditions.
Ideally, when performing monetary diagnosis, we would decipher whether money supply is veering ahead or below demand. Some market monetarists assure us that monetary disinflation is now underway, based on recent sharp slowdowns or falls in broad money supply. Yet the amount of overhang from the pandemic mega–money expansion coupled with the neutering of the monetary base by quantitative easing, quantitative tightening, and the resulting interest payments on reserves makes any fine judgment impossible.
Yes, reported measures of goods and services inflation are falling, but trendspotting is not a good way forward in monetary diagnosis. Additionally, a falling reported inflation rate may in fact be symptomatic of serious monetary inflation if the “natural rhythm of prices” is downward, which is likely the case now as the supply constraints of the pandemic continue to ease and the war-related natural gas shortage diminishes.
As regards to the second key symptom of monetary inflation, asset inflation, we could say that actual experience (the rebound of beaten-down tech, buoyant high-yield credit, and bitcoin up 40 percent from its crypto-winter low) is consistent with the diagnosis of a new virulent phase—the asset inflation symptom often historically emerges well before in the form of goods and services inflation. Also, we know from history that asset inflation often forms when the central bank takes advantage of a downward rhythm of prices to pursue a policy of lower interest rates.
In making a diagnosis of monetary inflation under present circumstances, it is instructive to consider three scenarios.
First, monetary disinflation by the Fed is still underway and will bear down on goods and services prices further, while present froth in some asset markets will fade as this continues. The monetary disinflation will prove a catalyst to an economic downturn, intensified most likely by the process of asset deflation (and related unwinding of credit excesses, including financial engineering).
Second, monetary inflation is still in process. We enter another growth cycle upturn, with the already superlong cycle extended yet again. There are open questions as to whether this new extension will end in a more substantial monetary tightening than in the past year as well as how much further inflation damage will be done first.
Third, monetary conditions might not be at present ostensibly “stimulatory” or “disinflationary.” However, the business cycle is turning down under the weight of endogenous factors—prominently, the accumulation of malinvestment during the past decade and the advance of monopoly capitalism. Peak valuations in credit and some real asset markets might succumb to a crash as income falls below expectations and financial engineering marvels of the past lose their wonder.
In Europe, the likelihood of monetary conditions already being disinflationary is less than in the United States—given the European Central Bank’s (ECB) long delay in raising rates from still-negative levels last year amidst a second big “fiscal expansion.” This expansion was ostensibly to subsidize personal incomes otherwise squeezed by the terms of trade losses inflicted by the Russian war. The big rebound of the euro in recent months is evidence of a prevalent view in the marketplace that in “playing catch-up,” the ECB will cause monetary conditions in Europe to become disinflationary just at a time when the Fed’s “disinflation grip” is lessening.
Even so we should note the now-high likelihood that the euro’s cumulative loss of purchasing power through the pandemic and war will be of a higher order than for the dollar. The tightening of monetary conditions in Europe came later than in the US, and it may well not be as tough. The scope for the eurozone to divorce monetary policy from ailing public finances given the evident “fragmentation risks” is limited. The fiscal theory of inflation, of which the future potential bankruptcy of governments is a factor in present inflation (due to the anticipation of eventual money printing to service the debt), has greater plausibility in the eurozone than the US.
Present escalation of the Russia-North Atlantic Treaty Organization (NATO) conflagration is surely a source of rational concern for the euro’s future purchasing power. Some euro-optimists might scoff at this, confident that NATO’s military buildup in Ukraine will bolster the likelihood of a Russian defeat. Euro-pessimists by contrast are troubled by the escalation.
One of their concerns is that the mounting cost of rebuilding Ukraine is already estimated at nearly $350 billion. The US and its NATO allies will encounter great domestic political difficulties joining this effort.
In the European Union, we can imagine a heightened tension between “New Europe” (Poland, the Czech Republic, the Baltic States, and of course Ukraine) on the one hand and “Old Europe” (primarily Germany) on the other on the question of the aid needed for rebuilding Ukraine. Washington will be siding with “New Europe” as has been the case since the early 2000s. Berlin-Warsaw relations, already difficult and bitter, have no counterbalance elsewhere, especially given the virtual snapping of the Paris-Berlin axis. The willingness of the German public to continue its bankrolling of an ailing Italian government and its bank finances is questionable under these circumstances.
Yes, there is the potential for the NATO allies to “direct” seized Russian assets, including central bank reserves, toward rebuilding in Ukraine. There are weighty legal obstacles to this without Russian agreement in a peace deal—not imaginable at this stage of the conflict. In sum, the euro’s present ebullience as a cheerleader for yet another extension of a superlong business cycle and the related asset inflation could succumb to the menace of the European credit and currency crisis.