Thursday, June 30, 2022

Stagflation and a Macro Economic update/ prediction

 

It is my personal belief that we are entering some unprecedented economic times in this country. I’ve been saying from the better part of year that while others continually discuss ‘Inflation”, I believe we are entering into a Stagflation period or perhaps even a deflationary period. Below is an article from an economic idol of mine Ray Dalio who started and still manages the largest hedge in the world ‘Bridgewater’ out of Westport, CT. I have omitted some of the article and reorganized in an effort to make it more readable and succinct, but also made additional comments at the conclusion of article.  



For me, hearing supposed “experts” talk about what’s now happening in the markets and economy is like listening to nails scratch against a chalkboard because they are typically saying incorrect things in a more complex way than commonsense would dicatate. Markets and economic movements are driven by much simpler and more commonsense linkages than most people care to articulate.

More specifically, I now hear it commonly said that inflation is the big problem so the Fed needs to tighten to fight inflation, which will make things good again once it gets inflation under control.

I believe this is both naïve and inconsistent with how the economic machine works. That’s because that view only focuses on inflation as the problem and it sees Fed tightening as a low-cost action that will make things better when inflation goes away, but it’s not like that. 

The facts are that:

1. prices rise when the amount of spending increases by more than the quantities of goods and series sold increase; 

2. the way central banks fight inflation is by taking money and credit away from people and companies to reduce their spending; 

3. They also take buying power away by raising interest rates which increases the amount of that has to go toward paying interest and decreases the amount of money that goes toward spending; 

4. raising rates lowers spending. 

My main point is that while tightening reduces inflation because it results in people spending less, it doesn’t make things better because it takes buying power away. It just shifts some of the squeezing of people via inflation to squeezing them via giving them less buying power. 

The only way to raise living standards over the long term is to raise productivity and central banks don’t do that. 

So, what do central banks do?

Central banks move demand around by providing and withdrawing spending power by influencing the creation and amounts of debt assets and debt liabilities. They do that in a way that naturally produces cycles in markets (bull and bear markets) and economies (expansions and recessions). More specifically, central banks inject doses of stimulation into the system via injecting credit and money into the system, which produces increases in demand for goods, services, and investment assets that are followed by periods of paying back and withdrawals of the stimulations, which produce lows in demand that are depressing. Whenever these depressing periods of paying back become too depressing, central banks typically provide another and even bigger dose of stimulation. They produce the short-term debt cycles (also known as the business cycle), which typically last for about seven years give or take a few.

These short-term debt cycles add up to the long-term debt cycles that typically last about 75 years, give or take about 25. That’s because most everyone wants the ups and not the downs, so the stimulations and debts that central banks produce typically add up over time to produce more ups than downs until the debt assets and liabilities get unsustainably large, at which point they have to go down via some mix of inflation (due to money printing to reduce the debt burdens by monetizing them, which is inflationary), debt restructuring, and paying the debt service in non-depreciated money (which is depressing). 

That is what we have been experiencing. It’s why debts have been increasing relative to incomes at the same time as each cyclical rise and each cyclical decline in interest rates since 1980 has been lower than the one before it until interest rates hit 0%, and since then each central bank printing and buying of debt has been greater than the one before it up until now.

So, what should central banks do to do their job well? 

Central banks should:

  1. Use their powers to drive the markets and economy like a good driver drives a car—with gentle applications of the gas and brakes to produce steadiness rather than by hitting the gas hard and then hitting the brakes hard, leading to lurches forward and backward.
  2. Keep debt assets and liabilities relatively stable and, most importantly, not allow them to get too large to manage well.

To do this they should not allow interest rates and availabilities of money to be either too good or too bad for the debtors or the creditors. 

By these measures central banks policies have not been good. More specifically,

  1. The Fed is moving from printing and buying debt at an annual rate of around $1.5 trillion to selling it at an annual rate of $1.1 trillion, and from sharply lowering interest rates to sharply raising them. For that reason, we experienced the big lurch forward and are now experiencing the big lurch backward.
  2. Because debt assets and liabilities are now very high and because government deficits will remain high, it is virtually impossible for the Fed to push interest rates to levels that are high enough to adequately compensate holders of debt assets for inflation without them being too high to support strong debtors, strong markets, and a strong economy. If the holders of debt don’t get adequate returns they will sell them, which worsens the free market debt supply/demand picture, which either leads to a dramatic cutback in private credit (which is depressing) or the central bank creating more money and buying more debt to fill in the funding hole (which is inflationary). 

In summary my main points are that 1) there isn’t anything that the Fed can do to fight inflation without creating economic weakness, 2) with debt assets and liabilities as high as they are and projected to increase due to the government deficit, and the Fed also selling government debt, it is likely that private credit growth will have to contract, weakening the economy, and 3) over the long run the Fed will most likely chart a middle course that will take the form of stagflation. 

Weitz take:  As I typically do, I agree with Ray whole heartedly in this assessment. Namely the buying debt to selling debt coupled with the dramatic increase in the Fed Funds rate is a double edge sword that is fairly insurmountable. I said to a colleague in late 2021 that if the Fed did increase rates as much as they intended to, it would be an intentional collapse. For better or worse, the inflation rates spooked the fed into slamming on the economic brakes, but that will not come without negative economic performance until we get to a new equilibrium. How far we must go to get there is uncertain, but the chance of severe headwinds is almost a certainty in my eyes. I'm always open to good faith dialogue so if you disagree, feel free to make a comment below. 

My Info for comments/ feedback: 

Scott Weitz

Scott@WeitzCommercial.com

105 Lake Street S; Ste 205

Kirkland, WA 98033

Cell: 206.306.4034




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