A Hair’s Breath From A Damp Squid

By Michael Every of Rabobank

The title of today’s Global Daily fuses two mangled English metaphors I hear into one message for markets – a narrative can be nearly right, but one wrong letter gives it a different meaning.

Yet again, UK deflationistas were proved painfully wrong in expecting a damp squid. Headline CPI remained over 10% in March, core CPI was unchanged at 6.2% y-o-y, and food inflation was nearly 20%. That’s with a weak economy, ‘healed’ supply chains – as far as Brexit will allow, higher BOE interest rates, and negative real wages growth. As a result, BOE rates are going to go even higher, with chatter of 5%. UK inflation go down from here, but how quickly it gets back to 2% is not clear: not when ‘UK warns of cyber-attacks from new ‘Wagner-like’ Russian cyber-hackers’ aimed at businesses and infrastructure, i.e., structural geopolitical supply-side shocks.

The Fed’s Beige Book was either a hair’s breath from a need for more rate hikes, or for rate cuts. Overall economic activity was little changed, with consumer spending, manufacturing, freight volumes, residential real estate sales, construction, and CRE leasing all flat to down; auto sales steady; but travel, tourism, and nonfinancial services up. Bank lending volumes and loan demand generally declined, with tightened lending standards amid increased uncertainty and concerns about liquidity. Employment growth moderated somewhat, with the labor market becoming less tight on increased supply; wages showed some moderation but remained elevated. Consumer prices generally increased due to still-elevated demand as well as higher inventory and labor costs. Home and rent prices levelled out at near record highs. Further relief from input cost pressures was anticipated, but changing prices more frequently vs. previous years was expected.

Likewise, New Zealand’s Q1 CPI was 1.2% q-o-q vs. 1.5% expected and 6.7% vs. 6.9% y-o-y. However, this was only due to a dip in tradables CPI from 1.4% q-o-q in Q4 to 0.7% in Q1, while non-tradables picked up from 1.5% to 1.7%, which is where it should be y-o-y. Moreover, Australia’s long-awaited RBA review saw a flurry of 51 recommendations including:

• No changes to the 2-3% CPI target or the inflation targeting regime;

• Remove the words “on average, over time” from the 2-3% inflation target;

• Split the RBA into two boards, one responsible for monetary policy to be “staffed by experts,” and another responsible for corporate governance;

• Hold fewer meetings by shifting to a 6-week interval, rather than monthly;

• Hold press conferences after every meeting to improve communication; and

• Remove the power of the government to override monetary policy decisions

A voice at the Council of Trade Unions said: “A big, fat load of nothing,” as changes to the policy board make no difference if you stack it with a bunch of MIT-educated New Keynesian Phillip Lowe clones. In that respect, the review was a damp squid. There was certainly no echo of Lagarde on what central banks are now for, i.e., helping on the supply side, which is a hawkish shift in the geopolitical sense. However, Rabo’s Ben Picton notes the reform reads as a hawkish tilt in a vanilla sense. First, loose language gives too much discretion to the RBA on how quickly they achieve their inflation mandate: it just admitted it is happy to take longer than peer central banks to bring inflation down. Second, a number of politicians have recently lobbied the Treasurer to exercise his power to reverse rate increases, and this seems to be a pointed response. As such, we are arguably a hair’s breath away from more trouble in the housing market.

Meanwhile, we saw headlines in the financial press on de-dollarisation and that the dollar may now account for less than half of global reserves. However, there are a few wrong letters in those claims according to @Brad_Setser, who comprehensively demolishes the argument with data for the broadest measure of reserves, including sovereign wealth funds and state banks. Indeed, he concludes: “the biggest driver of the fall in reported dollar reserves was bond market valuation changes tied to rising US rates — and the biggest reason why folks sold reserves and FX was the dollar’s extreme strength.” That’s being felt in economies like Egypt, scrambling to find dollars.

Here I have to underline again that a global shift away from the dollar would be massively inflationary for some; deflationary for others; see Eurodollar defaults on a scale dwarfing the GFC; and end the current global economic architecture, including supply chains, with no global replacement. In short, it would not be a damp but a giant squid – or a Kraken.

Yet some economies are trying to move in that direction by shifting to more dollar-priced, local FX-cleared barter. It remains to be seen if we are a “hair’s breath” away from trouble as a result. A lot of drive in this direction is likely due to China preparing a bunker immune to US sanctions. That raises the question of what might happen ahead that could force the US to introduce them: though as we argued back in our ‘Ukraine Metacrisis’ report in early 2022, the logic was always that sanctions on Russia would have to extended wider in order to work, risking a terrible outcome for the global economy. However, before then, as Setser alludes to, the response is likely going to be even higher US rates and a stronger dollar to punish commodity exporters trying to go their own way: that’s not in the Beige Book. Then we see what happens with Fed swaplines.

Meanwhile, the EU’s foreign policy chief, Borrell, just underlined its stance towards China: “de-risking, not de-coupling”, via a 4-element strategy: values, economic security, Taiwan and Ukraine. Typically, this is not a hair’s breath from a damp squid: it’s already there.

• On values, China can only see this as confrontational.

• On economic security, given China’s civilian-military fusion, how can one differentiate? Saying “diversification of supply chains, control of inbound and outbound investments, and the development of anti-coercion tools” is easy. Delivering them means forcing a dilution of export, import, and FDI exposure across the private sector: how? Moral suasion, or tariffs and capital controls? The EU wants to reduce its EUR400bn trade deficit with China: how, without being mercantilist in turn?

• On Taiwan, China sees this as interference in its internal affairs.

• On Ukraine, the EU says it can only develop relations with Beijing if it persuades Moscow to withdraw. This is not going to work for a multitude of reasons.

Elsewhere, Egypt was ready to produce 40,000 rockets to sell to Russia to fight Ukraine, but after ‘a talk’ with the US, it decided to sell artillery to the US to send to Ukraine to fight Russia; Russia says it will arm North Korea if South Korea helps arm Ukraine; a potential civil war in Sudan could drag in regional powers on the different sides (one pro-Russian, one not); Canada told the US that it will “never” meet its pledged commitments to NATO; China is seeking to acquire equipment and knowledge in the Dutch space sector, sometimes in circumvention of export restrictions, says Dutch military intelligence; Michael Dell says customers are demanding less reliance on China; and the US Select Committee on the CCP tweets: “HAPPENING NOW: The fate of the Indo-Pacific hangs in the balance as members of the Select Committee engage in a fictional war game to decide the American response to the Chinese Communist Party’s 2027 invasion of Taiwan.”

Also, the Financial Times notes: ‘The new Washington consensus: Yesterday’s US economic orthodoxy is today’s heresy’.

On multiple fronts, we are hair’s breadth from something – and I think it involves something larger than a squib.