Rabobank: The Only Question Is When, And How Large The Fed’s Policy Error Will Be

By Michael Every of Rabobank

A dialogue between the mute and the deaf

Yes, I am going to talk about inflation and the Fed. But let’s start with Russian Foreign Minister Lavrov, who described his ice-cold meeting with his UK counterpart Liz Truss as “a dialogue between the mute and the deaf”. He may have meant “…and the daft”, because when he asked her if she supported Russian sovereignty over Rostov and Voronezh, she replied the UK would never do so – both have always been parts of Russia, as the ambassador had to point out. It was a deliberate Lavrov trick that did not change the undiplomatic dynamic. Nor the military one.

Russia is still placing more forces just kilometres and minutes from the Ukrainian border; building field hospitals (for all the injuries peaceful exercises produce); making Ukraine’s Black Sea ports impossible to use (technically a breach of UNGA Resolution 3314 and an act of war?); removing all but essential workers from its Kyiv embassy; claiming the Kremlin “sees signs of a possible offensive by the Ukrainian army” in Russian-held Donbas; reportedly, allowing the Duma to consider an appeal to President Putin to recognize Ukraine’s breakaway republics as Russian territory on 15 February; and Belarus is issuing emergency conscription notices. None of this looks like the “no further escalation” President Macron was waving around earlier his week.

Macron was meanwhile busy agreeing to sell 42 Rafale fighter jets and new submarines to Indonesia, reflecting tensions in that region, as well as pledging to build 14 new nuclear reactors by 2035 at home, showing huge EU tensions between those closing down nuclear power in the face of an energy crisis and those seeing it as a way out of one. That is also a dialogue between the mute and the deaf, it seems – as is so much else around us.

On which, back to that US inflation print: the price of *many* things is soaring – except market rumours of downside inflation surprises, which should be heavily discounted. Headline CPI at 0.6% m/m was two ticks above consensus and, for those who obsess, a hair away from being 0.7%. In y/y terms it was 7.5%, a 40-year high. Meanwhile, CPI ex-food and energy was 0.6% m/m, a tick higher than consensus, and it has been stuck at 0.5 – 0.6% m/m for months now. That was equal to 6.0% y/y: and even excluding shelter it was 7.2% y/y.

How many Keynesian economic thinkers were deaf or mute about the logic that injecting stimulus into a US economy not structurally able to supply goods to match new demand would cause inflation? Yes, there was the belief the US could import more, as usual: except the rest of the world is in the same supply-constrained boat! Senator Manchin again pointed out the inflationary effects of the multi-trillion Build Back Better bill, which now appears completely dead.

How many people in the MMT crowd failed to see this too? Said crowd are now arguing despite inflation/expectations soaring, now is not the time to raise taxes, which is the one thing they argue one should do in response. They are right in that it is supply-side – but are showing they have as little idea about what to do when faced with real-world inflation. I can summarize the whole MMT argument here: Yes, it works –which will infuriate many of you– but only if you have spare domestic supply and/or a trade surplus to firewall your currency – which will infuriate those advocating it who don’t want to recognize that this makes it a zero-sum geopolitical issue.

How many neoliberals are reading the reports on US supply-chains on prospect.org? These summarize how ocean carriers, railroads, warehouses, and industry after industry have come to be dominated by cartels, oligopolies, monopolies, and monopsonies making for both a lack of competition and a logistics system with a non-linear dynamic of emergent, cascading single-points of failure. “Too Big to Sail”, as I have dubbed this neoliberal equivalent to the pre-2008 banking system. The current trucking protests in Canada, which may be about to spread to the US, further underline systemic vulnerabilities. A former Obama White House DHS member argues: “The Ambassador Bridge link constitutes 28% of annual trade movement between the US and Canada. Slash the tires, empty gas tanks, arrest the drivers, and move the trucks.” Yet how can one move blockading trucks if they have slashed tires, no gas, and no drivers? Canadian tow-truck drivers have already refused to tow away problematic trucks out of sympathy: and does anyone recall the UK fuel blockades of autumn 2000? Yet this backdrop also confuses those pro-MMT given the following Twitter meme: ‘Socialists – “Workers should seize control of the economy!”; Truckers – “OK.”; Socialists – “No, not like that!!”’

How many Keynesians, MMT-ers, or neoliberals read ‘The Global Financial Resource Curse’ (Benigno, Fornaro, and Wolf), which argues: “Since the late 1990s, the US has received large capital flows from developing countries –a phenomenon known as the global saving glut– and experienced a productivity growth slowdown. Motivated by these facts, we provide a model connecting international financial integration and global productivity growth. The key feature is that the tradable sector is the engine of growth of the economy. Capital flows from developing countries to the US boost demand for US non-tradable goods, inducing a reallocation of US economic activity from the tradable sector to the non-tradable one. In turn, lower profits in the tradable sector lead firms to cut back investment in innovation. Since innovation in the US determines the evolution of the world technological frontier, the result is a drop in global productivity growth. This effect, which we dub the global financial resource curse, can help explain why the global saving glut has been accompanied by subdued investment and growth, in spite of low global interest rates.”

In short, free movement of capital and of goods into the US destroys global productivity. We already see evidence that free movement of people, if low wage workers, can do the same. So what shred of the globalised neoliberal model do we have left? Yet Keynesian stimulus in a supply-constrained world cannot work either – and China may be throwing debt at the economy again based on total social financing data showing around $1 trillion in new borrowing in just one month: coal and metals think so. Moreover, MMT can’t work unless the economy has spare capacity and you make things at home, or at least the central bank finances the rebuilding of supply chains, not consumer demand: so, you can have MMT socialism – just nationally. (And that’s a worrying taxonomy if you reverse the adjectives.) So, what’s a central bank to do?

The market clearly expects the Fed to make a policy error, with the odds of a 50bp hike in March over 50%, hikes at every meeting this year expected, the US 7s-10s curve having inverted, 5s-10s just 10bp away from inversion, 2s-10s now below 50bp, and rate *cuts* being priced in for 2023 and 2024 before any move is even made.

Indeed, with the Fed’s Bullard calling for 100bp of hikes by July, and rumors of an emergency intra-meeting Fed rate hike(!), which I believe would be the first since Volcker’s ‘Saturday Night Massacre’ in October 1979, when rates moved from 11% to 12%, the only question is how long until we get that policy error, and how large it will be.

The bigger question to my mind is “So, what next?” Just don’t expect any intelligent answers to emerge rapidly. Because fundamentally we have an economic –and geopolitical– dialogue between the mute and the deaf and the daft.

Happy Friday.