If Central Banks Do Not Tackle Inflation → Deflation Will Come from A Crisis

The guest commentary below was written by written by Daniel Lacalle. This piece does not necessarily reflect the opinions of Hedgeye.

Most market participants have been surprised by the last six months. The total return of the US Treasury Index was the worst since 1788 according to Deutsche Bank.

Stocks closed June with one of the largest corrections since 2008. Bonds and equities are falling in unison, driven by rate hikes and normalization of monetary policy.

However, there is no such real normalization. The balance sheet of the main central banks has barely moved and remains at all-time highs according to Bloomberg.

The ECB continues to ignore the highest inflation rate in the eurozone since the early 90s by keeping negative rates. The Federal Reserve rate hikes have been more aggressive, but it is still injecting billions of dollars in the reverse repo market and monetary aggregates remain excessive.

In the United States, money supply growth (M2) is still much higher than in the quantitative easing years. M2 money supply has risen to 21.8 trillion dollars and yearly change shows a rise of 1.3 trillion dollars, which is more than double the annual figure of the expansion phase of 2008-2011.

Money supply (M2) annual growth in the United States was 6.5% in May, 6.6% in the eurozone. Global monetary growth in May was 9.9%, all figures according to Yardeni Research. In the eurozone money supply growth is higher than in the middle of the so-called “Draghi bazooka”, the famous “whatever it takes”.

Central banks have gone from “whatever it takes” to “no matter what”.

We already explained in a previous article that commodities do not cause inflation, money printing does, and the monetary aspect of inflation is not being addressed properly.

One or two prices may rise due to an external crisis, but the rest would not rise in unison given the same quantity of currency. Between 2012 and 2014 we saw energy commodity prices soar, yet inflation measured as CPI was low because the supply of currency was in line with demand.

We did see enormous inflation in asset prices, though, and policy makers did not pay attention to the impact on house prices and markets of enormous liquidity injections. When newly created currency stopped going to risky assets and was targeted at government current spending, inflation shot up.

Central banks seem to fear markets. However, it is better to create a correction in bonds, equities, and risky assets after years of all-time highs than to lead the world to a crisis created by the destruction of purchasing power of salaries and deposits.

Policy makers should be very concerned about the so-called “prudent” normalization because the expansion was far from prudent. The pace at which they bloated their balance sheets and cut rates is what they should have been worried about, not the normalization.

Consumer confidence is plummeting around the world, real wages are negative, and families are consuming the little savings they had just to make ends meet. At the same time, businesses are struggling with weaker margins as input prices soar.

The worst thing that governments and monetary authorities could do is to let the economy slip into a crisis where the productive sector, families, and businesses, collapse just because they did not want to cut deficit spending and truly normalize monetary policy.  

By then, the problem will not be inflation, but deflation coming from the asphyxiation of the private sector.

Once consumers and businesses fall, tax revenues will also plummet, taking government debt to new highs. Even Keynesians should be worried about letting inflation run wild because the result would be that governments face an even worse fiscal crisis when the private sector slumps.

Inflation can be addressed by properly reducing central bank balance sheets, raising rates, and cutting deficit spending. If policy makers send the private sector to a crisis due to inaction, the crisis will be far worse than 2008. It is still time.

End the perverse incentives of excessive monetary action. It may still create another leg down in markets, but they will eventually recover. The destruction of businesses and families’ disposable income is far more challenging to restore.