“Higher Inflation. Higher Protectionism. Higher Global Tensions… For Longer”

By Michael Every of Rabobank

When most of the market was saying “transitory!” this Daily was among the first to float the idea that inflation and rates risked being “higher for longer”. This was considered a ‘colorful’, counter-consensus view: like Russia invading Ukraine; or a US-China Cold War in 2017; or Trump winning the 2016 election. Yet Valentine’s Day saw a slew of Fed speakers say higher for longer in so many words; and the market –finally– shifted its rate projections up to the most dovish end of the Fed’s dot plot, at least until 2024, while starting to price in the odds of rates rising in June rather than being close to the start of a series of falls.

US January CPI was slightly stronger than expected at 0.5% m-o-m, 6.4% y-o-y headline and 0.4% m-o-m, 5.6% y-o-y core, but not the upside surprise some had feared. However, core services excluding shelter, which the Fed is focusing on, only edged down from 7.5% to 7.2% y-o-y. That was the lowest print since July 2022, but it’s still over three times higher than the Fed wants it to be. Clearly rates are *not* going to go down against that backdrop.

Moreover, this was after a new statistical polish had been applied. Used car prices fell rather than rising sharply, as the industry actually recorded, and new seasonal-adjustments saw big changes, mostly downwards: unadjusted CPI was up 0.8%, not 0.5% m-o-m; food at home 0.8%, not 0.4%; fruits and veggies 0.5% not -0.5%; energy 3.1% not 2.0%; electricity 2.3% not 0.5%; and apparel 2.6% not 0.8%, etc. Did the seasons really shift that much this year?

This morning sees Bloomberg quoting Rogoff and El-Erian on inflation, with the former saying, “Back in the day, they should’ve said 3%, not 2%,” as a US CPI target, but it’s too late to change it now: he thinks the Fed will keep saying 2% while not getting there. El-Erian also says the CPI target can’t be changed without a massive loss of credibility, but that if a new target were to be drawn up today, it would be 3-4% – which is where he also sees US inflation getting stuck.

Where do financial assets trade if global inflation is stuck well above target? Note I said “global”, as this is not a US but a Western problem; and not just Western, with India and the Philippines both recently seeing large upside inflation surprises. Those talking US CPI need to look more widely and deeply – that they didn’t is why they were wrong on “transitory” calls.

Let me first live up to my promise to quote the US NFIB small business survey: “Owners are managing several economic uncertainties and persistent inflation and they continue to make business and operational changes to compensate.” Persistent inflation. Now, let’s look globally.

The Financial Times warns ‘Western intelligence shows Russians amassing aircraft on Ukraine border’. That’s the spring offensive the market hasn’t been pricing for, as the new German defence minister bitterly points out none of the EU countries who promised to deliver tanks to Ukraine while Berlin was floundering have actually done so. It’s not like timing matters in war as in markets; or that war is inflationary.

To repeat a point the market keeps missing, Dean of International and Security Studies Andrew Michta notes:

“For 20 years of the Global War on Terror, the assumption was that a major war of this kind was unlikely. The mantra was “just-in-time” when it came to munitions and supplies in the name of efficiency.  That “efficiency” is today our vulnerability. The big five US defence contractors are scrambling to surge production. The situation of Europe’s defence industry is borderline dire.

The extent to which the proponents of globalization have de-industrialized the country leaves us with little capacity to switch to wartime production in an emergency. In WWII, Chrysler could retool from making cars to making tanks. How do you retool Facebook to make missiles? Consider the long wait times after orders have been placed for Abrams tanks, F-35s, etc. Bottom line: We need to invest now in expanding our defence industrial capacity and build stocks of weapons and munitions. The mantra of “just-in-time” must be replaced by “just-in-case.”

The implication is the need for more industrial capacity that can be retooled in a crisis. (By the way, as India opts to buy 220 Boeing passenger airliners in a $34bn order.) Indeed, other defense analysts point out in the fat-tail scenario of a major war in Asia, even a US victory would mean appalling military losses, and it is no position to replace its ships and planes with the current flow of production. Other countries are.

In the background, the White House has admitted three of the last four objects it shot down look to be private civilian balloons, not foreign military ones; and Iran’s President Raisi, in Beijing while nuclear tensions rise in the Middle East, heard Xi Jinping underline his “solidarity” with Tehran and that, “No matter how the international and regional situation changes, China will unswervingly develop friendly cooperation with Iran.” If people who look at dot plots could better join those dots, they would see risks of inflationary global fragmentation.

Some see it, but don’t like it. The Financial Times’ Martin Wolf warns ‘security concerns are driving the fashion for active industrial policy, but there are potential downsides’. He points to the sweeping trend CEOS see towards onshoring, reshoring, and nearshoring, and notes historically this has not played out that well. He’s right in the examples he shares. Except many countries did develop rapidly via industrial policy: the Hamiltonian US, 19th century Germany, 20th century Japan and South Korea, and 20th/21st century China. Moreover, free trade has only existed in brief historical pockets between major wars, which says something about its structural stability. Wolf just argued for land taxes, which are an even more radical policy. The missing link between his two editorials is free movement of capital: domestically, which a land tax addresses, and internationally, because if you stop the latter, trade may revert to comparative advantage as we mis-sell it today. That might be sustainable, but will first see a wrenching adjustment process – which is inflationary. By the way, expect the US to impose outbound capital controls on China.

Meanwhile, China will offer free fertility treatment to try to boost its record low birth rate; Asia-Nikkei says ‘Japan readies ‘last hope’ measures to stop falling births’; and Singapore’s budget just offered a baby bonus. Fewer workers for the same number of jobs is inflationary. To combat that, we now won’t see more outsourcing, at least not to China, while more immigration is politically unpopular. So what then? A rates response of higher for longer.

On that front, RBA Governor Lowe today told the Aussie senate that he won’t resign and that “There is a risk that the tightening of policy that’s taken place does dampen spending more than we think. But there is a risk on the other side. There is a risk that we have not yet done enough with interest rates.” I had already dismissed Lowe’s happy median talk months ago. He added, “I think the probability of a price-wage spiral is low, but if we’re wrong on that then the cost is very high. If we’re wrong on that then we are going to see higher interest rates and higher unemployment… If people think that inflation is going to be 7-8% the year after next, we’re going to have all sorts of trouble.”

Yet it would be remiss not to point out that there are deflationary signals out there – from China: just due to domestic weakness and not cheap-goods export strength, as we are accustomed to. Bloomberg carries two recent stories on that front:

• Analysis stating China’s housing slump exceeds that of the US in 2007, which took 16 years to recover from in terms of new-home sales, and China might struggle to do that well: indeed, if the population is much smaller in 2039, then how can sales recover?

• ‘Xi’s Consumer Boom Thwarted by Secret Stock Trades, Debt Misuse’ claims borrowers are using low-cost consumer loans to prepay mortgages or buy stocks. The article notes a 37-year old borrowed CNY798,000 via two consumer loans at 3.2% and 3.65% to pay off her mortgage at 5.65%, and will apply for low-cost business loans to do more of the same, presumably on another property. In short, the desired consumer boom in China is not going to happen. Once again the market consensus is dead wrong, this time in having expected inflation, not missing it. The market is also wrong in saying China will contribute x% to global growth in 2023. If it is not importing more, then any GDP growth it sees benefits it alone, while any stimulus that pushes up producer price inflation for everyone else reduces growth elsewhere.

Higher inflation. Higher rates. Higher protectionism. Higher global tensions. For longer.