This Is A Cycle Of Illusion: You See What You Want To See

By Stefan Koopman, senior macro strategist at Rabobank

We are living in a time of economic bewilderment. The pandemic has given us an unprecedented shock, but we have also seen a surprisingly swift recovery. Inflation has risen to the highest level in decades, but has been declining while unemployment sits at its lowest in years. Central banks have raised interest rates at breakneck pace, yet markets continue to soar to new heights. How is this possible?

The answer lies in the realization that we are not experiencing a typical business cycle, but rather a cycle of illusion. This is not a cycle driven the by organic macro processes as outlined in our economics textbooks and forecasted by our DSGE models, but one marked by huge disruptions in demand and supply, by logistical chaos and geopolitical tensions, by pent-up demand and increased savings, by mismatches in the labour market and strong wage growth, by vacant commercial real estate and shortages of residential real estate, by China offloading their excess capacity overseas and the West trying to rebuild its own capacity. It is a cycle that constantly gives false signals about the state of the economy and the prospects for the future.

The hope that inflation will gently recede to around 2 percent has been gaining a lot of ground since November. Such a scenario seemed completely unattainable in October. Decreasing risk premiums and heightened expectations for a ‘normalization’ of monetary policy were the outcomes. But will we finally get a normal business cycle?

It appears not. We are still in a transitional phase, wherein the global economy grapples with adapting to a new, harsher geopolitical reality. Risks such as the war in Ukraine, the crisis in the Red Sea, or escalating tensions between China and the United States are not isolated incidents. They are not some unlucky draws from the same tail of the distribution of risks we’ve always had. Instead, we have seen a shift in the entire distribution of those risks. This not only leads to more supply shocks but will also introduce new macroeconomic paradoxes. The cycle of illusion, it seems, is far from over.

So the economy is playing tricks with us, and markets and policymakers have fallen for them. Only a very, very brave analyst would at this stage forecast a couple of rate hikes instead of cuts. Yet some of this month’s data do tell that different story. Take the US, for example. In January, non-farm payrolls surged by 353,000, initial claims fell, and core inflation proved stubborn at 3.9% y/y. The producer price index (PPI) jumped by 0.5% month-on-month, University of Michigan inflation expectations rose, and the prices paid index of the ISM services survey hit 64. That’s not exactly rate-cutting territory. However, things may do a 180 again in February, as this economy is like magic. You see what you want to see; the reality is too complicated anyway.