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Macroeconomic Quick Takes: Inflation, Debt and Central Bank Decisions
I’ve been thinking about you all. Sorry for my silence recently. Just been busy for months. I wanted to take a minute to share some thoughts with you all since there are several things going on and coming up, even this week.
Inflation and recessions around the world are a mystery, at least when viewed together.
Government spending and debt is a worsening problem, and increasingly rapidly so.
The US Fed, Bank of England, and Bank of Japan all make decisions this week. The European Central Bank made news last week. It barely raised rates, and hinted it might be done raising them.
Without further ado - or additional deep research – here are my quick takes on things today.
Inflation and Recessions
It is not true that lowering inflation requires a recession and, hence, more unemployment. It’s just that usually lowering inflation causes a recession, which causes more unemployment.
Everyone still looks at unemployment as a sign for inflation. When unemployment rises, they expect it means inflation will fall. That relies on the old-school Phillips curve logic, and I’ve explained why it’s just a statistical relationship (read more via links in footnote), so reliance on it in this way is wrong in my view.
Rather than explain that again, let me say that there are plenty of cases where inflation rose when unemployment also rose and the economy took a nose dive. Most economic crises unfold that way.
Today, if we had good data, you’d find that economic activity is down but inflation is through the roof in places like Venezuela and Argentina. In the 1970s we had periods of rising inflation and unemployment in the United States. In the 1980s we also had falling inflation with falling unemployment and economic growth.
In the 1980s many Latin American economies suffered hyperinflation along with high unemployment. In the 1990s, during the Mexican crisis (around 1994) inflation took off along with unemployment and recession. The same happened later, around 1998, when the Asian Tigers – Thailand, Malaysia and others - suffered a wave of crises as well. And, in all those cases, when they came out the other side of the crisis you saw falling unemployment, economic growth and falling inflation.
That is not to predict a crisis in the US or Europe. It is only to say that unemployment, recession, and inflation do not have to move in the way everyone is expecting today. I continue to hear that we “need” unemployment to rise to lower inflation. No, we do not.
When economies are humming along, under normal conditions, and doing fine, then some unexpected boost to demand can push up prices (inflation), and this will lower unemployment too. Then, the central bank, raises interest rates to slow demand, which leads to a decrease in inflation, and usually causes unemployment to rise back up. That’s usually, but not always, what happens when there’s a small shock to demand alone, and when things are humming along “normally” otherwise. But…
…Nothing Is Normal Today
Is there anything about today that is normal? Economically speaking, I mean.
Those crises I mentioned were periods when governments blew out budgets, printed too much money, and frequently tried to manage their currency by fixing the exchange rate. When all of these things get out of macroeconomic balance in a serious way, different mechanisms kick in to move the economy back to balance. And every economy’s challenges are a little different, so the adjustments are a little different.
We just went through Covid where we shut down both the supply side and the demand side of our economies. Normal crises hit one side or the other, but not usually both at once.
We also totally changed our buying patterns, moving from restaurants and services outside the house to in-house only. We moved from services to more goods… and wanted them delivered overnight, on time, for free.
On the policy side we in the US, and many other countries too, printed more money and at a faster rate than we ever have, other than in wartime. Wartime. Like WWI and WWII wartimes. Big, giant, historical wars. And we did the same on the fiscal side. We pumped money into people’s pockets, business’ pockets, and so on via transfers, subsidies, and other stimulus.
We even entered that period of insanity in a historically low interest rate environment. Entering Covid, many countries already had near zero interest rate policies, and some had/have negative interest rate policies. That, in and of itself, was abnormal.
Some people spent all the stimulus money, some people saved it. Personal savings skyrocketed, and many people enjoyed “holidays” from paying mortgages, rents, student loans, and other things. Abnormal.
Even if households didn’t and don’t see it this way, this period of low interest rates and a flood of money caused a massive shift in their portfolio allocations. Some may have explicitly altered their allocations with their investment and retirement accounts, others may not have. But, for macroeconomic purposes, the whole bundle is important. The key is how much they spend versus hold as “cash” or save in various forms from bank accounts to stocks, bonds, and so on. The whole mix matters.
All that is still unwinding. Many governments around the world extended their Covid emergency procedures longer than was justified and that continued to distort all those private choices people make. The US government only now lifted the student loan payment holiday. It’s September 2023, for goodness’ sake. No comment on other countries’ extended emergency policies.
All of that unwinds through a myriad of economic mechanisms other the usual one. It is complex.
The Fed and other central banks hoped that things would bounce back to normal, like hopping back on a bicycle that fell over. Just hop on and resume course as if nothing happened. But it did. Lots of things happened.
And, that’s just the economic side of things. We are social, psychological beings that are slow to adapt and to process massive change. Heck, to keep the analogy, some people crawled out of their Covid caves, looked at the bicycle that fell over and wondered “do I even want to get back on that bike at all?”, “do I want to resume in the same direction as before?”, and even “hmmm… I wonder, if I can bike from home… I did buy a Peloton”.
Different. Not normal.
We are adjusting personally, individually, in our families, and all those individuals and families collectively form an economy. The economic laws of nature still apply, but the choices may be different and take time to settle into a new pattern.
Different. Not normal.
Debt and Government Spending
Central Banks caught up eventually. They started turning off the money spigots and raising interest rates. All else equal, that should reduce inflation over time. It should also slow economic demand and growth. That slowdown should lead to higher unemployment. But… and it’s a big, (mostly government) but(t)…
Our governments keep spending, literally, like there’s no tomorrow.
The price level in an economy balances many things. On the one hand, it’s the aggregation of all the prices in an economy. So, demand growing faster than supply in many markets should push up prices in those markets, and when you average it all up, the price level should rise, and that’s called “inflation”. As people emerged ready to live again, they demanded different goods, sometimes more goods (with lots of unplanned savings to spend down), and many spent on experiential goods like vacations, flights, hotels, etc.
On the other hand, the price level balances out – along with the interest rate – broader macroeconomic choices over portfolio holdings of domestic versus foreign currency, of cash versus bonds, and so on. People have way more “cash” than they would normally want to hold, and that oversupply lowers the value of that cash, which means a rising price level (inflation).
One of those things it balances out is also the value of outstanding government debt. For this purpose we are reminded that a national currency is only as good as the government that issues it. No matter what Kim Jong Un’s policymakers do with interest rates, money supply, etc., no one values their currency. Heck, I don’t even know what it’s called. The same is true for Venezuelan currency today. In both cases it’s because no one believes in the government. Kim’s because he runs a communist dictatorship. Venezuela’s because they ran the economy into the ground trying to become a communist dictatorship. Sad in both cases, and I pray for change.
In a more subtle way, when the US government runs massive deficits and issues more bonds than ever before in the history of our great country, it causes people to worry about the value of our government, namely, its ability to repay debts down the road. When that happens, the price level rises (inflation), until the real value of the debt falls in line with the expected future value of the government’s ability to generate surpluses and sustain debt payments.
In all the crisis examples I started with earlier, at some point, the governments blew their credibility by overissuing money and debt, and the resultant inflation was part of the adjustment process to bring the real values back in line with reality.
The United States spent more and borrowed more than at any time other than during serious wartime. Today it is running deficits that, honestly, would have led to panics around the world only, say, 10 years ago. Many other countries are doing the same.
You cannot lower inflation when the fiscal side of government is blowing hot air up the economy’s… well, let me be polite… if the economy is a balloon, the hot air can come from money or government spending, especially, if it’s financed by borrowing. Both blow hot air into the balloon, inflating it. We did both, and continue one of them, fiscal spending and borrowing.
What I Worry About and Am Watching
Today the US is in the strange situation that we have raised interest rates, cut the money supply, yet also increased government spending, continue to increase it, and are issuing ever more debt. That’s not sustainable.
It’s not 100% clear that the government spending is causing the GDP growth, low unemployment, and inflation at this point, but it’s suspiciously likely, in my mind. I’ll be watching the data over the coming months, but we might only know – and then still likely debate it – years later.
The higher interest rates are also rapidly raising the costs of the US and other countries’ debts. The reason is that countries tend to borrow more short-term than long-term debt, and therefore have to refinance a lot every year. Only 1-2 years ago, they borrowed at near zero interest rates. Today they are refinancing that at much higher interest rates. For the same level of deficits and borrowing, that would raise the financing cost, and make deficits worse because we also borrow more to pay the interest! And, we are additionally spending more and raising deficits, even without this interest rate effect. That’s not sustainable.
At the same time, other countries like Japan, are buying less US debt. So, the supply of debt is high and growing, but demand for it is the same or lower. Therefore, the value of each piece of debt issued should be lower. Guess what that means? US dollar inflation to erode the real value of that debt.
I’m watching what the Fed does this week, not because I’m curious about interest rates per se. (My guess is they’ll pause this time or raise them a tiny amount.) Rather, I’m very interested to hear how they see the world, and see these trends playing out. Do they see strong GDP growth? Where and why? Is it because of government spending? If yes, then that would be concerning to me, because it’s not “organic” GDP growth, it’s debt-financed and temporary, and therefore also likely inflationary. Are they seeing strong demand for US debt and the US dollar?… I’ll be watching.
I was worried that the rising interest rates on US Treasuries (our government debt) were a sign of global concerns over our ability to repay. It was in the back of my mind, and was a concern.
But, we can’t tell right now, because, yet again, Europe is slowing, the UK is slowing (although recent revisions suggest it’s not quite as bad as earlier thought), and so is China, along with other economies around the world. For the most part, they are all facing similar fiscal spending and debt challenges too. And, in troubled times, people still turn to US markets, US Treasuries, and the like as a safe haven.
That’s great for us in America, at least in the short run. It helps us avoid a crisis today. But it finances the profligate and unsustainable government spending, and could be bad long-term. It also masks the signals from the prices of those assets. Higher demand raises the value of US government debt not because it became inherently better, it just became relatively not as bad as in other places. It blows hot air on the economic tea leaves I was hoping to discern regarding the sustainability of US spending policy. But I’ll be watching, and this concern remains in the back of my mind every time I see reports on US Treasury rates rising.
Pulling It All Together
No one is 100% sure of why we are where we are today. I didn’t even touch the war in Ukraine, energy policies in many developed economies, including the US economy.
We have no choice but to watch the numbers we can see: unemployment, inflation, GDP, interest rates, and so on. But in times of crises when macroeconomic imbalances grow dramatically – as they did in recent years – different mechanisms can be at play that we aren’t used to looking at. We need to look and think more broadly.
In my opinion, many US macroeconomists miss these things because they usually only think about the US economy. Those of us in open economy macroeconomics are used to looking around the world, and know there are many examples where numbers seem to move in strange ways until you realize there’s been a debt-inflation-portfolio imbalance unraveling. It acts like some sort of black hole or space phenomena that’s understandable, but very hard to see until after the fact, and you say “Aha! Now I see what was happening”.
That’s the feeling I have. It doesn’t mean we’ll be sucked into a dark vortex. It could easily mean a “soft landing”, avoiding a major recession while lowering inflation. But it does usually mean governments have to get spending under control. It also usually means inflation and interest rates continue adjusting until macro-rebalance is obtained.
My gut tells me that there’s something like this going on. So I’ll be watching the US Fed this week (Sep 19 and 20) for insights, the UK monetary policy meeting (Sep 21), and the Japanese one as well (Sep 21).
I forgot to mention the European Central Bank meeting last week. So, I’ll close with that.
They raised interest rates a little, but the European economy is struggling, and Germany wrestling with recession. The ECB’s policy interest rate is only 4%, however, and inflation is 5.3% or so. That means policy rates are still currently negative. That’s not restrictive. So I think that part of their strategy is a mistake. Interest rates should be higher, and raised sooner and faster.
Europe is about to slip into a bad situation where they have persistent or rising inflation and a recession. Again, just what I mentioned at the beginning. These things can totally coincide with one another.
I’ll be watching European numbers to see how it unfolds. It will impact other economies too, and how they react. I also worry it could be a bad sign of potential things to come for other countries. I hope not, but I’m watching.
I hope this column helped you think about what’s playing out in the economic news today. It’s what’s on my mind, and I appreciate your interest, and for letting me share.
Thank you for reading.
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 But, in that same situation – i.e., starting when all is running fine – something could negatively affect the supply side of the economy pushing up prices (inflation) while simultaneously raising unemployment and lowering output (recession). It’s just less common.