What would you do about an incorrect medical diagnosis?

Saturday, 8 July 2023 — South Melbourne

[7 min read]

Dear Reader,

What would you do if you knew your doctor has made an incorrect diagnosis before prescribing you some medicine? Would you just sit there and take it?

Because right now, PhD bearing central bankers are completely misunderstanding the source of inflation. And so, their response has been dangerously misguided. But investors don’t seem to be acting in response to the threat.

Today, we explore what’s really going on, and what you can do about it…

As the modern macroeconomists who run our monetary policy see things, inflation is caused by aggregate demand shifts. If people buy more stuff, it raises prices. If they’re buying less, prices fall.

Closely tied to this is employment, which has an impact on the amount people can buy. But it’s a secondary factor.

A central bankers’ job is to manage the economy so that demand is growing moderately. If it grows too fast and prices start rising, higher interest rates are used to slow it down. If the economy is struggling and prices don’t go up, or even fall, the economy needs stimulus with lower interest rates.

The fact that this doesn’t really consider the supply side of things is the first big flaw in the theory. Especially in the wake of a pandemic that disrupted the supply sector of the economy badly.

What we’ve seen over the past two years is a spike in producer costs. Resources and energy prices surged first, well before consumer prices. Yes, this eventually led to a shift in consumer prices too. But the causation is obvious because of the temporal relationship — producer prices moved and then consumer prices followed.

In 2020 and 2021, I tracked this through producer price indices (PPIs) and purchasing manager indices (PMIs). These are also known as ‘factory gate prices’, meaning the prices that factories pay for their inputs. They surged rapidly long before consumer prices did, allowing me to predict the consumer price inflation we’ve seen since.

The misdiagnosis on the part of central bankers — confusing the inflationary spike for a demand-based issue rather than a supply issue — is the source of what happens next in financial markets.

You see, interest rates are not just important to demand, but to supply too. Raising interest rates doesn’t just slow demand. It also raises costs for producers, including those that supply energy and resources, the lack of which caused the PPI spike in the first place.

In other words, central bankers have made producer price spikes worse by adding costs to struggling factories, energy producers, miners, and other producers. They’ve added to the cause of inflation.

Worse still, they have created a demand slowdown where they didn’t need to. This is because excess demand was never the source of the inflationary problem. It was one of supply.

Before we unpack the implications for investors, a quick tangent for those of you who are thinking that inflation is everywhere and always a monetary phenomenon.

The trouble with monetary policy is that, at some point, the dose of monetary policy needed to keep the economy ticking over becomes so high that money itself becomes undermined.

If you have a hammer, then every problem looks like a nail. But eventually, the hammer will break from whacking the wrong thing. In the same way, at some amount of quantitative easing, negative interest rates, and other interventions in the economy, people will lose faith in the currency. And faith is all a fiat currency has. That’s when true inflation emerges — the loss of value of the currency, rather than prices moving.

The fact that the symptom of such inflation is the same as what gets central bankers into trouble. Just as they can’t tell the difference between cost-push and demand-pull inflation, they can’t tell if inflation is happening because of a loss of faith in the currency.

Hence the risk of hyperinflation — when central bankers still blame profiteers, greedy businessmen, speculators and everyone but themselves and their policies, right until the end.

We clearly haven’t reached this point yet. And, while the very definition of inflation may well be price increases caused by the money supply, that doesn’t mean monetary policy doesn’t have effects on supply and demand as I’ve focused on today. So, let’s go back to focusing on those effects.

Central bankers, having misdiagnosed a supply problem as a demand one, are busy making it worse by raising interest rates, only further constraining the recovery amongst producers and thereby worsening inflation.

The result is that producers face a nightmarish combination — rising costs from their suppliers and falling demand from their consumers. This is the definition of stagflation.

The eurozone, for example, has high inflation and a recession at the same time. Not so long ago, predicting this was economic heresy.

It happened because higher producer prices are still filtering through to consumer prices. However, consumers can’t afford to buy thanks to higher interest rates adding to cost-of-living pressures.

The misdiagnosis of the problem has led to the worst of all possible outcomes — severe side effects from the medicine, but no cure for the underlying disease. Inflation and a recession at the same time.

The correct response is, of course, to go and see another doctor for a second opinion and get some very different medicine. Which, in the monetary context, means having a chat with Dr Copper and gold.

Dr Copper got his PhD in economics the hard way — by being useful and operating in the real world. That’s why the price of copper is such a good economic signal of what’s really going on.

Copper is up by around 35% from the trading range it was in between 2014 and 2020, dramatically adding costs to just about all real-world economic activity and pushing up inflation. But it’s down by 20% since the post-pandemic surge, undermining the recent inflationary spike. More on that in a second.

Gold, meanwhile, remains stuck inside its trading range, which formed in early 2020. It’s signalling neither inflation nor deflation has an upper hand. That’s because the inflation happened, disproportionately, amongst producer prices, not consumer prices.

So much for what got us here. What’s happening now?

The combination of high producer prices and a lack of demand keeping a lid on consumer prices risks a severe corporate profits crunch. Companies face higher costs without consumers able to bear the burden of passing those costs on.

Unemployment comes late in the business cycle because it occurs once businesses struggle in this way. It’s a consequence, not a cause, of inflationary turning points.

But here’s the thing. Producer prices have recently stopped rising. The eurozone’s producer price index fell for the first time since inflation spiked this week. The US’ PPI is close behind. This signals that the struggle has begun amongst companies.

Just when the central bankers have managed to cause an unnecessary recession by clobbering demand, they’re going to see the true source of inflation pull the rug out from under it. They have overdosed on high-interest rates.

The next phase is a struggling corporate sector, with bankruptcies and unemployment making the recession worse. In the US, corporate bankruptcies are at recession levels already.

It’s bad news for investors. Especially when bond yields are still not compensating for high inflation. In fact, bond yields may be signalling that investors expect inflation to turn soon and are pricing this in.

In 2022, the year inflation began to roar, cash was one of the best-performing asset classes in the US because everything else fell in price, including bonds. If you expect inflation to drop fast, it may outperform once again.

Perhaps bed rest is the best way forward from here.

Interestingly, my colleague Greg Canavan has a similar metaphor for the click-hungry investment journos gushing about income stocks right now:

‘The buffet is plentiful…but you’ll get food poisoning if you make the wrong selections…[and] the obvious solutions are rarely the best ones…’

Intrigued? Go here to check out the ‘Royal Dividends Portfolio’.

Regards,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

Dear Reader,

Will this new financial crisis continue? We know that a banking crisis has already begun. Here’s the casualty list:

Silvergate Bank — Announced its bankruptcy on 8 March 2023
Silicon Valley Bank — Taken over by the FDIC on 10 March 2023
Signature Bank — Taken over by the FDIC on 12 March 2023
First Republic Bank — US$30 billion liquidity rescue by 11 banks on 16 March 2023
Credit Suisse — Swiss Government shotgun wedding with UBS on 19 March 2023

That’s five bank failures or rescues in 11 days, including Credit Suisse, one of the largest banks in the world and the second largest in Switzerland.

Combined losses of stockholders and creditors of these institutions exceed US$200 billion. Market losses in the banking sector are much greater.

Walter Wriston, the greatest banker of the 20th century after Pierpont Morgan, personally tutored me on this topic 40 years ago.

In a bank run, you can pull your money out of banks and invest in gold, silver, land, or anything else. But you give the money to the seller, and she puts it back in the bank.

The point is the money always ends up in the bank. The system is a closed circuit.

Of course, it could go to a different bank, but all banks can borrow from each other through the fed funds market and the Eurodollar market. Again, the money always ends up in the bank.

Putting cash in a coffee can (or mattress) is one exception, but if you try to withdraw more than US$10,000, your bank will file a Currency Transaction Report (CTR) with the Financial Crimes Enforcement Network (FinCEN), and you’ll end up in a file next to Osama bin Laden. And the IRS gets a heads-up.

So, that’s not a practical solution.

These failures and rescues were accompanied by extraordinary regulatory actions.

These actions have thrown the US banking system and bank depositors into utter confusion. Are all bank deposits now insured or just the ones Janet Yellen decides are ‘systemically important?’ What’s the basis for that decision?

The most important question is: Is the crisis over? Has the Fed done enough to reassure depositors that the system is sound? Has the panic subsided?

The answer is no.

The panic is just getting started

We base that answer on the history of the two acute financial crises in recent decades — 1998 and 2008.

The 1998 crisis reached the acute stage on 28 September 1998, just before the rescue of LTCM. We were hours away from the sequential shutdown of every stock and bond exchange in the world.

But that crisis began in June 1997 with the devaluation of the Thai baht and massive capital flight from Asia and then Russia. It took 15 months to go from a serious crisis to an existential threat.

Likewise, the 2008 crisis reached the acute stage on 15 September 2008 with the bankruptcy filing of Lehman Brothers.

But that crisis began in the spring of 2007 when HSBC surprised markets with an announcement that mortgage losses had exceeded expectations.

It then continued through the summer of 2007 with the failures of two Bear Stearns high-yield mortgage funds and the closure of a Société Générale money market fund.

The panic then caused the failures of Bear Stearns (March 2008), Fannie Mae and Freddie Mac (June 2008), and other institutions before reaching Lehman Brothers.

For that matter, the panic continued after Lehman to include AIG, General Electric, the commercial paper market, and General Motors before finally subsiding on 9 March 2009.

Starting with the HSBC announcement, the subprime mortgage panic and domino effects lasted 24 months from March 2007 to March 2009.

Averaging our two examples (1998, 2008), the duration of these financial crises is about 20 months. This new crisis could have a long way to run.

Regards,

Jim Rickards,
Strategist, The Daily Reckoning Australia