25 Jul

Teetering on an Economic Knife-Edge

“What does ‘the death-of-deflation’ mean for America?” – The Lonely Realist

TLR yesterday received the following letter from Cassandra, the mythical Trojan princess gifted by the Greek God Apollo with the ability to prophesize and burdened with the curse that her prophesies would not be believed. As readers of TLR well-know, there have been many times over the last 7-1/2 years when TLR has tapped into Cassandra’s predictive abilities. Some of her predictions have proven accurate and others less so…, which is a risk when consulting a mythical figure. Cassandra, after all, can only imagine interpreting portents, sifting data to discern future probabilities and using her fabled 3,000 years of experience. Readers, however, should be aware that even with her record of discerning prophecies, her views (as well as those of TLR) are not investment, economic, legal or tax advice:

Dear Mr. Realist:

I have given deep thought to your July 4^th commentary, “The Art of Inflation,” in which you predict that the Federal Reserve will lower interest rates in an effort to satisfy the President. Doing so would, after all, moderate consumer inflation and incentivize asset inflation, both of which are Trump 2.0 goals. You therefore conclude that America is in for a further run of Quantitative Easing. That is not correct. It is not the path that Fed Chairman Kevin Warsh will follow. Those who adopt your reasoning, Mr. Realist, will be economically devastated. Interest rates over the coming years will trend higher, not lower. History demands an inflationary direction…, and for cogent experiential reasons.

For >7 decades after the Second World War, the U.S. dominated the global economy, reigning supreme as the international mercantilist. By rebuilding the economies of Europe and much of Asia, both became economic dependencies, eager clients for American goods and services as well as willing suppliers of raw materials and inexpensive manufactured products. This was the golden era of globalization during which the law of “comparative advantage” benefited America by maximizing its huge educational, agricultural, manufacturing, research, and technological advantages and compelled other countries to focus on producing cheaper goods and services to satisfy American needs. During the globalization era, goods frictionlessly flowed among countries. Throughout, the balance heavily favored America. That era has ended. One consequence of globalized “comparative advantage” was that, because the U.S. bought lower-cost goods, services, minerals and machinery from foreign producers, America’s businesses priced themselves out of competitiveness with respect to those goods, services, minerals and machinery…, as well as with respect to others that, at the time, seemed unattractive (for example, because of environmental policies). America therefore exited certain industries that now are critical.

The effect of “comparative advantage” was deflationary. Because goods and services were sourced at their lowest possible cost, consumers all over the world were able to buy everything at their relatively lowest prices. Consumers gave little thought to where goods and services came from, and businesses (and the American government) gave little thought to the sources of raw materials and machinery or to the policies of the countries supplying them. America’s government, its industries and its populace operated on the assumption that goods, services, raw materials and manufactured goods would be available indefinitely at reasonable prices.

The world today is experiencing a reversal from American-led globalization to multi-polar deglobalization that necessarily is creating — and will continue to create — global inflationary pressures. Epochal changes in American foreign policy, America’s disruptive tariff policies, and changing American immigration policy are combining with expanding global conflicts to accelerate “competitive disadvantage.” As a consequence, costs are increasing as governments and industries prioritize input redundancy, security and control instead of optimizing for price and efficiency. Countries and industries therefore are duplicating investments…, which has costs. Prices for goods, services, raw materials and manufactured products are inflating … and are destined to continue doing so. Moreover, as redundancy and capacity increase, the amount of money needed to fund ongoing expansions will create further inflationary pressures. With government and corporate debt at historic highs, risks to the financial system are multiplying. Because businesses and consumers have been conditioned to expect declining interest rates as well as cheap financing, the next several years are going to be very different from the last 7 decades.

The Fed most definitely would prefer to lower interest rates, Mr. Realist. As you’ve written, it would like to satisfy the President. The Administration’s Bureau of Economic Analysis is doing its part to further the President’s interests by providing statistical justification that would support the conclusion that inflation is moderating by adjusting its calculation of the Personal Consumption Expenditures component of CPI, which is expected to lower core inflation by ~0.2 percentage points [ED NOTE: as TLR previously projected, such justifications are likely to increase]. But declining inflation is not the reality and will not sufficiently motivate the Fed to lower interest rates in today’s inflationary environment where doing so could galvanize increased spending and accelerating inflation. Gasoline and agricultural prices are continuing to rise (with America’s Strategic Petroleum Reserve now at 44% of capacity, its lowest level since 1983, and US crude inventories at a 40-year low), supplies of critical goods are tightening, AI token costs are doubling every 45 days while productivity is gaining only 5%, and the Department of War now is requesting substantial additional funding that will further increase the Federal deficit (with 2026 defense expenditures already having exceeded budgetary authorizations in funding a war that shows no sign of ending). Even though the Fed cannot lower interest rates, it also cannot raise interest rates in today’s overleveraged financial environment without flouting the President’s wishes and risking a self-reinforcing waterfall in asset prices [ED NOTE: the 2-year US Treasury bill now is at 4.34% compared with 3.48% on January 2^nd]. Given the Fed’s record of QE interventions and money printing, the enormity of Federal spending deficits, and the potentially calamitous global arms race, the Fed’s hands are tied.

My conclusion, Mr. Realist, therefore is that inflation and Federal debt and deficits are destined to increase while the Fed Funds Rate remains range-bound and bond/commercial interest rates face growing pressures.

Finally (from a good friend)