Three months have passed since the infamous Jackson Hole Symposium in August. This year's event was widely expected in the backdrop of COVID-19 crisis and lockdowns that had triggered unprecedented monetary and fiscal stimulus. The Fed's Chair Jay Powell did not disappoint by announcing a new policy towards inflation which allows overshooting of the previous target of 2% while aiming for the average inflation rate to be at or near 2%. CPI numbers published in the U.S. last week revealed a narrative that the Fed's effort has not yielded in any return as the core inflation was flat 0%, vs consensus expected +0.2% (MoM); and 1.6%, versus the consensus expectation of 1.8% (YoY).
Despite record amounts of monetary and fiscal stimulus that pushed U.S. annualized GDP growth in Q3 to 33%, flat core inflation must be causing a headache to the Fed. Absolute stagnation of prices of everything from education, hospitality, restaurants, delivery services and home improvement, should feel like a bucket of cold water. Other economies are not faring much better – Eurozone headline inflation is currently -0.3% (core 0.2%), Japan headline 0.0% (core -0.3%), U.K. headline 0.5%, Canada 0.6% and even the mighty China is struggling with 0.6%.
Whilst one cannot discount the ripple effects of the pandemic and subsequent lockdowns to people and the economy, it's hard to pat the central bankers on the back. Meeting inflation expectations is after all one of their two mandates (on top of maintaining full employment). Growth has been scarce since the GFC, and advanced economies have witnessed deflation, or meagre inflation oscillating between 0% and 2%. So, we entered this crisis with a slowing economy, borderline deflation and record amounts of debt. Additionally, there have been several secular trends in place that contributed to the dis-inflationary environment.
A few previously established secular trends were working from home, cooking at home, de- urbanization and do-it-yourself economy. COVID-19 related lockdowns only expedited each of these as blue-collar workers retreated to their living rooms and kitchens. City dwellers realized they could get more and pay less by living in the suburbs or even other towns or states. And lastly, people discovered the beauty of doing things with their own hands. From an economic perspective, these phenomena translate into less consumption as suddenly there is less demand for gasoline, cars, restaurants, commercial real estate and for other goods and services. Thus, what is left, is a huge demand shock pushing the prices lower and creating a negative output gap we have never seen before. All major economies, except for China, witness a record contraction in their economic activity this year due to COVID-19 related lockdowns, in nominal and real terms.
Another variable impacting aggregate demand was increased savings rate. Understandably middle- and low-income workers have been scarred, having experienced or witnessed job losses and bankruptcies at such a large scale. Supported by government transfer payments and subsidies, the same people decided to pay back their loans and save for rainy days, instead of consuming. Global savings as a share of world GDP has surged since 2008, hovering near 26.5% as of November. In the U.S. long-term saving rate has fallen from the peak of 33.7% in April to 14.8% in October and is expected to stabilize near 9% (vs previous long-term rate of 7%) as per Rosenberg Research estimates. Middle- and low-income classes generally have higher propensity to consume but less so as we advance, which will act as a drag on growth. Consumer spending, which is around 70% U.S. GDP, and consumer price index, will be impacted.
What does this mean for global markets? We know that growth will continue to be scarce is the most advanced economies. China is an exception as they continue to pour money into capital investments which are currently around 45% of their GDP. That growth, however, is fueled by debt. The sustainability of such growth is a topic for another post. The U.S. is also looking to stimulate the economy through fiscal spending under the new administration. We expect President-elect Biden to focus on rebuilding infrastructure, igniting several green initiatives, and support small businesses and individuals through transfer payments. These actions can potentially increase inflation and velocity of money. The Eurozone does not have the luxury of fiscal spending due to member states having autonomy over the expenditure. However, we expect the ECB to announce further easing in December to escape from deflation spiral and weaken EUR that is currently near 2-year highs at 1.1841 vs USD.
The markets seem relatively lukewarm when it comes to inflation – GLD (SDPR Gold shares), trading at 174.68 is testing support levels near 174.00 that was established in September but has already broken all short- and medium-term moving averages. The 200-day moving average is not too far near 168.13. 10-year treasury yield is currently 87 basis points, whilst 10-year breakeven inflation rate is at 1.7%. Crude oil futures are currently trading near 42.0 levels – still rangebound since early June, failing to break the 44.0 resistance levels.
Central bankers seem out of tools when it comes to boosting inflation and need to be supported by governments' easing policies. Once the dust settles after lockdowns and the U.S. election madness, we can assess whether the Eurozone and the States are on the path of becoming Japan, or whether they can break the vicious deflation spiral.
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