Used to Fixating on the Central Bank, We Are Missing that the Central Government is Trying to Take the Mantle of Running the Economy. We are Witnessing the Rise of Fiscal Dominance. We Believe This has Long-Term Inflation and Growth Implications.
A Century of Moving to the Black Hole of Centralization
Nearly 100 hundred years ago much of the world took a hard turn toward strong central government control as numerous elites of the day were enamored by fake Soviet success, China's Communist Party had won out and even the United States had veered toward big government with the New Deal. Centrally planned economies in the Soviet Union and China ultimately proved to be failures in the post-war economic development race. It was not until China's unique embrace of free-market reforms in the late 1970's that the stage was set for its astonishing growth. Now, here we are just six years away from the 100 year anniversary of Black Tuesday and the fiscal is eclipsing the monetary in influence on economies and the money supply. Whether under the guise of industrial policy or solving the social ills of the day, the centralized fiscal authority model is emergent. Starting with the avoidance of the banking system's liquidity function during the Covid stimulus packages to the institution of tariffs and regulatory barriers designed to accomplish social goals, the fiscal camp is, in our view, creating numerous issues that will erode soundness of economic growth and price stability.
Near-Term, Inflation Peaks but What Then?
Forecasts for the inflation trajectory for 2023 abound and let's be honest, estimating a turn in the cycle of accelerating inflation into 2023 is pretty straightforward. Just consider the four charts below where we show money supply changes, oil prices, food prices and wages. Energy, commodities, industrial metals and food all peaked in Q1/Q2 2022, so on simple compares these will likely contribute to a dis-inflationary impulse as we head into 2023, especially as the economy continues to weaken. Money supply is also declining, the most since 1980. Finally, the rate of increase in hourly wages looks to likewise have peaked. So, on base effects alone, inflation is likely to decline over the next several quarters. This is well known and may even have bias to the downside given the deceleration in economic growth.
Why are we even writing about inflation if the likely scenario for 2023 says "problem solved"? This is because our interpretation is that it matters where inflation settles in over the longer term. The cycle in monetary stimulus and the macro-economy will determine much of the short term, but we see structural issues coming into play over time. Two of these we see emerging are sustained lack of fiscal discipline and more friction in the global trading system. Two stark examples of the move away from a globalized supply chain and their effect on price levels are the Covid19 pandemic and the Ukrainian War. The pandemic constrained supply as transport and production were dramatically cut. Then energy availability became severely disrupted as the number #2 oil producer invaded its neighbor. Even as supply chains have opened substantially from the lock-down days in 2020 and China appears to be gradually opening, the economies ex-China are slowing considerably. We would highlight three fiscal/regulatory events that could somewhat offset better supply availability over time. These are the European carbon tariff scheme, the trade implications of the US environmental transition and the deficit implications of the recently passed $1.3 trillion American budget. We understand these three to be medium-term inflationary and proof points that while central banks may be serious about price levels, political actors (the fiscal) are not.
Life remains full of mysteries but one that continues to befuddle us is the strange coziness that the political class (the fiscal camp for purposes of this discussion) still feels for policies, regulations and tactics that are inflationary and anti-growth. Slow growth accompanied by inflation is clearly more negative for the lower income population as their purchasing power is destroyed and employment security is threatened. Given the political instability that comes with periods of inflationary spikes and more specifically, the regressive impact that accompanies it, why would any politicians go for this? Why would governments enact policies that will make the situation worse? Either the fiscal actors don't see how their actions impact price levels and growth rates or they judge benefits in other areas (for which they presume to get credit) as more than offsetting. In reality, this is not very mysterious. In politics, the promise of benefits received today eclipse the difficulty of the payment tomorrow.
Some of these fiscal moves recently highlight why we believe the inflationary environment will not revert to the period of lower highs and lower lows of the mid 1980's to the late 2010's. We realize there are potential natural offsets over the long-term to some of these actions (think demographics) but we are mostly convinced aging populations are CERTAINLY growth curtailing and MAYBE deflationary. We expect a higher average level of inflation over the next several decades, above the 2.6% we calculate for the previous regime from the early 1980's to 2020. This is part of the new regime we see investors facing over the years to come.
Own Goal #1: The Carbon Border Adjustment Mechanism or CBAM
This one is brought to us by the EU in the form of a carbon border tariff. This is designed to prevent cheaper goods from countries with weaker environmental rules from leaking into the EU trading zone. Europeans in favor of this are touting how this will support domestic industries and reduce reliance on global trade. This is a vivid example of the inflation cost of re-shoring supply chains and creating a sort of economic stick with which to beat CO2 heavy economies that currently supply price advantaged inputs such as iron, steel, cement, hydrogen, fertilizers, electricity and aluminum.We have no interest here in wading into the deep waters of international trade law, the distribution and use of tariff revenues or the effects of this action on less developed countries. Our call is simple on this. Increased costs of compliance and monitoring, expenditures to construct cleaner processes and the very payment of adjustment tariffs are inflationary. In our world of probability weighting future states in order to invest to them, we don't need to wait for a fancy model on this, frictions raises costs, they do not contain them. Own goal #1.
Own Goal #2: The Inflation Reduction Act
The Inflation Reduction Act (IRA) wins the prize for most misnamed legislation of the century so far. What is really the US government's effort to make a strong step forward in their climate change mitigation agenda is assigned a name that has nothing to do with what the bill actually does. The objective analyses conclude the IRA will not affect the trajectory of inflation (CBO, Wharton-Penn) measurably, if at all, over the next decade. We interpret the bill by looking at the set of friction points it has. These two are primarily the local content and prevailing wage aspects of the bill. Incentivizing local content rules we believe can cause distortions in the international competitiveness of domestic producers, invite retaliatory moves by other countries and since access to potentially lower input prices is constrained, is likely to support end prices, not reduce them. Further, our firm view is that subsidies that support demand are inherently inflationary, think student loan availability and university tuition in the United States. This is essentially the same line of thinking when we consider the prevailing wage rules inside the bill which pretty much sets a floor, potentially higher than the market derived level, at which wages must be paid. The IRA looks to us as a garden variety industrial policy bill where the political class is imposing local content/wage restrictions, this time for certain types of clean energy build outs. Friction in whatever form is on balance inflationary, regardless of what we call it.
Own Goal #3: The Recently Approved US Federal Budget of $1.3 Trillion
The omnibus budget recently passed by the US government will total $1.7 trillion in discretionary spending, resulting in a total deficit for the 2023 fiscal year of $908 billion, according to the CBO report on the President's budget. CBO also projects an average deficit of -4.1% of GDP for the 2024-2030 time period and public debt to GDP of 97.5% for 2023-2030. These compare unfavorably to a 50 year average of -3.2% and 43.0% of GDP for the deficit and debt, respectively. This budget is basically an own-goal double, negative for inflation AND growth. Debt levels are projected over twice what they have averaged over the last 50 years and well above what various long-term analyses have found is detrimental to growth in industrialized countries. Our interpretation of these over-levered economies as well as individual companies is that at the high end of spectrum of debt/GDP(equity), growth is constrained. At the micro level, access to credit facilities to a point is necessary for commercial concerns to grow as they finance working capital and capital expenditures. However, degrees of capital deployment freedom suffer if a company becomes highly indebted (the level is dependent on business model and capital intensity profile and can vary dramatically). When the fight is between ratios demanded by bond holders and the ability to return capital via say, dividends, the ability to invest becomes constrained. Likewise, the ability to react to economic shocks is diminished. We believe much the same goes for the aggregate economy. Consider interest expense as projected by the CBO will increase 118% from 2023 to 2030, while total outlays ex interest rise by just 26.9%. So interest expense will make up 12.2% of total outlays by 2030 and 50.9% of discretionary spending, up from 7.5% and 25.2% for these same metrics in 2023. When combined with the well-known demographic issues of flat lining growth in working age adults, the spending profile and debt implications of the central government's lack of spending restraint all but locks in a lower growth profile going forward.
What of the deficit's impact on inflation? Inflation is not a single variable phenomenon but rather a results of a mix of factors. One we see influencing price levels is the monetary base, in the case of the chart below, specifically M2. The other are fiscal deficits run by the Federal government. Our belief is that these two forces can sometimes work to offset each other if they are moving in opposite direction. That said, all else equal, deficits contribute to inflationary impulses and given the scoring of the 2023 Omnibus budget that calls for deficits sustainably above long-term trends, we see the lack of fiscal restraint as a contributor to higher baseline inflation on a secular basis. Own goal #3.
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