A little over six months ago, when stocks were still trading near all time highs, former NY Fed repo guru and current Credit Suisse strategist Zoltan Pozsar made an immodest proposal to the Fed: crash stocks to contain inflation, to wit:
The FOMC has one big problem: inflation. There are two ways to slow inflation: by hiking short-term interest rates or by forcing long-term interest rates higher. Historically, the Fed used rate hikes to engineer recessions that generated the slack needed to keep inflation in check (“opportunistic disinflation”). With the Fed’s “updated dual mandate” of inclusive low unemployment and the political imperative of redistribution through firmer wage growth at the bottom of the income distribution, the Fed aiming to slow inflation via a recession is unimaginable. Hikes today then are meant to slow inflation without a recession… which is not something that the Fed has ever managed to achieve before.
Zoltan was also confident that "lower risk assets won’t kill growth" and his solution to contain inflation and "to improve labor supply, the Fed might try to put volatility in its service to engineer a correction in house prices and risk assets – equities, credit, and Bitcoin too…" In short: crash everything.
Fast forward to today when once again the Fed has followed Zoltan's advice to a tee with stocks in a deep bear market, bitcoin in another crypto winter, commodities soared then plunged (with the exception of nat gas and oil), the economy in a technical recession... and yet inflation remains sticky to the upside.
Of course, with oil and gasoline sliding in anticipation of Biden's recession, and most other commodities at or below Ukraine war levels, it's unlikely that inflation will remain quite so sticky, especially when considering that yesterday, we saw the ISM-Prices Paid sub-index print 60.0, down from 78.5 prior. This, JPMorgan writes, “...feeds into our house view from Mike Feroli that between now and the September FOMC we should continue to see CPI levels cool due to energy prices/base effects and along with likely softening in jobs data, indicative from higher initial claims recently, leaves us expecting a 50bp hike in September and a more dovish stance for the rest of the year. Jackson Hole at the end of August could deliver more support for the dovish pivot.”
Here we completely agree with JPM for once, as it has been our base case for a long time that the Fed will use this month's Jackson Hole to hint at the coming dovish reversal.
But let's assume that's not the case and inflation remains deeply entrenched, Friday's jobs come in hot, wage growth continues to beat expectations as the wage-price spiral proves unbreakable, and next week's CPI print comes in far hotter than expected. Well, that in a nutshell is what Zoltan Pozsar's latest note is all about.
According to the repo guru, inflation is now so embedded, that the US economy may need to undergo a deeper and longer recession than investors (and he himself) anticipate before sharply higher prices can be brought under control.
Amid growing expectations that peak CPI is now well in the rearview mirror, markets have turned increasingly receptive to a dovish pivot by the Fed, but according to Pozsar, there’s a high risk that global cost pressures will remain elevated, in large part because inflation is not just a function of excessive cyclical stimulus but also the result of the war economy, the shift in supply-chains and other structural reasons which will not be easily undone, to wit:
After visiting over 150 clients in eight European capitals over six weeks, my impression is that the expected path of Western policy rates rests on two hopes: first, that inflation is about to peak; second, that we are near peak hawkishness.
Obviously, if the first view is right, the second view is right too. But the risk with the first view is that it assumes a stable world with no geopolitical risk premia where demand management is more powerful than issues related to supply, when in fact we live in an unstable world where geopolitical risk premia are rising and where supply-side issues are more powerful than demand management. It follows that if the first view is wrong (inflation is driven by the economic war, not stimulus), the second view is wrong too (we are not at peak hawkishness). The aim of today’s dispatch is to highlight risks to the peak hawkishness view. We won’t be forecasting. We’ll be observing.
Pozsar then follows with a rather long and rambling "observation" that lays out his views on how inflation had disappeared in the past 40 years, which draws heavily on history and geopolitics, goes through a tangent about the "great macro investors" of our generation George Soros, Stanley Druckenmiller, Paul Tudor Jones, and Louis Bacon "who traded in a peaceful world, punctuated only by relatively small military conflicts.... But today’s conflict, a complex economic war between “empires”, drives the fourth price of money: the price level and its derivative – inflation", before turning his attention to today's sticky inflation:
Inflation today is simply everywhere. It’s plain impossible to talk to anyone who doesn’t complain about rising prices, or to read the financial press without articles about inflation. It is also impossible to have a client meeting where inflation is not the center of discussion. As James Aitken recently noted, “inflation expectations are well anchored when nobody talks about inflation”, and by that measure, inflation expectations are becoming clearly unanchored...
As a relatively junior member of the Credit Suisse economics team explained to me recently, “the experience with forecasting inflation in the post-pandemic period has been humbling; everyone’s forecasts have been way off, including the Fed’s”.
Now, if an economist straight out of university gets that in a stochastic world – where the price of everything is thrown around randomly by a pandemic and an unrestricted economic war – inflation is impossible to forecast, why is the market so confident that inflation is about to peak? Because the Fed says so?
For once, Pozsar's argument is hardly unique or even insightful: all he is saying is that he is on the side of the argument that views the Fed as remaining hawkish for much longer than markets anticipate. Well, with all due respect, that's the argument that the Fed itself has been making this week in hopes of pushing yields higher, stocks lower and sending financial conditions sharply tighter. After all, the opposite would mean that all the rate hikes it has done so far will have been for nothing if the market is now pricing in a much easier Fed in the future. All Pozsar is saying is that he sides with the same Fed that he on every possible occasion indirectly claims is clueless. That's just a little... concerning.
Of course, it doesn't mean that the Credit Suisse banker is wrong, although in this case, he likely is, especially if we get a handful of catastrophic eco prints, and the political pushback to more hikes becomes a raging howl of rage from the likes of Liz Warren, the progressives and eventually, Biden's handlers who will soon realize that mass layoff-inducing recessions poll even worse than soaring inflation.
Ignoring the most basic lesson of capital markets, that inflation is always a political - not market - consideration, Pozsar then tries to squash any parallels between the current experience and the recession of the 1970s and early 1980s, saying that unlike then, a couple of rate hikes will be insufficient to eradicate inflation. He lays out several reasons why that is the case (professional subs can read all about them in the report available in the usual place), but one example is amusing enough to highlight. Discussing why the US labor market will remain broken for a long time (i.e., not enough workers, and persistent wage-price spirals) Zoltan writes:
"today we have a bigger problem: a shortage of labor, particularly in services, which is due to a mix of factors such as tougher immigration policies to appease nativists; early retirements and other labor market changes driven by the pandemic; and extreme wealth gains sapping labor force participation on the one hand (“feel rich, work less”) and driving demand for services on the other (“feel rich, spend more”). It’s a mess: it’s easier to deal with the politics of wage setting than it is to “grow” people – even in The Matrix, that’s possible only over time. Until then, we are stuck with a labor shortage, and President Biden’s top labor lawyer is the anti-Reagan: she’s encouraging the unionization of workers from Amazon to Starbucks..."
True, he may be on to something... but again, nothing that a good, hard recession - or depression - can't fix (an outcome which will only force the Fed to step in and reverse the slowdown as soon as feasible, restarting the cycle from square one).
So what does Pozsar think will help? Well, as he writes, "instead of playing “catch-up” with the pre-GFC trend of aggregate incomes, we’re now playing “catch-down” to the post-nativist, post-Covid, and post-Ukraine trend of aggregate supply. The level of economic activity needs to adjust down in an “L”-shaped manner. If it doesn’t, we will have more inflation problems..."
Ah yes, the politics of convincing people that the standard of living will decline and stay there. Good luck passing through through committee - or Congress - without historic blowback and/or a revolution. In fact, one could argue that it's even more difficult to reset the economy into a lower step level of output than it is to contain inflation at the expense of recession (something we now know won't last long especially after we recently wrote that "Democrats Prepare To Unleash Hell On Fed Chair Powell For The Coming Recession").
Which is not to say that Zoltan is wrong: as far as we are concerned, he is 100% spot on. But trying to convince 300+ million Americans that the stellar standard of living (both in absolute and certainly relative terms) they've been accustomed to for decades is now gone for the foreseeable future... well, good luck with that. So yes, the Hungarian is right, but his proposal is impractical from the offset. But
this note is not about what we think, but what Pozsar believes, so let's get back to that.
In this context, the market’s recession/no-recession soul-searching is ridiculous: if the inward shift of supply curves across multiple fronts (labor, goods, and commodities) is the main driver of today’s inflation; if demand needs to be curbed significantly to slow inflation; and if a substantial reduction of aggregate demand means an “L”-shaped path for the economy, why is it so bloody hard to see that we need a recession to curb inflation? Instead of the question of “whether”, why don’t we think about the “depth” of the recession needed to curb inflation?
Zoltan next shares some more insights which lead us to believe that for all his financial genius, he is simply unfamiliar with the American mindset:
In a global economic war, it isn’t possible for every major country but the U.S. to be engaged in “general mobilization”, and if Jay Powell is engaged in the “general mobilization” of Paul Volcker’s legacy, he also needs to engage in a “general mobilization” of U.S. consumers to spend much-much less; that is, “general mobilization” in the U.S. means a recession. A big, long-lasting one...
...to purge the “Super Size Me” mentality and replace it with Jimmy Carter’s theme of living thriftily (a “cultural revolution”). And that involves not only slowing the interest-rate sensitive parts of the economy (housing and durables) but also reducing demand for labor in the service sector, which, as we have argued here and here, is a function of the level of wealth across a range of assets (housing, stocks, as well as crypto) to weed the “feel rich, spend more” and “feel rich, work less” mentality from the system. And what the Fed is telling us when it flat-out dismisses two quarters of negative GDP growth is that it it isn’t focusing as much on the rate-sensitive parts of the economy as it did in the past. Instead, it is focusing much more on the services economy and the labor market, which still remain strong. And therein lies the cautionary tale for the market...
Alas, here again Zoltan reveals that his thinking about America at the socio-economic level is extremely naive, and fails to account for centuries of corrupt political incentives and of course, an American mentality of "me first" and "we rule the world." We are confident he will figure it out in due course, but until then let's pursue his idea about a voluntary permanent slowdown in the US economy:
The market can talk all it wants about a “soft landing,” but as explained above, we need an “L”-shaped adjustment in activity, and an “L”-shape has two parts: first an “I” which you can think of as a vertical drop (perhaps a deep recession); second, an “_” which you can think of as a flatline (stagnation, as in stagflation).
Regarding the first bit, there is nothing “soft” about a vertical drop.
Regarding the second bit, there is nothing that guarantees an interest rate cut after the vertical drop: stagnation, especially when paired with inflation (stagflation), means that interest rates may be kept high for a while to ensure that rate cuts won’t cause an economic rebound (an “L” and not a “V”), which might trigger a renewed bout of inflation. To date, I haven’t heard anything from the FOMC that would suggest that the Fed wants to avoid a recession (“there will be pain”), or that the Fed would rush to cut rates if we had a recession with high inflation (“we’ll cut when we are confident that rate cuts won’t ramp inflation back up”).
Well... maybe Zoltan should stop listening to the Fed - which itself now admits it is clueless and will no longer provide forward guidance, and instead will react to data - including "data" from US politicians - and listen to Congress, where anger at the Fed is already building up.
To be sure, there was a faint glimmer of realization that the inflation debate is not about the Fed but about Congress in Zoltan's conclusion, where he touches upon something that should have been the core of his paper, namely that the Fed is accountable to Congress, and as such, it is up to Congress to decide what is a bigger threat: inflation... or a crippling recession and an L-shaped collapse in economic activity.
If you think that the peak of tightening is 3.5% because inflation peaked, and that cuts are coming next year because a recession is nigh and stocks are now at the cusp of a bear market (maybe not, because we need a recession, and lower asset prices are the path to a recession), you might be terribly wrong.
On the other hand, since that is also the narrative pitched by the Fed which is always wrong, you might be "terribly right." But we digress.
Bill Dudley and Larry Summers are right about the direction of travel (more from here, not less), but Jay Powell sets the pace... ...because he is accountable to Congress; Dudley and Summers are not. But make no mistake about it: the risk of the Fed hiking to 5% or 6% is very real, and ditto the risk of rates cresting there despite economic and asset price pain. The market and the Fed’s SEP (perhaps the market, because of the Fed’s SEP) is telling us that we will curb the biggest outbreak of inflation in fifty years with a “hiking cycle”, where the peak of the “hiking cycle” next year corresponds to negative real interest rates... unless you think that inflation moderates to target, that is 2%, by next year. If that is true, I am going to re-take Economics 101.
What could I be missing?
A lot, Zoltan, and you yourself admit it in the penultimate paragraph of your note:
Is Jay Powell a dark horse who is more political than serious about inflation? I do not think so. Once you go down the path of invoking Paul Volcker’s legacy, you can’t avoid making good on that promise: if you do, you damage the Fed’s reputation irreparably. The risks are such that Powell will try his very best to curb inflation, even at the cost of a “depression” and not getting reappointed...
Between a deep recession and damaging the Fed’s reputation as an institution, a deep recession is the lesser of two evils. The former is public service, and the latter is public disservice. The former is a central banker’s clear conscience, and the latter is a life-long burden. Whether Jay Powell will succeed in slaying inflation is not the question; in the context of economic war, we can doubt that. Rather, the question is whether he’ll try his best to slay it. There I have no doubts.
The problem with this line of thinking is that Pozsar thinks anyone - whether Congressional Republicans or Democrats - will agree to a "depression" just to contain inflation. Spoiler alert: they won't as it means an immediate end of all their political (and all other careers). Instead, they will browbeat Powell and the Fed, into doing just enough to avoid this outcome even if it means raising the inflation target, which we are 100% certain is how this episode ends: with the Fed raising its inflation target quietly from 2% to 3% or more, with the usual hedonic adjustments of course.
To summarize: the problem with Pozsar's latest note is that it is too rational, too logical, and it reduces to the following - US society can be fixed at the individual level by realigning incentives, motivations and beliefs, and the Fed will do what is right even if it means the collapse of the US political system. Alas, that will never happen, and that's why Zoltan's argument crashes and burns. After all, it's far easier to simply print a few trillion (again) and kick the can for a few more years and dump the plate of troubles on some other unhappy politician. It's also why the gating constraint here is not inflation but the dollar reserve currency status: at the end of the day, the Fed will devalue the dollar to permit both more monetary and Fiscal easing thus keeping both the lower and upper classes happy, and it will keep doing so until it risks hyperinflation - pushing the dollar-based to the point beyond which the world will no longer accept it; after all, that was the endgame since the day the Fed was launched in 1913.
Professional subscribers can access the full Zoltan Pozsar note in the usual place.