Can the Fed Kill This Inflation Without Killing Too Many Other Things First?

Your humble blogger has argued that central banks are not going to be able to do much to address our current very bad and getting worse inflation outbreak. This inflation is not the result of excessive demand, as commonly conceptualized, but a marked, and it sure looks like durable, contraction in productive capacity.

Some of that loss is due to Covid. The US has lower labor force participation than before the pandemic, yet unemployment is low and many establishments complain about the difficulty in getting workers. Covid led many, particularly in the medical establishment, to retire early. Covid also got some couples to realize they could get by on one income and they’ve decided they like it that way. Some low wage workers decided they aren’t going back to high risk positions in restaurants and retail. Some got long Covid and can’t work full time. And a million people died, some of them working age. Pilot shortages are the tip of the iceberg of a thinning out among seasoned employees who are hard to replace.

We had supply chain bottlenecks and breakage during Covid and that’s still not cleared up. China has been and will still lock down as needed, and the West be damned. Many ports are still a mess.

And we have yet to get to the elephant in the room, the Russia sanctions blowback. The US and EU would put even more sanctions on if they were not already scraping the bottom of the barrel….even though Russia is not only not bowed, but coping surprisingly well. The central bank just cut rates again to 9.5%, the level they were at before the war, and is worried about the rouble, now at 58 to the dollar, becoming too strong. As we predicted, car parts are a mess, but the latest Levada poll, from May (and remember Levada is the most anti-Putin pollster in Russia) found that only 16% of respondents reported that the sanctions were causing “very” or “quite” serious problems for their family (the next category was “didn’t create any serious problems”).

You can find a vastly more comprehensive and well-documented explanation of where our inflation came from in a Servaas Storm post, Inflation in a Time of Corona and War.

But even though the West is suffering far more from collateral damage of the sanctions, most of all higher energy prices, there’s not even a peep in the press about rolling them back.

So because our policy-makers refuse to do things like make workplaces less scary for the Covid-cautious, or unjam ports, or climb down and admit they were wrong when business survival and citizens’ lives are at stake, they’ll leave it all to central bankers and their blunt instrument of monetary policy.

To reduce things to simple-minded but still pretty accurate terms, since too much demand is not the cause of our inflation, it correspondingly seems likely that central bankers will have to overkill the economy to kill inflation.

We’re not the only ones thinking along these lines. The hedge fund manager who writes as Doomberg passed around this tweet:

I suspect Gromen is fighting the last war. Yes, many experts do expect to see developing nations winding up with debt defaults, but that’s the result of high energy and food costs, and the high dollar. Those bad outcomes are baked in unless the so-called collective West does a fast about face with sanctions, which is not in the cards.

It is true that when Paul Volcker let interest rates go to the moon, he had to relent sooner than he liked due to the Latin American debt crisis, which was particularly imperiling America’s favorite risk-binging big bank, then Citibank, later Citigroup. But the flip side is oil prices had peaked as of April 1980, yet Volcker had even more brutal rate hikes in 1981. Were those necessary, or would have inflation fallen, albeit less quickly, once energy prices started retreating, and at lower cost to the US economy? One consequence of Volcker driving rates so high in 1981, to see them drop in 1982 and 1983, was a big rise in the formerly weak dollar. US automakers lost tremendous share to the Japanese during a 30 month period, and they never got it back.

In other words, we’ll have emerging debt crises whether or not advanced economy central banks act.

Where I see big rate increases doing serious damage is in leveraged activities, and we have hidden leverage aplenty due to far too many years of super low interest rates, plus the Fed conditioning investors to expect the Greenspan/Bernanke/Yellen put to rescue them before things got too awful.

And where is the big leverage bomb likely to sit? In derivatives. Recall the Archegos “family office” meltdown. Bill Hwang used total return swaps to turbo-charge his investments in certain stocks, when Great Depression reforms were designed to limit margin loans against stocks to 50% of the price. Per the Department of Justice, “In one year, Hwang allegedly turned a $1.5 billion portfolio and pumped it up into a $35 billion portfolio.” Admittedly, that was purportedly due to market manipulation too, but that is still a lot of juice.

As we’ve repeatedly pointed out, the financial crisis was a derivatives crisis. Credit default swaps created subprime exposures (and in the riskiest credits, ECONNED explains how this perverse outcome came about) four to six times the real economy value of dodgy loans. If we’d had a mere housing bust, the result would have been a very bad recession, not a near death experience for the global financial system.

And in the runup to the crisis, the authorities knew CDS were a ticking time bomb. The Bank of England’s semi annual Financial Stability report had detailed and clearly concerned discussions about them. We criticized the Fed and Treasury in the runup to the big meltdown in September 2008 for not doing everything they could to map the exposures, since if you don’t know how severe and extensive a problem is, you can’t get in front of it.

But there were no meaningful derivatives reforms. Even though a fair bit of derivatives clearing now sits with central counterparties, many commentators, including this humble blog, have pointed out that these are simply new too big to fail entities. Virtually all derivatives don’t require users to post adequate margin to cover the risk….since sufficiently high margin would make derivatives uneconomical for most purposes. In other words, the reason these markets continue to exist is the implicit state guarantee. It’s one thing to guarantee deposits. But speculative instruments? Where the most profitable uses are for accounting and tax gaming, as in socially destructive purposes?

I could go on about how valuing complex derivatives depending on being able to hedge them, but hedging is dynamic and the models assume continuous markets. It’s really easy for derivatives traders to blow up in very volatile markets. Look at LTCM or many highly respected quant funds in the financial crisis.

So while a lot of wheels are pretty certain to come off if central banks don’t relent in their drive to kill inflation and other living things, watch for derivatives counterparties to be among the first casualties.