The failure of monetary policy

Published: Mon 18 April 2022
Updated: Sun 01 January 2023
By steve

In Markets.

Monday 18, April 2022

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Inflation

The media is going wild about current inflation, but the market is remarkably sanguine. In the USA, expectation are no higher now than they were in 2018.

In the UK, the forward expectations is fairly steeply downward sloping, with a kick in the tail.

https://www.bankofengland.co.uk/-/media/boe/images/statistics/yield-curves/ukinf.gif?h=390&la=en&w=532&hash=C6F2803F5963F8DE2C5F9962F1B0DCB8064220F9

The markets are not always right, but they represent a money-weighted guess about the future. Maybe they are wrong this time, but inflation will not survive a severe downturn.

The failure of monetary policy

Monetary policy works by reducing real wages across the board so the labour market can clear, while allowing the market for capital to remain in equilibrium. That’s my non-economist understanding of the policy.

The left likes using monetary policy, because it can work to reduce unemployment. The right likes it because it keeps capital markets buoyant. The finance sector likes it because it has lead to a hyper-financialized economy in which the City is the most important sector in the UK economy, with a concomitant rise in political influence.

The problem is that monetary policy has run out of road. Interest rates are a very blunt tool. It’s possible to control inflation by jacking up rates, but only at the price of destroying the capital-intensive parts of the economy, like housing and manufacturing. When supply chains are stretched to breaking point, and most housing markets have not recovered since the 2008 crisis, this is not a great look. The UK has chronically failed to build houses at a replacement rate, with the result that we have a housing stock which is epically unsuited to being insulated cost-effectively.

Allowing energy and food prices to rocket will have a deeply asymmetrical impact on voters. The poor devote much more of their income to these items. They do not have the luxury of going from luxury foods to ‘budget’ ones. They cannot afford £60,000 for a new EV.

The only solution is fiscal action. Messy, targeted, flawed fiscal measures, I don’t like it, and I’m sure Rishi doesn’t but the alternative is defeat at the ballot box. The May local elections will give an indication of how ordinary people feel about inflation.

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The oil bull case

Macro Ops nailed this thesis back in 2017. I could kick myself for not having the courage of my convictions, but the basic thesis, that all the EVs in all the world are not going to make a damn bit of difference to oil usage is correct.

Bison Interests, Kuppy, Pinecone Macro, have all been spot on about this, but until recently nobody really believed them. Markets are driven by narratives. We are still in the narrative of ‘OK, Russia is at war, and there is a transitory disruption to supplies of Russian oil but this will soon be finished and we can go back to ever-declining oil.’ Maybe this thesis will win for a bit, but at some point the oil bears will capitulate. Especially if governments the world over start subsidizing the price of oil products to consumers. If the cure for high prices is high prices, then suppressing high prices is the way to prolong the disease.

Wrap

Many markets were closed today: Easter Monday. For those that were open, trends largely continued:

  • bonds continued to be weighed down by inflation concerns,
  • the Yen was weak,
  • the dollar was strong,
  • equity markets were generally weak, with the exception of Europe and Brazil,
  • gas and oil went up, as did commodities generally, in spite of the dollar strength, as were Canadian gas producers such as Range Resources and Sandridge.
  • home construction ($ITB), a proxy for US real estate prices, was down. Housing is the biggest asset class of all, and 30 year mortgage rates in the US are up by ~40% (up to ~5% pa), which when combined with food and energy inflation draining spending power from the US consumer things are looking bad.

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