Stagflation, and Intransigence.

May 27, 2022

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Once a new future becomes inevitable the present soon becomes the past.

” … all central banks share the same misconception, that they are managing a business cycle that emanates from private sector business errors and not from their licenced banks and own policy failures.” Alasdair Macleod

Our biases have biases. We typically have a bias that tells us we are less susceptible to bias than everyone else.Will Storr

Investor behavior and portfolios are struggling to transition from the biggest bull market in 100 years to a transformed environment, Stagflation. Investor allocations follow the markets and peaked with the market highs at the end of 2021.

Important market shifts in the outlook this week intensified the Fed’s challenge. The latest data show that the growth slowdown has accelerated, and with that the 2 year Treasury yield has fallen by more than 40bp from the recent peak. At the same time, the inflation estimate for the CPI in Q4 2022 has increased to around 7%. Still far above the Fed’s 2% target.

My view that the real Fed Funds interest rate will likely peak at a negative rate, for the first time, looks increasingly likely. This would be confirmation that investment conditions have materially changed. Already negative real interest rates have become the norm for the foreseeable future.

This is a key signal that the central bank’s intransigent commitment to flawed policy is reaching a new phase. Investors also need to adapt to this change in the economic environment with a robust and systematic full cycle strategy. It does not look like the turn at the beginning of 2022 has played out.

The main problems with economic policy have accumulated over time

Central bankers’ narratives are falling apart. And faced with unpopularity over rising prices politicians are beginning to question central bank independence. Driven by the groupthink coordinated in the regular meetings at the Bank for International Settlements, they became collectively blind to the policy errors of their own making.” Alasdair Macleod

Economic thinking has found no place for Austrian Economic perspectives. Main stream universities don’t even cover it.

My book, Invest Like the Best, covers this issue in greater depth. Austrian Economics embraces complexity and behavior in a way that is missing from main stream teachings, and provides insight on policy problems.

Here are the issues that need watching to understand the policy weaknesses which should provide some guidance on how events will evolve:

1. Main stream economics incorrectly assumes that business cycles arise out of free markets. Instead, they are the consequence of the expansion and contraction of unsound money and credit created by the banks and the banking system.

2. The inflation of bank credit, transfers wealth from savers and those on fixed incomes to the banking sector’s favoured customers. It has become a major cause of increasing disparities between the wealthy and the poor.

3. The credit cycle is a repetitive boom-and-bust phenomenon, which historically has been roughly ten years in duration. The bust phase is the market’s way of eliminating unsustainable debt, created through credit expansion. If the bust is not allowed to proceed, trouble accumulates for the next credit cycle.

4. Today, economic distortions from previous credit cycles have accumulated to the point where only a small rise in interest rates will be enough to trigger the next crisis. Consequently, central banks have very little room for manoeuvre in dealing with current and future price inflation.

5. International coordination of monetary policies has increased the potential scale of the next credit crisis, and not contained it as the central banks mistakenly believe.

6. The unwinding of the massive credit expansion in the Eurozone following the creation of the euro is an additional risk to the global economy. Comparable excesses in the Japanese monetary system pose a similar threat.

7. Central banks will always fail in using monetary policy as a management tool for the economy. They act for the state, and not for the productive, non-financial private sector.

The chart below shows the economic evolution over the last few years.

The chart above summarizes our current predicament. It shows:

1. Federal debt has expanded far faster than GDP since 2008, and more than in prior periods before 2008.

2. Interest rates have failed to remain above zero for long, but are now rising again.

3. The Federal Reserve balance sheet has expanded to $9 Tillion, but is now scheduled to decline again, starting next week in June.

4. Even with all these supports, growth overall since 2008 has been weaker than prior decades.

5. All of the supports are now being reduced.

6. Long term growth has been declining for the last 70 years as shown in a previous insight.

How will all this work out?

Here is the latest view from small businesses, which seems to corroborate Quad 4 conditions for the foreseeable future as mentioned in previous insights.

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