Good cop, bad cop

First, good news: US headline inflation fell for the 9th consecutive month, and this time by a full point to 5%. It has nearly halved since its peak of 9.1% last May. It is still 2.5 times the Federal Reserve’s target of 2% but undoubtedly heading the right way.


Less good (and in the immediate future, the more important) is the political deadlock in Congress as negotiations make no tangible progress on the future level of the debt ceiling; having the world’s biggest economy effectively in special measures while global investors ponder the guillotine beyond which the US government can no longer support its day-to-day spending commitments and simultaneously meet its obligations to bond holders is not surprisingly putting strain on both the dollar and US government bond prices.

The Economic Delphic Oracle Speaks
However, looking to the longer-term but directly related to the above, a significant talking point this week was the World Economic Outlook (WEO), the International Monetary Fund’s (IMF) half yearly assessment of the global economy. To the extent the IMF is better or worse than anybody else at forecasting the future, of no surprise at all is the prediction of a hard landing for the global economy if interest rates persist at high levels for a prolonged period. And it threw red meat to the BBC who gleefully reported that, suffering a projected 0.3% year-on-year decline, not only will the UK be the worst-performing economy in the G7 this year, but also in the G20, “including sanctions-hit Russia” (that at 4% the UK was the fastest growing, or more accurately fastest recovering, in the G7 last year is old hat). Looking out to 2028, it also disagrees with Chancellor Jeremy Hunt that the UK will achieve a budget deficit of under 3% of GDP (the Office of Budget Responsibility estimates 1.7%), predicting that ours will be more likely to be 3.7%. Not mentioned but what is still a genuine concern, however, is that the UK remains the principal outlier among developed economies which in real terms is yet to see its GDP exceed pre-pandemic levels, along with some Brexit dislocation a direct result of that catastrophic double-digit collapse in economic fortunes in 2020; despite the massive fiscal lifeboats (or perhaps because of them!), the manner of our confinement to barracks produced a more marked decline than among our major competitors.

Invoking Galbraith’s First Law of Forecasting (“forecasters divide in to two types: those who don’t know and those who don’t know they don’t know”) on a five-year view and much more so beyond, the one thing that is virtually guaranteed is that both the IMF and the OBR will be wrong. The tendency of fickle human beings to go off-piste and wander their own way has an inconvenient habit of confounding economists’ tidy spreadsheets. And additionally in the case of the UK, in 2028 we will already be three-fifths of the way through a new parliament, more than likely with a Labour government and a very different fiscal agenda.
Beware! Deep water! Confusing real interest rates and nominal
The troubling element of the IMF’s report is when it starts looking at the reverse slopes of the inflation and interest rate curves and its prediction that interest rates will fall to “pre-pandemic levels”. The phrase “rock bottom” has been reported regularly in the media, not least being attributed both to the IMF and the Governor of the Bank of England. As a reminder, before the central banks slashed interest rates in Q1 of 2020, the UK base rate was 0.75% (before August 2018 it had been no higher than 0.5% since the Global Financial Crisis); the eurozone deposit rate was already -0.5% and had been consistently negative since 2015; the US Fed Funds target range was 1.5-1.75%.

The IMF has already lost the integrity of its narrative thanks to laboured explanations allied with sloppy lay-journalism and the demand for easy soundbites (“rock bottom” sounds good, grabs headlines). When referring to the interest rate outlook, buried deep in the WEO report and couched in the technical double Dutch of economic-speak, rather than simple nominal rates of interest what the IMF is projecting is the future path of real interest rates (i.e. the nominal level adjusted for inflation) and where the ‘natural rate’ might settle. The ‘natural rate’ in this case is the inflation-adjusted rate of interest that neither stimulates nor impedes economic growth.

We have used the analogy before that predicting ‘natural’ or ‘neutral’ rates is akin to the children’s game of pinning the tail on the donkey while blindfold: only in this case the donkey’s backside is constantly on the move thanks to the twin prods of a dynamic economy and a shifting inflation rate. Compounding the problem, as we have discussed often in these columns, is that far from being a precision tool, interest rates are a blunt instrument. Often there is a lag of between 12-18 months between a change in the interest rate and a perceptible effect being measurable; when being used as a lever to change demand-side behaviours, there is the risk of overshoot because of the lag.
Demographics and feeble growth
Whatever the immediate outlook for inflation as we navigate the current rockiness, the IMF sees long-term macro forces reasserting themselves. In its view the most significant factor is demographics and the deflationary effect of an ageing population. It describes the growth outlook as ‘feeble’. Essentially, by 2025 it expects the average rate of inflation in advanced economies to be at the target rate (i.e. for the US, the UK, Japan and the eurozone, 2%). For the UK, the IMF’s base case is an estimated natural rate of 0.4% (i.e. assuming a 2% inflation rate, a nominal rate of interest of 2.4%); based on this assessment of the natural rate, the UK should have an implied inflation rate of 0.35% for the nominal interest rate to be the pre-pandemic level of 0.75%. For the US the estimated natural rate is 0.6% and 0.1% for Germany. For the quarter century beyond that, out to 2050, it cheerfully assumes that natural rates remain essentially stable. What can possibly go wrong?
Don’t confuse estimates with predictions
First is that people forget what this means in practice (it is why the “rock bottom” soundbites are unhelpful): what the IMF explicitly is NOT forecasting is a nominal rate of interest on any date in the future; it is expressing the projection as a rate of interest adjusted for inflation that is neither revving up the economy nor causing it to brake. Both the economy and the inflation rate are dynamic, neither is static: by definition the natural rate itself is not a constant. To illustrate the danger of relying on forecasts, the IMF itself has had to admit that since the publication of its WEO a year ago, its peak inflation estimates for 2022 were out by at least 100%!
Alternatives to Keynesian economics? Not on your nelly
Second, the IMF devotes a whole chapter to reducing governments’ debt/GDP ratios, focusing on ‘fiscal consolidation’ (ostensibly those ‘eye wateringly difficult choices’ about government expenditure referred to by Jeremy Hunt in his Autumn Statement, the ones so ‘eye wateringly difficult’ they could be delayed by two years beyond the election so as not to frighten the horses; they also go to the heart of the US debt ceiling argument and the political crisis in France about raising the pension age).

However, the IMF remains institutionally wedded to the established, lazy, consensus centre-left Keynesian fiscal bias (betrayed last year in its stinging criticism of Kwasi Kwarteng’s budget as “not what is expected of a major developed economy”). Nowhere does it suggest that to break out of the constraints of a ‘feeble’ growth tramline, a strong dose of monetarist fiscal policy might work wonders: lower state intervention; public sector reform hand-in-hand with lower tax rates (and higher tax revenues); a strong vibrant, match-fit private sector to drive economic prosperity and national wealth creation and attracting inward investment.

On the contrary: recognising the potential burden of national economies meeting the nirvana of carbon net-zero, the IMF advocates that public subsidies should be widely used to ease the path. Given the (eye watering) extent of the commitment, lumping much of the the financial risk onto governments’ balance sheets does not make the problem go away, it merely shifts it up the chain; but it still must be paid for, on which grounds it sits uneasily with ‘financial consolidation’ unless governments are prepared to make real fiscal compromises elsewhere. Politically (let alone ideologically) for most governments which are already fiscally incontinent (with the exception of Germany, not one single member of the G7 has produced a government surplus since before the Global Financial Crisis), those choices are a step too far when considering electoral prospects. The political path of least resistance is too often to spend your way out of trouble rather than confront hard choices.
What of long-term inflationary forces? Net zero, for example
Third, with demographics being the dominant deflationary theme in the IMF’s assumptions, there is little if any thought given to the great new industrial revolution that society and the economy are only just embarking upon. The plan is to replace the reliable fuels which have powered civilisation for three centuries with entirely new and less reliable sources of energy, all in less than three decades. We have discussed this often. 2050 is a fixed, legally binding date in the net-zero calendar. The inexorable passage of time marching on and meeting national emissions reductions being politically brought forwards, almost inevitably creates a climate compression collision between the mid-2020s and the mid/late-2030s. Virtually every country on the planet will be competing for the same scarce resources simultaneously: materials; labour; capital. Still in its infancy, the potentially powerful inflationary forces of this revolution are obvious.

Black Swans and Black Elephants

There are ‘known-knowns, known-unknowns and unknown-unknowns’’. It goes without saying that outside of the normal economic cycle, exogenous factors can have a profound effect both economically and politically (and the two are interlinked). We have discussed these on many occasions: shifting geopolitical allegiances and alliances and the reactions they provoke; specific risks including China eyeing up Taiwan and North Korea flustering South Korea and Japan. There are many others. Economists cannot reasonably include them in their forecasts, but they can and should contextualise the sensitivities to risk and term premia.
“Rock bottom” in its literal sense. Please, not again!
Finally, what if we take “rock bottom” at face value? Instead of the IMF’s inflation-adjusted real interest rate, we go back to nominal interest rates at virtually zero, possibly even negative as was the case in the eurozone for half a decade. A seductive prospect for borrowers, the reality is a zero- interest rate is a false and feckless mistress. Depositors have no incentive to keep their money in the bank, especially with negative rates where losses are guaranteed. Negative rates have the effect of sucking liquidity from the banking system which requires replacing, usually by central banks and quantitative easing and in extreme cases (as was seen in Italy) the central bank having to support commercial bank balance sheets with additional artificial capital structures to prevent them toppling over. Further, a powerful contributing factor to the IMF’s ‘feeble economic growth’ was the long-term corrosive effect of prolonged ultra-lax monetary policy combining very cheap financing costs (interest rates) and very easy access to credit (encouraged by QE). Such policies perpetuate the low-performance ‘zombie’ economy, one in which in the absence of a cost to credit, debt is allowed to accumulate with few hard constraints. Productivity is eroded as are real wages. If not feeble, then at least with demonstrable evidence of this fiscal drag creating sub-par growth across most major economies in the post-GFC era, and with depressed wages and low productivity but also enduring high tax burdens, the only conclusion can be that the combination of loose monetary policy combined with undisciplined fiscal policy has been an expensive experiment.

And as a reminder, debt is not a right or an entitlement: not to a government, a company or an individual consumer. It carries an obligation, it ought to have a cost and lenders should expect a right to a positive return on their investment or loans. We are in the risk business, after all.
Heed Einstein!
It should certainly not be an ambition to return to where we were at the end of 2020 when close to 30% of all global government debt carried a negative yield (i.e. those governments were being paid to borrow, on which basis, the argument went, why would you not?). As we discussed a couple of issues ago, the consequences of similarly low discount rates create real distortions in the valuations of all assets. Led by the pension and life insurance companies with their regulatory obligation to own significant proportions of bonds in their portfolios and always hungry for cash to meet their immediate liabilities, investors are forced to go hunting elsewhere for income at a reasonable cost. As yields fall and prices rise, we end up in the grip of the Law of the Greater Fool again, creating asset bubbles with the potential to collapse.

As Einstein’s Parable of Quantum Insanity says: “the definition of insanity is doing the same thing over and over and expecting a different result”. QED.

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