PMIs Defy Logic... and Central Bank Tightening

The S&P flash (preliminary) PMIs show improvement across all early reporters in the table for the composite and for services. All composite indexes are above 50 showing expansion and all service sector readings are above 50 showing expansion in that sector as well. Manufacturing gauges improve month-to-month in the U.S. and the U.K., but they ease in Japan, the EMU, as well as in Germany and France separately. Manufacturing PMIs are still below 50 showing contraction everywhere.

A shift to strength- These results stand out starkly in the table that labels readings as stronger or weaker month-to-month. In January, only 4 of 18 readings were weaker month-to-month. In December, only four were weaker and three of those were readings for the U.S.

Sequential trend- Despite monthly evidence of the tide turning toward strength, over three months (a period calculated on hard data and ending in January) data show only 5 stronger readings over three months, four are stronger on balance over 6 months compared to 12-months and only two are stronger over 12 months compared to their levels of 12-months ago (both of those are for Japan).

Overall view of February- Flash standings data for February values show eight of eighteen readings above their median values on data back to January 2019. Manufacturing has a rank below 50 (below its median) for all countries and areas in the table. Services readings are below 50% only in the U.S. and Germany. Only the U.S. and Germany have composite standings below their respective 50% marks – but France is on the cusp….

Manufacturing- The U.S., France, and Japan have extremely low manufacturing sector queue standings in February with rankings below the 15th percentile. The EMU, Germany and the U.K. have standings around their 33rd percentile, at the border of the bottom third of their respective queue of responses.

Service sector- Only Japan has a strong service sector in relative terms with a 96th percentile standing, the U.K., France and the EMU have standings near the upper one third of their historic queues of data. Germany has a below-median 46th percentile standing; the U.S. has an even weaker 26th percentile standing.

Like going on a diet and gaining weight… Monetary policy has been tightening everywhere globally except in Japan. In the U.S., monetary policy has tightened and yet, the PMI readings have strengthened; the same is largely happened in the European Monetary Union, Germany, and France. The Bank of England has raised rates and has seen the economy strengthen as well. It's a bit of a paradox why the economies have strengthened while inflation has remained high and broken lower only slightly. Monetary policy has continued to ratchet rates higher. Markets have been preparing for central banks to slow their tightening, something that has already happened in the U.S. In some cases, markets look for central banks to stop tightening relatively soon. Yet, the PMI data create a picture, combined with other domestic data sources, that doesn't always point to a slowing economy either in the U.S. or in Europe. Markets have been betting on an ending of monetary tightening and have been of the belief that inflation will nonetheless continue to fall because interest rates have been moved up high enough even though there's little historic reason to think that is true. Historically when inflation has been stopped interest rates have been brought up well above the rate of inflation not just ‘up to’ or ‘short of’ the prevailing inflation rate. To use a famous expression, ‘maybe this time things are different,’ but probably they're not. The optimism in markets is hard to understand even in the face of what has turned to somewhat more aggressive language on the part of central bankers - at least in the U.S. Inflation remains too strong and recent reports have showed that it's not falling quite as fast as it appeared to be falling earlier; that raises the question of how much longer it will continue to fall as well as, the question: if left alone, what inflation level will become the new equilibrium?

Why?- We might ask why this happened and why it is happening. My explanation is that monetary policy works with a lag. While everyone knows this, they act as though it applies only to tightening cycles. That’s not true. The lag argument is the mantra of people who want central banks to slow down especially the Fed in the U.S. after raising rates so rapidly. But rates are still not high. The U.S. fed funds rate is still below the inflation rate. It’s not clear to me what is the rationale for expecting that a still-stimulative, and less-than-restrictive, rate level should be viewed as ‘enough.’ Turning away from real rates to look at money supply, we see a different mechanism at work. This one finds the early post-Covid policy as extremely stimulative especially in the U.S. The U.S. logged its strongest money growth in 60 years in this cycle- now it is facing its first contraction in the nominal money stock, M2, in 60 years. So the global economy may still be responding – due to lags- to the boom phase in financial policy while the response to nascent bust cycle still lies ahead. Fine tuning an economy that has run boom-bust policies back-to-back is difficult if not impossible. Despite the risk of a coming - even severe slowdown - I think the Fed must protect against not doing enough to put inflation in its place, the same goes for the ECB.

Price-stability, at what cost? There is a movement afoot to have central banks reinspect their inflation targets at 2% and raise them. However, globally 2% has been the standard that has been called price stability and, frankly, if central banks are going to pursue a policy of price stability, it's hard to see how any number higher than 2% fits that bill. If central banks decide they want to pursue a strategy of low inflation, then they could change the target. But if they want to continue to pretend that they are seeking price stability, it's hard to see them moving the 2% target higher. That could be the next central bank parameter that comes under attack globally.