Viewpoints

The Fed finally admits it has an inflation problem. Yet, what is the bigger inflation problem and potentially more destabilizing to the economy as it unwinds? Is it the 40-year high in consumer price inflation, or is it the surge and record valuations of asset prices? Of course, policymakers would say it's consumer price inflation. However, I would argue its asset prices since easy money has fueled a record surge in equity prices, lifting macro valuations far above the dot.com bubble.

Asset inflation has been a dominant feature of business cycles for the past two decades or more. And, over the past two years, helped by an avalanche of liquidity as the Fed doubled its asset balance sheet to $8.5 trillion, the market valuation of domestic equities to nominal GDP (i.e., the Buffett Indicator) has jumped to levels never thought possible. At the end of 2021, the market value of domestic equities to nominal GDP stood at 2.55.

It is worth noting that before the pandemic, the Buffett Indicator hit a record high at the end of 2019, surpassing the peak level of the dot.com bubble. In other words, the Fed's easy money policies that resulted in an over-valuation of equities at the end of 2019 created a mind-boggling extreme over-valuation at the end of 2021.

To put the equity market's valuation in perspective, if equity prices dropped 25% in 2022, or a decline four times bigger than the decline in the S&P 500 to date, that would only bring the Buffet Indicator back to the peak of the dot.com bubble. And a drop of nearly double that scale to bring it to the average of the past two decades.

Before the last two years, history shows several years of negative returns following periods of extreme overvaluation. Yet, the S&P equity index has jumped nearly 50% over the past two years, while the Nasdaq is up over 80%. So instead of correcting in value, the equity market moved into a new orbit of over-valuation.

If there are laws of gravity in finance, the equity market is in for a big hurt. That's because monetary policy is a blunt instrument. As policymakers use traditional and non-traditional monetary policy tools to kill the consumer price inflation cycle, it will hit asset prices hard. Moreover, given the scale of over-valuation, the potential decline in equity prices could rival the "big" ones of years past. So investors should take note: history sometimes repeats itself in the world of finance.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Figure 1: Average unit wage cost inflation in developed economies

State payroll were generally modestly changed in January. Only 9 states reported statistically significant increases from December; the rest did not statistically significant moves of any size (the sum of the state increases was only 340,000, compared to the 481,000 increase reported in the national survey). California (53,600), New York (36,800), Pennsylvania (20,000), Georgia (19,400), and Ohio (18,600) had the largest increases, while Kansas and Maine had boosts of .6 percent.

Virtually all states saw job growth over the last 12 months. California picked up well over 1 million jobs; Nevada saw a 10.3 percent increase. Job gains were most notable from Texas west and in parts of the Northeast as well as Michigan and Florida; job growth was soft in the Plains.

19 states saw statistically significant drops in their unemployment rates in January (none larger than .3 percentage point), while Connecticut and DC saw increases of .2 percentage point. The range of unemployment across the nation has narrowed, in part reflecting revisions to recent numbers announced on March 2 (for instance, New Jersey's unemployment rate was reduced about 1 percentage point). Aside from DC's 6.3 percent, the highest rate in January was New Mexico's 5.9 percent, and Nebraska and Utah's 2.2 percent were the lowest. 10 states set new unemployment record lows.

Puerto Rico's unemployment rate fell from 7.5 percent in December to 7.1 percent in January, setting another new record low. The island's job count grew 7,600, and is now higher than its pre-Maria level, though still more than 150,000 under its 2005 peak. Gains over the past year have been most evident in retailing and leisure and hospitality, perhaps reflecting revived tourism.

By all indications, the Fed will raise the level of the federal funds rate, currently 0.08%, by 25 basis points on Wednesday, March 16. This will likely be the first of series of Fed rate hikes this year. (As this is being written, March13, the 12-month Federal Funds futures contract has priced in a rate of 1.87%. Later in this commentary I will explain why I do not believe the Fed will hike this much in this time period. When Fed Chair Powell is replaced by the reincarnation of Paul Volcker, then we will see more aggressive federal funds rate increases.) Two years ago, when Covid began spreading here, the federal government began handing out money to the bulk of American households, whether or not their incomes were adversely affected by Covid. Where did the federal government get this money to hand out? A lot of it came from the “printing presses” operated by the Federal Reserve and the banking system. And households still hold a lot of this Covid money. This means that as households face rising prices for essentials such as food and gasoline, they will be able to rundown their cash holdings to pay the higher prices without having to cut back on their purchases of discretionary goods and services as they otherwise would. These excess cash holdings by households will blunt the effects of the initial Fed rate hikes.

The red bars (mass) in the chart below represent the sum of currency, plus checkable deposits plus money market fund shares held by households. These cash holdings skyrocketed beginning at the end of Q1:2020. The blue line in Chart 1 represents this cash held by households as a percent of their after-tax income. This ratio also has skyrocketed, reaching a post-World War II high of 154% by Q4:2021. Think of the blue line as the inverse of the velocity of money.

Figure 1: Latest sentix survey suggests incoming economic data could disappoint

In the movie "Draft Day," Kevin Costner, the GM of the Cleveland Browns, tells a stunned GM of the Seattle Seahawks of a last-minute trade involving current and prospective draft picks that Seattle got from Cleveland only a few days ago "We live in a different world than we did just 30 seconds ago." The Fed also lives in a different world than just 30 or 60 days ago, meaning what many Fed officials thought would be the appropriate policy stance when they exited the January 25-26 FOMC meeting is no longer adequate or sufficient at the March 15-16 meeting.

At the press conference following the January FOMC meeting, Federal Reserve Chair Jerome Powell stated, "it will soon be appropriate to raise the target for the federal funds rate." Since that meeting, most policymakers have hinted that they would support a 25 basis points hike in the federal funds rate at the March meeting.

Yet, a 25 basis points hike in the federal funds rate would result in the real federal funds rate being lower in March than it was estimated to be in January. The reason is that reported consumer price inflation is markedly higher. To be sure, the reported twelve-month change in the consumer price index at the January meeting was 7%, and now through February 2022, it's almost 100 basis points higher at 7.9%.

At next week's FOMC meeting, will policymakers adopt a "go slow" or a "go bold" strategy? Betting odds indicate a "go slow" approach. Yet, if policymakers want to change the narrative and regain credibility on fighting inflation, "go bold" would be a better decision.

Ideally, a "go bold" strategy would start with a 50 basis point hike and end the promise that official rate increases would be gradual, modest in scale, and only occur at regularly scheduled meetings. Breaking the inflation cycle and inflation psychology requires bold moves.

In 1994, former Fed Chair Alan Greenspan stated, "If the Federal Reserve waits until actual inflation worsens, it would have waited too long." Policymakers have waited too long, and it's now incumbent on them to move quickly and limit the downside risks to the economy that have accompanied every inflation cycle of the past 60 years.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Last week, Financial Secretary Paul Chan delivered the last Budget speech of his term at the height of the pandemic. In his expansionary budget, he announced counter-cyclical fiscal measures to the tune of $170bn, much higher than last year’s $120bn and one of the largest in Hong Kong’s history. If we include infrastructure and other spending, the whole package is expected to bolster the Covid-stricken economy by approximately 3 percentage points. So far, the media has focused largely on the “sweeteners” (the consumption vouchers and tax relief). However, we think there are other underlying issues that need to be addressed in this Budget.

Highlights

Concerns over forecasting errors - The government often made large revisions to the budget forecasts, we think this is due to outdated forecasting infrastructure and philosophy at the FSO. We compared budget estimates made since 2012, they tend to overestimate government expenditure and underestimate revenue. As a result, there is a negative bias to the fiscal balance estimates, as much as 5% of GDP. With so much at stake, a misallocation of resources because of inaccuracy of the forecast will have long term socio-economic implications.

Rapid rise in recurrent expenditure growth - It is worth noting that recurrent expenditure has been rising faster than nominal GDP growth in recent years, deviating from the Golden Rule set out in the Basic Law. This is unsurprising given rapidly aging population and the enlarging wealth gap. While this underlying trend is unlikely to change, we think the government should widen its tax base when the time comes.

Imbalanced economic development - The financial industry accounts for 23% of GDP but only 7% of employment, economic success is clearly not being felt so broadly in the society. While the government should continue to invest heavily in the new economy in order to generate more economic activity and revenues, they should also focus on revamping and realigning the education system to better match the future needs from the new economic structure, so that more locals can share the benefits of economic development.

What to do with the Brain-Drain? - Many expatriates and locals had left Hong Kong because of social unrest and the adopted pandemic measures. Brain-drain is occurring in many key industries, including health services, finance and professional services. The government should focus on making policies to retain talents, but not just to attract new ones.

Permanent housing for cage home residents - Currently there are at least 5000 individuals living in illegal cage housing, it makes sense to convert some of the quarantine centres (purposed built for city-wide Covid testing) into permanent home for residents living in these bedspace apartments, solving this decade long social problem.

Highlights with charts can be found here.

A longer version of this commentary is available here.

In February, the Institute of Supply Management (ISM) reported that the lead time for capital expenditures, production materials, and maintenance and repair supplies hit record levels. Lead times for CAPEX jumped six days to 173 days, materials two days to 97, and maintenance four days to 50.

Leadtimes are a valuable indicator of current and future demand. When backlogs rise and get stretched out, firms protect their production schedules by building safety stocks and placing long-dated orders for materials and supplies to meet expected future demand.

The current generation of policymakers probably does not follow lead times, but the old generation did. (Read the 1994 transcripts of the Federal Open Market Committee meetings). Former Federal Reserve Chairman Alan Greenspan religiously tracked lead times, order backlogs, and delayed deliveries (i.e., vendor performance or supplier delivery index) as signs of future inflation and inventory building. The latter is an essential part of demand-driven fast growth and inflation cycles since it adds a layer of demand, putting more pressure on prices.

In February, the customer inventories index stood at 31%, with 16 industries reporting too low and none reporting too high. The ISM report indicated that February marked the 19th consecutive month customer inventories were at historically low levels. The prices paid index of 75.6% remains relatively high, and 17 industries reported paying more for raw materials and none paying less.

In 1994, with a set of lead time, suppliers index, and price paid data that is not as scary as today, the old generation of policymakers saw the need for substantial monetary restraint to break the inflation cycle and limit the cyclical rise in general inflation. That policy playbook worked as pipeline price pressures never reached the consumer level.

It's too late for the current generation of policymakers to follow the 1994 playbook as pipeline price pressures are present at the consumer level, with more to come. Yet, policymakers can make things worse by not acting quickly and aggressively. Russia's invasion of Ukraine complicates the timing of monetary policy adjustment, not the scale, as the stance of monetary policy remains far too easy to break the inflation cycle.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.