Viewpoints

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over forecasting errors - The government often made large revisions to the budget forecasts, we think this is due to outdated forecasting infrastructure and philosophy at the FSO.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.

Figure 1: Heightened default concerns and a big interest rate response in Russia

China's manufacturing PMI in February ticked up to 50.2 in February from 50.1 in January, continuing to hug that breakeven line between expansion and contraction at 50. At a reading of 50, manufacturing is stagnant. The 12-month average for this index is 50.4, the six-month average is 49.9, and the three-month average is 50.2. China has been on the borderline of expansion-contraction in a weak mode for well over a year – easily back to 2018.

Zero growth is not nothing, but it's not much either Apart from a period in 2017 and early-2018 and another period in late-2020 and early-2021 when the index lifted more considerably, the index has been hugging the 50 level since early-2013. China's manufacturing sector simply been in a flat mode. The three-year average for the manufacturing PMI gauge hovers between 50 and 51 from late-2013 to date. Since February 2020, that average has not been higher than 50.3 – barely above pure stagnation. Essentially China's manufacturing sector has been stagnant for a long stretch now that precedes the arrival of Covid.

Manufacturing is slogging through a long funk The ranking of China's overall manufacturing PMI back to 2005 stands in its 29th percentile that's in the lower third of its range and during period of extended weakness.

• Orders also are weak at their 30th percentile in just about the same relative spot.
• Output is extremely weak, at its 5.8 percentile standing.
• Delivery lags at a 6.8 percentile standing indicate that there hasn't been any pressure on capacity so that firms have been able to deliver goods relatively rapidly because there's been considerable slack in the manufacturing sector and extremely weak output conditions.
• Order backlogs now are only at their 35th percentile.
• Employment, one of the stronger components, has crept up to its 55.5 percentile, putting it above its median reading. But rising employment and weak output mean that productivity in manufacturing has had a terrible performance in this period.
• Input prices are relatively strong at their 70th percentile standing.
• The purchases of inputs are at only about their 32nd percentile standing.
• New export orders stand in their 38th percentile.
• Imports stand in their 35th percentile.
  It is a wholistic picture of a weak sector. Only prices are stirring and that is a legacy of the global virus and the shifting sands of global supply chain problems. It also reflects rising global energy costs and war…

PMI standings are poor across the board These standings show all of manufacturing be in a very weak mode or a place-holding mode. There isn't really anything that's strong outside of input prices and this is in a global environment where inflation forces have ramped up very strongly. In this environment China, of course, is different. It has been running this zero COVID policy, trying to keep the disease COVID from spreading at all and even trying to stamp out its very existence. But totalitarian policies work better against people who can be made complaint than against a virus that spreads at will – its own will not yours… And this approach has put a real damper on activity over the last six months or so since this policy has been in effect.

Momentum is weak Looking at momentum in China, manufacturing only output, order backlogs, and stocks have momentum easing over three months compared to over six months. However, over six months, there are more categories easing: output, order backlogs, employment, import prices, and stocks all are showing weakness compared to their levels over 12 months. Comparing 12 months to 12 months ago, the signs of slowdown are much broader with only four categories showing momentum on an upswing including delivery speeds, employment, stocks of major inputs, and new export orders.

Whether one chooses to look at China by looking at changes in the manufacturing PMI and its components or at their PMI index levels, the conclusion is still the same: weak.

Figure 1: Flash PMI surveys suggest global supply side congestion may be easing

The Fed has a problem. It's in the business of creating money, but it formulates monetary policy without regard to money itself. So in times when its policy decisions produced a record surge in broad money, policymakers are not attentive or alerted to the negative (inflation) consequences.

From February 2020 to the end of 2021, broad money increased by $6.5 trillion or over 40%. That increase over less than two years is roughly equivalent to the rise over the previous ten years. Yet, policymakers who have long argued that "inflation is always and everywhere a monetary phenomenon" called the surge in inflation transitory, owing to supply bottlenecks. Had policymakers still recognized money as a potential source of inflation, it would not be in the pickle that they find themselves today.

Policymakers now face the unprecedented challenge of dealing with consumer and producer inflation and elevated asset prices ( possibly bubbles.) Policymakers' record on reversing inflation cycles and recognizing asset bubbles is lousy. Policy adjustments have always been late (except for Greenspan's 1994 preemptive strike), resulting in awful economic and financial outcomes, some much worse than others.

As bad as policy decisions were in the past year, it is reckless that policymakers are still easing policy today. Publically saying the monetary policy is "wrong-footed" but not doing anything until the next policy meeting, a month away, is like saying we want the fire to burn some more before being compelled to distinguish it.

Before the preemptive strike against emerging inflation pressures in 1994, Fed Chair Alan Greenspan stated in his semi-annual monetary policy testimony, " if the Federal Reserve waits until actual inflation worsens, they would have waited far too long." It's too late to use Mr. Greenspan's playbook, but policymakers still need to act swiftly. Some policymakers have argued that only a modest adjustment in official rates is needed because of well-anchored inflation expectations. That is short-sighted and wrong. Actual or realized inflation leads to changes in inflation expectations, not the other way around. Persistent inflation will increase inflation expectations over time.

Several decades ago, the Bureau of Economic Analysis (BEA) created the monetary and financial flow index (MFF). It consisted of the growth in broad money (adjusted for inflation), change in business and consumer credit, and liquid assets. BEA stopped publishing this series in the early 1990s, and I recreated the series with assistance from BEA, plus updating the series for new financial instruments, such as new flows into bond and equity funds.

The MFF index was a helpful gauge to predict the peaks and troughs of economic growth cycles and pinpoint excess liquidity situations. The MFF index signaled excessive liquidity growth ( i.e., well above GDP) before the dot.com and housing bubbles. The primary source was explosive private sector credit growth and robust gains in liquid assets.

Over the past year, growth in the MMF index has been more than twice that of dot.com and housing bubbles, owing to record growth in broad money and bank credit. Too much liquidity is the fuel for inflation.

The Fed started this inflation fire by creating too much money. Now, it has to produce less. In January 2022, broad money is up roughly 14% in the past year, down from 25% a year earlier, but still far too fast to kill the inflation dragon. Policymakers have to curtail money growth to a rate well below nominal GDP. That will require a substantial increase in official rates and a sizeable shrinkage in the balance sheet.

Removal of liquidity will appear in asset prices, financial ones before tangible, long before it shows up in conventional measures of inflation. Mr. Market, the biggest beneficiary of Powell and company liquidity bonanza, will soon cry about too little liquidity. Investors forewarned.

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

Now that the cognescenti have judged that goods/services price inflation has transitioned from transitory to something more persistent, the Fed has signaled that it is ready to start raising its main policy interest rate, the federal funds rate, at the mid March FOMC meeting. Moreover, the Fed has suggested that a March interest rate hike will be one of several this year. By how many basis points will the Fed raise the federal funds rate this year from its current level of 0.08%? No one knows, especially the Fed. The federal funds futures market is currently priced to suggest a cumulative 150 basis point rise in the federal funds rate over the next 12 months. But just as Fed policy is "data dependent", so is the federal funds futures market. However many basis points the Fed raises the federal funds rate over the next year, it will have a fiscal effect. That is, it will contribute to an increase in federal outlays in the form of higher net interest payments. Higher Treasury debt-servicing expenses imply higher future federal budget deficits, all else the same.

The blue bars in Chart 1 are the fiscal year values of Treasury net interest expenditures as a percent of total federal outlays. The blue bars in the shaded area from fiscal year 2022 through 2031 are baseline forecasts made by the Congressional Budget Office (CBO) in July 2021. CBO baseline projections of budgetary variables incorporate current laws pertaining to the federal budget and the CBO's estimate of economic variables that would have an impact on budgetary variables. Also plotted in Chart 1 are the actual and CBO-forecast fiscal year average values of interest rates for the three-month Treasury bill (the green line) and the 10-year Treasury note (the red line). In FY 2021, Treasury interest expense as a percent of total federal outlays was 4.8% -- the lowest percentage in the period starting FY 1965. Given that federal debt held by the public increased by $6.2 trillion in the two fiscal years ended 2021, this low ratio of Treasury debt service expense relative to total federal outlays is remarkable. Of course, extremely low interest rates on Treasury debt played a major role in reducing debt-servicing costs relative to total federal outlays. More on this in a moment.

Chart 1

With many Central Banks now more actively tightening monetary policy, financial markets have unsurprisingly been more unsettled in recent weeks. The dilemma for investors is obvious. Should they assume that policymakers are applying a gentle brake to a world economy that is barely breaching its speed limit and will now seamlessly guide it back to a more inflation-friendly speed? Or, are they slamming on the brakes far too hard, and far too early – and to mix the metaphors – now taking a sledgehammer to crack a nut?

To this scribe the risks are tilted toward the second scenario. There is little question that monetary policy is still accommodative and that a slow normalisation campaign is warranted as the world economy normalises in a likely post-pandemic adjustment phase. But a growing number of Central Banks appear to be of the view that inflationary pressures have been building because their monetary policies have been too loose. A more active tightening campaign is therefore deemed necessary in order to squeeze out these pressures. But as we argue in more detail below this strategy carries tremendous risks. And global economic and financial stability are in danger at present of being sacrificed somewhat unnecessarily at the altar of Central Banks' inflation-fighting credentials

This view is based on several messages from the analysis below. Firstly, that the inflationary pressures that have been building in recent months are globally - not nationally - rooted. Secondly, that those global pressures have largely been driven by COVID-related supply side congestion, not by excessively loose monetary policy and overheating demand. Thirdly, and to that last point, credit impulses in most major economies have moved into negative territory in recent months. That's not symptomatic of excessively loose monetary policy. Fourthly, nearly every major economy - including the US - is still operating below levels that would have been expected based on pre-pandemic trends. And that's not symptomatic of an overheating world economy. Finally, wage inflation in nearly every major economy is not yet even close to keeping pace with headline price inflation. Household purchasing power is therefore being significantly eroded even in the absence of tighter monetary policy and igniting recession risks as a result.

Globally-rooted supply side pressures

Let's start with those global roots and those supply-side roots. A recent paper from the Federal Reserve Bank of New York (see The Global Supply Side of Inflationary Pressures) assessed in some detail the recent evolution of inflationary pressures in the US and Euro Area. One of the key findings is that globally-rooted supply factors – including those that pertain to the price of oil - are very strongly associated with the levels of - and persistence of - recent producer price inflation across countries, as well as with consumer goods price inflation (see figures 1, 2 and 3 below). This is noteworthy because all major advanced countries have experienced a large rise in goods price inflation during the initial pandemic recovery phase. Services inflation in contrast has been more muted.

As the paper's authors additionally note if their analysis is accurate and the bulk of many major economies' inflation issues can be traced to global roots and to supply-side roots, it suggests that domestic monetary policy actions could have only a limited effect in containing inflationary pressures.

Figure 1: US goods price inflation has been highly correlated with goods price inflation elsewhere