Unraveling the Economic Quandary: The Peril of Deflation as Bank of England's Missteps Compound
Inflation, once a concern, is slowly being suffocated across the West due to a confluence of factors, including cut-price Chinese imports, declining commodity costs, and a contraction of the domestic money supply on both sides of the Atlantic. Alarming predictions suggest that British inflation might dip below 2% over the first half of this year, significantly earlier than anticipated by the Bank of England, with Capital Economics even suggesting a possible hover near zero by late autumn.
Critics argue that the Monetary Policy Committee (MPC) was lethargic in responding to spiraling money growth in 2021, fueling the situation belatedly with a second round of pandemic quantitative easing (QE). Now, there's a looming risk of the opposite mistake—keeping interest rates too high for too long and persisting with quantitative tightening (QT) despite a decline in the M4 money aggregates and credit tightening.
The drama unfolds as two MPC members vote to further raise rates, while Swati Dhingra stands out by advocating for a cut, challenging the prevailing consensus. This raises concerns about the credibility of the Bank of England under Governor Andrew Bailey.
Critics warn that the current policy stance is turning viciously restrictive, with potential damage only becoming apparent when it's too late, given typical lag times of one to two years. Economists on the "shadow" MPC, hosted by the Institute of Economic Affairs, unanimously call for an immediate rate cut to avert a recession and possible debt-deflation by 2025. They also advocate for a halt to QT bond sales until liquidity has recovered.
Trevor Williams, the coordinator of the shadow committee, questions why the Bank of England is maintaining rates at 5.25%, advocating for a 50-point cut followed by another 50 points in April. He argues that the implied neutral rate is 3% to 3.5% at this juncture. The disappearance of excess savings from the COVID era has led to a slide in retail sales, contrasting with the situation in the United States.
As the overhang of money from pandemic-era excess savings vanishes, concerns rise about the dangerously low money growth in the UK, prompting experts like Peter Warburton to sound the alarm for the economy. The unfolding economic scenario underscores the complexities and challenges faced by the Bank of England, raising critical questions about the path forward in navigating this precarious economic landscape.
Warning Signs of Economic Turbulence: Rising Insolvency Rates and the Unsettling Contraction of Credit
As economic storm clouds gather, insolvency rates are rapidly on the ascent, and lenders are becoming increasingly selective in choosing borrowers. A prominent voice in economic analysis contends, "It is singularly inappropriate to continue shrinking the balance sheet when liquidity and credit are so weak.
Analysis conducted by the Boston Fed suggests that the tightening of conditions hits US companies a year later, especially during refinancing or when breaching debt covenants, amplifying the impact through the "financial accelerator channel." A parallel situation is anticipated in the UK, where Begbies Traynor estimates that a significant number of businesses—539,900—are grappling with financial distress, and 47,000 teetered on the edge of collapse as 2024 commenced.
The Bank of England's concern about wage growth, standing at 7.2% over the three months from August to October, is underscored, albeit considered a lagging indicator. Governor Bailey acknowledged, "It is not as simple as inflation falling to target in the spring and the job being done." The Bank's forecast of inflation rebounding above 2% in the third quarter faces skepticism, with Capital Economics projecting headline inflation heading for 0.3% by September. This is attributed to mechanical factors linked to the energy price cap, expected to fall by 16% in April and an additional 8% in July.
Dynamics in global energy markets, reflected in a dramatic drop in TTF gas contracts in Europe and substantial declines in lithium carbonate, nickel, and cobalt prices, indicate a broader trend of deflation. This deflationary pressure is set to impact the electric vehicle (EV) sector as cheaper inputs feed into EV battery production, coinciding with advancements in cost efficiency.
While uncertainties persist in the oil market, marked by the Russia-OPEC cartel's attempts to influence prices, the dominance of Texas frackers snatching market share has tempered the Saudis' ability to drive Brent prices to the desired $90-100 range. The overall commodity index has been on a downward trajectory for the past eighteen months, signaling a broader trend that adds complexity to the economic landscape. As these interconnected factors converge, the narrative points toward challenging times ahead with implications for various sectors, particularly in the ever-evolving landscape of global economics.
Global Economic Crossroads: Central Banks and the Underestimated Deflationary Wave
In my perspective, major central banks, including the Bank of England, the European Central Bank, and the Federal Reserve, are falling behind the curve in comprehending the evolving dynamics in China. This failure to keep pace has led to a systemic underestimation of the burgeoning deflationary trade shock, which is not only currently impacting global markets but is poised to intensify. The shift in China, as Xi Jinping embraces familiar pitfalls in the development model, is crucial. The resumption of investment to the exorbitant levels of 42-44% of GDP signals an accumulation of industrial and manufacturing capacity that exceeds China's absorption capacity, raising the specter of global dumping.
Chinese export prices have already experienced a significant dip, falling by 12% in dollar terms and 18% in euros over the past year. With China's annual trade surplus in goods at a staggering $900 billion (£707 billion), the repercussions are disrupting global trade and pose a substantial shock for Europe, currently mired in a semi-slump. This downward pressure on the prices of Chinese goods provides insight into the enigma of the U.S. running a substantial budget deficit while witnessing a decline in core PCE inflation to just 1.5% (annualized) over the last three months.
The narrative challenges the consensus that the world has transitioned into a new era of perpetually higher inflation and bond yields post-pandemic. It contends that the forces of artificial intelligence, Moore's Law governing semiconductor chips, and the learning curve of clean-tech are inherently deflationary. The demographic shifts that initially pushed Japan into deflation have since spread to Korea, China, and much of Europe.
As fiscal largesse diminishes in the U.S. and Europe throughout 2024, there is a reasonable expectation that inflation will further recede. The contention is that we might wake up in the coming year to a reality not dissimilar from the pre-Covid era, characterized by ultra-low inflation and a natural interest rate pinned to the floor. This challenges the prevailing narrative of a new inflationary paradigm, suggesting that central banks, including the Bank of England, might be hedging against the wrong risk. The intricacies of global economic forces, technological advancements, and demographic shifts intertwine, presenting a complex scenario that necessitates a nuanced understanding and proactive response from central banks worldwide.
In conclusion, the global economic landscape stands at a critical crossroads, with major central banks seemingly underestimating the impact of a deflationary trade shock emanating from China. As Xi Jinping reverts to familiar patterns in the Chinese development model, rising investment levels and a surplus in trade pose challenges that may intensify on the global stage. The downward trajectory of Chinese export prices and the massive trade surplus significantly impact international markets, with Europe facing potential shocks amid a semi-slump.
The prevailing narrative of a post-pandemic era marked by consistently higher inflation and bond yields is questioned, as deflationary forces driven by artificial intelligence, semiconductor advancements, and clean-tech innovation come to the forefront. The demographic shifts that previously led Japan into deflation now extend to other regions, presenting a potential return to an era of ultra-low inflation reminiscent of the pre-Covid period.
As fiscal stimuli wane in the U.S. and Europe throughout 2024, expectations arise for a further decline in inflation. The complexity of these intertwined economic forces challenges conventional wisdom, suggesting that central banks, including the Bank of England, might be hedging against a different risk. Navigating this intricate landscape requires a nuanced understanding and proactive measures from central banks to address the evolving dynamics and ensure economic resilience in the face of potential deflationary pressures.