1 00:00:00,240 --> 00:00:04,360 The S&P 500 is currently sitting near an all time high. 2 00:00:04,680 --> 00:00:08,080 Equity traders seem to have decided that a war in the Middle 3 00:00:08,080 --> 00:00:11,480 East, one that has effectively closed the world's most critical 4 00:00:11,480 --> 00:00:15,560 energy choke point, is simply a great opportunity to buy the 5 00:00:15,560 --> 00:00:17,800 dip. And buying the dip has become 6 00:00:17,800 --> 00:00:21,200 such a winning strategy in recent years that dips don't 7 00:00:21,200 --> 00:00:25,800 really happen much anymore. The average consumer is a bit 8 00:00:25,800 --> 00:00:29,280 less convinced. U.S. consumer sentiment has 9 00:00:29,280 --> 00:00:32,640 recently fallen to a 74 year low. 10 00:00:32,960 --> 00:00:36,880 To put that in perspective, those 74 years included the 11 00:00:36,880 --> 00:00:42,960 assassination of JFK, the 1973 oil embargo, September 11th, the 12 00:00:42,960 --> 00:00:46,520 global financial crisis, and a global pandemic. 13 00:00:46,800 --> 00:00:50,720 And people are more miserable now than they were during any of 14 00:00:50,720 --> 00:00:54,160 those times. That is not a great number if 15 00:00:54,160 --> 00:00:57,080 you're an incumbent politician running for office. 16 00:00:57,440 --> 00:01:01,040 The immediate cause of this collapse in sentiment is the 17 00:01:01,040 --> 00:01:05,280 closure of the Strait of Hormuz, though as we'll see, the 18 00:01:05,280 --> 00:01:07,920 problems run much deeper than that. 19 00:01:08,280 --> 00:01:12,320 In late February, an assault on Iran shut down the transit of 20 00:01:12,320 --> 00:01:16,600 roughly 20 million barrels of oil a day, about 1/5 of the 21 00:01:16,600 --> 00:01:19,760 global supply. Martin Wolf, riding in the 22 00:01:19,760 --> 00:01:24,240 Financial Times, points out that the Strait is a vital artery of 23 00:01:24,240 --> 00:01:28,360 the world economy, a place in which one starts a war only 24 00:01:28,360 --> 00:01:32,920 after careful consideration of goals, means and risks. 25 00:01:33,120 --> 00:01:36,440 He goes on to say that's not what happened. 26 00:01:36,920 --> 00:01:41,240 Brent crude has, as of the time of this recording, been pushed 27 00:01:41,240 --> 00:01:46,400 above $125.00 a barrel. As I mentioned in last week's 28 00:01:46,400 --> 00:01:50,560 video, oil prices feed directly into the cost of food, 29 00:01:50,560 --> 00:01:54,960 fertilizer, and shipping, so that increase is rapidly working 30 00:01:54,960 --> 00:01:59,600 its way into everything you buy. Politicians would very much like 31 00:01:59,600 --> 00:02:03,800 to blame our current cost of living problems entirely on this 32 00:02:03,800 --> 00:02:07,520 geopolitical bad luck. And while the energy shock has 33 00:02:07,520 --> 00:02:11,520 certainly acted as a massive accelerant, several highly 34 00:02:11,520 --> 00:02:14,600 credible economists had been warning that a surge in 35 00:02:14,760 --> 00:02:18,400 inflation was sitting in the pipeline long before the 1st 36 00:02:18,400 --> 00:02:22,520 missile was fired. The war merely exposed the 37 00:02:22,520 --> 00:02:27,120 problem, according to a new book by Manoj Pradhan and Charles 38 00:02:27,120 --> 00:02:29,760 Goodheart. For three decades, central 39 00:02:29,760 --> 00:02:33,720 bankers have been taking credit for a structural decline in 40 00:02:33,720 --> 00:02:37,720 global prices that had almost nothing to do with their policy 41 00:02:37,720 --> 00:02:41,080 decisions. They had the wind at their backs 42 00:02:41,240 --> 00:02:43,960 and mistook it for the power of their own legs. 43 00:02:44,320 --> 00:02:47,920 Now that the windows changed direction, the job of central 44 00:02:47,920 --> 00:02:51,680 banker has become one of the most difficult and politically 45 00:02:51,680 --> 00:02:56,800 dangerous roles in public life. Pradhan and Goodhart argue that 46 00:02:56,800 --> 00:03:01,880 from about 1990 until recently, the global economy was coasting 47 00:03:01,880 --> 00:03:05,320 on what economists call a demographic sweet spot. 48 00:03:05,560 --> 00:03:09,480 The baby boomer generation had entered the workforce, female 49 00:03:09,480 --> 00:03:13,520 labor participation rose sharply, and China and Eastern 50 00:03:13,520 --> 00:03:16,160 Europe joined the global trading system. 51 00:03:16,400 --> 00:03:20,720 This essentially amounted to a once in history doubling of the 52 00:03:20,720 --> 00:03:25,440 effect of global labor force, which is a very reliable way to 53 00:03:25,440 --> 00:03:28,240 keep wages and prices from going up. 54 00:03:28,760 --> 00:03:33,280 Central bankers looked at this massive structural gift of cheap 55 00:03:33,280 --> 00:03:37,560 labor and cheap goods and concluded that their success was 56 00:03:37,560 --> 00:03:39,920 down to their own financial genius. 57 00:03:40,520 --> 00:03:44,320 To understand why this matters, we need to talk about something 58 00:03:44,320 --> 00:03:47,560 called the Phillips Curve. It's one of the most important 59 00:03:47,560 --> 00:03:51,400 relationships in economics, and for years people thought that it 60 00:03:51,400 --> 00:03:54,800 was broken. The Phillips Curve is the idea, 61 00:03:54,800 --> 00:03:59,920 dating back to 1958, that when unemployment is low and workers 62 00:03:59,920 --> 00:04:03,920 are scarce, wages go up and prices follow. 63 00:04:04,400 --> 00:04:08,040 When there's lots of spare labor, prices stay flat. 64 00:04:08,120 --> 00:04:11,440 Simple enough. But for the last two decades, 65 00:04:11,440 --> 00:04:14,840 central bankers kept interest rates at rock bottom. 66 00:04:15,120 --> 00:04:19,000 Unemployment fell to historic lows in several countries, and 67 00:04:19,000 --> 00:04:22,920 inflation barely moved. Economists started writing 68 00:04:22,920 --> 00:04:25,720 papers about the death of the Phillips curve. 69 00:04:26,040 --> 00:04:29,840 Central bankers took credit for having conquered inflation 70 00:04:29,840 --> 00:04:34,600 through sheer competence. Pradhan and Goodhart argue that 71 00:04:34,600 --> 00:04:39,440 the Phillips curve wasn't dead, China had just put it in a coma. 72 00:04:39,800 --> 00:04:43,320 The author's insight is that we shouldn't be looking at 73 00:04:43,320 --> 00:04:47,720 inflation as one big number. There are two separate inflation 74 00:04:47,720 --> 00:04:49,840 dynamics running at the same time. 75 00:04:50,160 --> 00:04:53,240 The 1st is a domestic services curve. 76 00:04:53,560 --> 00:04:57,760 Your hairdresser, your plumber, your lawyer, the people who have 77 00:04:57,760 --> 00:05:02,480 to physically be where you are. Their prices are driven by your 78 00:05:02,480 --> 00:05:06,320 local labour market. When workers are scarce, those 79 00:05:06,320 --> 00:05:09,880 prices go up. That relationship never broke 80 00:05:09,880 --> 00:05:13,480 down. The second is a goods curve, and 81 00:05:13,480 --> 00:05:17,880 for the last 30 years this one was essentially made in China. 82 00:05:18,240 --> 00:05:22,120 When you offshore most of your manufacturing to a country where 83 00:05:22,120 --> 00:05:25,800 labour is cheaper, the price of physical goods falls 84 00:05:25,800 --> 00:05:29,400 relentlessly. And that goods deflation was so 85 00:05:29,400 --> 00:05:34,080 powerful that it masked the fact that services inflation, the 86 00:05:34,080 --> 00:05:38,480 domestic part, was ticking along quite normally the whole time. 87 00:05:39,120 --> 00:05:43,560 What this meant in practice was that central banks in the US and 88 00:05:43,560 --> 00:05:46,800 Europe were essentially outsourcing their inflation 89 00:05:46,800 --> 00:05:51,200 targets to Chinese factories. Politicians got to enjoy solid 90 00:05:51,200 --> 00:05:54,160 economic growth with low borrowing costs. 91 00:05:54,320 --> 00:05:59,440 Workers in the services sector got steady pay rises and nobody 92 00:05:59,440 --> 00:06:02,760 had to make any difficult decisions because cheap 93 00:06:02,760 --> 00:06:06,320 televisions and cheap clothing from China were pulling the 94 00:06:06,320 --> 00:06:10,000 average down. It was a great arrangement for 95 00:06:10,000 --> 00:06:12,480 everyone. The workers who lost those 96 00:06:12,480 --> 00:06:16,400 factory jobs didn't vanish. Most of them ended up in the 97 00:06:16,400 --> 00:06:20,400 services sector, which is one of the reasons services inflation 98 00:06:20,400 --> 00:06:25,120 never actually went away. But that era is now coming to an 99 00:06:25,120 --> 00:06:27,760 end. The world's population is aging 100 00:06:27,760 --> 00:06:31,640 rapidly, and the global labor force is beginning to shrink. 101 00:06:31,920 --> 00:06:35,640 China is still flooding certain sectors with cheap goods. 102 00:06:35,800 --> 00:06:39,160 European car manufacturers can tell you all about that. 103 00:06:39,440 --> 00:06:43,760 But the structural force that kept global prices falling for 104 00:06:43,760 --> 00:06:49,480 30 years is running out of Rd. China's own population is aging 105 00:06:49,480 --> 00:06:52,440 faster than almost any major economy. 106 00:06:52,680 --> 00:06:56,920 It's workers are moving out of export driven manufacturing and 107 00:06:56,920 --> 00:07:01,480 into domestic services, and on top of that tariffs and trade 108 00:07:01,480 --> 00:07:05,280 barriers are now actively blocking whatever cheap goods 109 00:07:05,440 --> 00:07:09,880 China does produce from reaching western consumers at the old 110 00:07:09,880 --> 00:07:13,080 prices. The The structural tailwind that 111 00:07:13,080 --> 00:07:17,600 made central banking look easy for 30 years hasn't just faded. 112 00:07:17,800 --> 00:07:21,880 It's being erased by demographics, by geopolitics, 113 00:07:21,880 --> 00:07:25,600 and by deliberate policy. And if you're a central banker 114 00:07:25,800 --> 00:07:29,880 operating without that tailwind, in an economy where workers are 115 00:07:29,880 --> 00:07:33,880 scarce, where services inflation is persistent, and where your 116 00:07:33,880 --> 00:07:37,240 government is running enormous deficits that it has no 117 00:07:37,240 --> 00:07:41,120 realistic plan to pay for, the job starts to look very 118 00:07:41,240 --> 00:07:43,920 different. If you think this structural 119 00:07:43,920 --> 00:07:47,880 shift sounds like an abstract long term problem for future 120 00:07:47,880 --> 00:07:50,640 generations to worry about, it's not. 121 00:07:50,880 --> 00:07:55,440 The bill is already coming, due back in January, before the 122 00:07:55,440 --> 00:08:00,800 Strait of Hormuz was closed, before Brent hit 125, Adam 123 00:08:00,800 --> 00:08:03,760 Posen, the president of the Peterson Institute for 124 00:08:03,760 --> 00:08:08,600 International Economics, and Peter Orszag, the CEO of Lazard, 125 00:08:08,880 --> 00:08:13,880 published a piece arguing that US inflation could hit 4% by the 126 00:08:13,880 --> 00:08:17,400 end of this year. That is double the Federal 127 00:08:17,400 --> 00:08:20,560 Reserve's target. And their argument had nothing 128 00:08:20,560 --> 00:08:24,240 to do with an energy shock. They were warned that the 129 00:08:24,240 --> 00:08:28,600 ingredients for a resurgence in inflation were already in place. 130 00:08:28,880 --> 00:08:32,679 The war has simply thrown gasoline on a fire that was 131 00:08:32,679 --> 00:08:36,760 already burning. Their case rests on several 132 00:08:36,760 --> 00:08:40,760 reinforcing pressures. The first is the lagged pass 133 00:08:40,760 --> 00:08:44,000 through of tariffs. When a government announces a 134 00:08:44,000 --> 00:08:48,000 massive new tariff, businesses don't raise their prices the 135 00:08:48,000 --> 00:08:50,880 next morning. They work through their existing 136 00:08:50,880 --> 00:08:52,800 inventory. They watch what their 137 00:08:52,800 --> 00:08:57,360 competitors do, and they wait to see if the policy gets reversed. 138 00:08:57,600 --> 00:09:01,200 But eventually the old inventory runs out. 139 00:09:01,720 --> 00:09:05,760 Poznan Orszag note that businesses have now depleted the 140 00:09:05,760 --> 00:09:09,280 stockpiles they built up ahead of the tariffs, and they're 141 00:09:09,280 --> 00:09:13,200 beginning to pass those costs on to consumers in smaller 142 00:09:13,200 --> 00:09:17,360 increments, which means the inflationary effect is still 143 00:09:17,360 --> 00:09:21,840 building, not fading. Then there's the labor market, 144 00:09:21,960 --> 00:09:25,800 which is tightening. When any economy loses workers, 145 00:09:25,800 --> 00:09:29,160 whether through aging, emigration or policy changes, 146 00:09:29,400 --> 00:09:33,040 the same thing happens. Labor is an input, just like 147 00:09:33,080 --> 00:09:37,400 energy or raw materials. When it becomes scarcer, wages 148 00:09:37,400 --> 00:09:41,600 rise and those costs get passed on to consumers. 149 00:09:41,760 --> 00:09:46,120 Several Federal Reserve banks now estimate that the break even 150 00:09:46,120 --> 00:09:50,240 employment level, the number of jobs the economy needs to add 151 00:09:50,240 --> 00:09:54,720 each month to keep unemployment stable, has roughly halved since 152 00:09:54,720 --> 00:09:58,960 early 2024. The labor market is considerably 153 00:09:58,960 --> 00:10:01,520 tighter than the headline numbers suggest. 154 00:10:01,800 --> 00:10:06,040 You might reasonably ask whether automation and AI could fill the 155 00:10:06,040 --> 00:10:09,040 gap, and over time, they possibly will. 156 00:10:09,040 --> 00:10:12,920 In some sectors, as Posner has argued, the history of 157 00:10:12,920 --> 00:10:16,840 technological disruption suggests that the productivity 158 00:10:16,840 --> 00:10:21,400 gains tend to arrive before the deflationary effects do. 159 00:10:21,720 --> 00:10:26,160 In the near term, scarce workers mean higher wages, and higher 160 00:10:26,160 --> 00:10:30,040 wages in the services sector means higher prices at the 161 00:10:30,040 --> 00:10:33,080 dentist, the care home, and the mechanic. 162 00:10:33,560 --> 00:10:38,720 On top of that, fiscal policy remains remarkably loose. the US 163 00:10:38,720 --> 00:10:43,760 government is expected to run a deficit exceeding 7% of GDP this 164 00:10:43,760 --> 00:10:47,640 year, which is the sort of number you usually only see 165 00:10:47,640 --> 00:10:51,760 during a war or a major recession, not during a period 166 00:10:51,760 --> 00:10:55,560 of full employment. And financial conditions are 167 00:10:55,560 --> 00:10:59,040 much more accommodating than the Federal Reserve's headline 168 00:10:59,040 --> 00:11:02,520 interest rate would suggest. Credit spreads are tight, 169 00:11:02,640 --> 00:11:06,280 household wealth is at record levels, and private credit 170 00:11:06,280 --> 00:11:10,280 markets are supplying nearly $2 trillion of alternative 171 00:11:10,280 --> 00:11:14,640 financing that sits completely outside the traditional banking 172 00:11:14,640 --> 00:11:17,760 system. As Posen put it on the Odd Lots 173 00:11:17,760 --> 00:11:21,960 podcast a few months ago, the Fed has tightened, but the 174 00:11:21,960 --> 00:11:26,480 economy hasn't really noticed. Finally, and this may be the 175 00:11:26,480 --> 00:11:30,520 most important piece, inflation expectations are beginning to 176 00:11:30,520 --> 00:11:33,160 drift. When people experience price 177 00:11:33,160 --> 00:11:37,480 increases on highly visible frequent purchases, eggs, 178 00:11:37,480 --> 00:11:41,880 gasoline, home repairs, they start to expect higher prices in 179 00:11:41,880 --> 00:11:44,920 the future. They demand higher wages. 180 00:11:45,160 --> 00:11:49,200 Businesses raise prices in anticipation of higher costs. 181 00:11:49,640 --> 00:11:54,080 It becomes self reinforcing. This is exactly what Paul 182 00:11:54,080 --> 00:11:58,800 Volcker warned about in 1979 when he said that inflation 183 00:11:58,800 --> 00:12:03,800 feeds in part on itself. The problem today is that after 184 00:12:03,800 --> 00:12:08,520 the pandemic surge, inflation never truly returned to 2%. 185 00:12:08,760 --> 00:12:12,520 We're entering this new energy shock with an economy that was 186 00:12:12,520 --> 00:12:16,880 already primed for higher prices, which is not an ideal 187 00:12:16,880 --> 00:12:20,720 starting position. This brings us to the question 188 00:12:20,920 --> 00:12:24,960 of who actually pays for all of this, because the inflation 189 00:12:24,960 --> 00:12:27,920 problem and the government spending problem are not 190 00:12:27,920 --> 00:12:31,160 separate issues. They are the same problem. 191 00:12:31,520 --> 00:12:35,160 To understand why government deficits are expanding at such a 192 00:12:35,160 --> 00:12:40,120 rapid pace, we have to look back to the 1960s, when an economist 193 00:12:40,120 --> 00:12:44,280 named William Baumol asked a fairly simple question. 194 00:12:44,600 --> 00:12:48,760 He wanted to understand why a string quartet playing Beethoven 195 00:12:49,240 --> 00:12:53,040 should be paid any more today than they were 100 years 196 00:12:53,040 --> 00:12:55,840 earlier. The instruments, he argued, are 197 00:12:55,840 --> 00:12:59,280 exactly the same. The sheet music is the same, the 198 00:12:59,280 --> 00:13:02,560 number of people required to play the piece hasn't changed, 199 00:13:02,840 --> 00:13:06,600 and the musicians productivity has not improved at all. 200 00:13:07,160 --> 00:13:10,640 The answer, it turns out, is that the rest of the economy had 201 00:13:10,640 --> 00:13:14,560 become more productive, and in such an environment, if you 202 00:13:14,560 --> 00:13:18,680 didn't pay musicians a higher wage, they would simply give up 203 00:13:18,680 --> 00:13:21,440 the violin and go work somewhere else. 204 00:13:21,640 --> 00:13:25,520 So to keep the quartet playing, the concert venue has to pay 205 00:13:25,520 --> 00:13:28,560 them more and ticket prices have to go up. 206 00:13:29,080 --> 00:13:33,440 This concept is known as balm oil's cost disease, and while 207 00:13:33,440 --> 00:13:36,560 it's very useful for explaining why concert tickets are 208 00:13:36,560 --> 00:13:40,960 expensive, it also explains the structural nightmare currently 209 00:13:40,960 --> 00:13:43,240 facing global government budgets. 210 00:13:43,920 --> 00:13:47,920 I should clarify that when economists talk about a lack of 211 00:13:47,920 --> 00:13:51,880 productivity in certain jobs, they aren't insulting anyone's 212 00:13:51,880 --> 00:13:55,200 work ethic. In economics, productivity just 213 00:13:55,200 --> 00:13:58,960 means output per hour. A factory worker with a new 214 00:13:58,960 --> 00:14:03,200 machine can build 10 times as many cars today as they could 50 215 00:14:03,200 --> 00:14:07,360 years ago, but a nurse, no matter how hard they work, can 216 00:14:07,360 --> 00:14:10,160 still only care for one patient at a time. 217 00:14:10,400 --> 00:14:14,080 This type of work is strictly constrained by the linear near 218 00:14:14,080 --> 00:14:17,720 nature of time, which economists generally find quite 219 00:14:17,720 --> 00:14:21,160 frustrating. As Pradhan and Goodheart point 220 00:14:21,160 --> 00:14:25,600 out, the classic examples of balm oil's Cos disease are 221 00:14:25,600 --> 00:14:29,960 education and healthcare. They are highly labor intensive 222 00:14:29,960 --> 00:14:34,440 services that are provided in person and are thus famously 223 00:14:34,440 --> 00:14:39,120 resistant to productivity gains. And while an aging population 224 00:14:39,280 --> 00:14:43,000 might not need much in the way of primary schooling, they do 225 00:14:43,000 --> 00:14:46,360 require an exponential increase in medical care. 226 00:14:46,680 --> 00:14:50,480 As the proportion of elderly people rises, so does the 227 00:14:50,480 --> 00:14:54,800 incidence of neurodegenerative diseases and the complex 228 00:14:54,800 --> 00:14:57,480 comorbidities that come with living longer. 229 00:14:57,720 --> 00:15:01,440 And despite what our tech elites might like to tell us, your 230 00:15:01,440 --> 00:15:05,880 grandparents are highly unlikely to be satisfied with a robot 231 00:15:05,880 --> 00:15:09,960 visiting them in the care home. Japan has actually been trying 232 00:15:09,960 --> 00:15:13,400 that approach for years, spending billions on healthcare 233 00:15:13,400 --> 00:15:18,440 robotics, and only 2% of its caregivers regularly use them. 234 00:15:18,800 --> 00:15:23,080 The elderly require human carers, and because those carers 235 00:15:23,080 --> 00:15:26,400 have the option of working in other increasingly productive 236 00:15:26,400 --> 00:15:30,080 sectors of the economy, you have to pay them steadily higher 237 00:15:30,080 --> 00:15:33,560 wages to maintain the exact same level of care. 238 00:15:34,000 --> 00:15:38,320 You are essentially paying more and more for the string quartet, 239 00:15:38,480 --> 00:15:41,960 except the quartet is your entire healthcare system, and 240 00:15:41,960 --> 00:15:44,560 the audience is getting older by the day. 241 00:15:45,040 --> 00:15:47,800 This all brings us to the fiscal problem. 242 00:15:48,120 --> 00:15:52,000 Because healthcare spending is structurally locked in to rise 243 00:15:52,160 --> 00:15:56,040 much faster than GDP, governments are staring down the 244 00:15:56,040 --> 00:16:00,080 barrel of massive structural deficits that have very little 245 00:16:00,080 --> 00:16:03,200 to do with which party happens to be in power. 246 00:16:03,840 --> 00:16:07,400 In the United States, the nonpartisan Committee for a 247 00:16:07,400 --> 00:16:10,960 Responsible Federal Budget estimates that the One Big 248 00:16:10,960 --> 00:16:15,040 Beautiful Bill Act passed by the current administration will add 249 00:16:15,040 --> 00:16:18,920 roughly $4 trillion to the national debt over the next 250 00:16:18,920 --> 00:16:21,240 decade. And there's also the well known 251 00:16:21,240 --> 00:16:25,240 Social Security Cliff approaching in 2033, when the 252 00:16:25,240 --> 00:16:29,320 trust fund that pays retirees is expected to run dry. 253 00:16:29,880 --> 00:16:33,120 Pradhan and Goodhart believe, and I think most honest 254 00:16:33,120 --> 00:16:37,080 observers would agree, that when that moment arrives, the 255 00:16:37,080 --> 00:16:40,920 politicians of the day will bail the system out rather than 256 00:16:40,920 --> 00:16:45,840 impose a 24% cut in benefits on the most reliable voting bloc in 257 00:16:45,840 --> 00:16:49,320 America. If you ask a politician how they 258 00:16:49,320 --> 00:16:53,280 plan to pay for all of this, they'll invariably point to a 259 00:16:53,280 --> 00:16:56,960 spreadsheet showing that their policies will generate a massive 260 00:16:56,960 --> 00:17:00,760 boom in GDP growth. This boom will supposedly lead 261 00:17:00,760 --> 00:17:05,119 to huge primary surpluses at some vaguely defined point in 262 00:17:05,119 --> 00:17:09,440 the future. This sounds great, except that 263 00:17:09,440 --> 00:17:13,359 these promised future surpluses almost never actually 264 00:17:13,359 --> 00:17:16,359 materialize. They serve as a convenient 265 00:17:16,359 --> 00:17:20,680 accounting fiction, allowing the current administrations to spend 266 00:17:20,680 --> 00:17:24,280 money today while leaving the bill for whoever happens to be 267 00:17:24,280 --> 00:17:26,440 sitting in office a decade from now. 268 00:17:26,800 --> 00:17:31,640 The result is a slow, grinding, structural deterioration in the 269 00:17:31,640 --> 00:17:35,080 public finances of almost every major economy. 270 00:17:35,360 --> 00:17:39,240 And when governments can't or won't fix their fiscal problems 271 00:17:39,520 --> 00:17:42,960 through spending cuts or tax increases, the pressure 272 00:17:42,960 --> 00:17:46,440 inevitably lands on the one institution that can still print 273 00:17:46,440 --> 00:17:49,480 money. If governments are unwilling to 274 00:17:49,480 --> 00:17:53,520 cut spending or raise taxes, they have to find more creative 275 00:17:53,520 --> 00:17:57,480 ways to manage the debt. In the United States, Treasury 276 00:17:57,480 --> 00:18:01,680 Secretary Scott Percent has chosen a particular approach, 277 00:18:02,360 --> 00:18:05,240 actively shifting the government's borrowing towards 278 00:18:05,240 --> 00:18:09,000 the short end of the yield curve, issuing more Treasury 279 00:18:09,000 --> 00:18:11,840 bills and fewer long dated bonds. 280 00:18:12,400 --> 00:18:15,880 There's a certain irony in this. During the previous 281 00:18:15,880 --> 00:18:20,040 administration, Besant was among the most vocal critics of Janet 282 00:18:20,040 --> 00:18:23,640 Yellen for doing essentially the exact same thing. 283 00:18:23,960 --> 00:18:28,640 His argument was a serious one, that the Treasury market derives 284 00:18:28,640 --> 00:18:33,120 its special status precisely from not being managed for short 285 00:18:33,120 --> 00:18:37,040 term convenience. the United States government can borrow 286 00:18:37,040 --> 00:18:40,200 more cheaply than almost any other entity on earth. 287 00:18:40,480 --> 00:18:44,320 Because the Treasury market is the deepest, most liquid, and 288 00:18:44,320 --> 00:18:46,960 most stable asset market in the world. 289 00:18:47,360 --> 00:18:52,040 Investors accept lower yields in exchange for that reliability. 290 00:18:52,280 --> 00:18:55,400 When you start gaming the maturity structure for political 291 00:18:55,400 --> 00:18:59,240 advantage, you erode the very thing that makes U.S. debt 292 00:18:59,240 --> 00:19:03,000 special and that tends to show up eventually in higher 293 00:19:03,000 --> 00:19:06,920 borrowing costs. It was a compelling critique at 294 00:19:06,920 --> 00:19:10,760 the time, and it remains A compelling critique today. 295 00:19:11,000 --> 00:19:14,520 Which makes it all the more remarkable that the man who made 296 00:19:14,520 --> 00:19:17,800 it is now doing precisely what he warned against. 297 00:19:18,480 --> 00:19:21,480 The logic behind the strategy is straightforward. 298 00:19:21,720 --> 00:19:26,160 Short term rates are lower, so borrowing short saves money 299 00:19:26,160 --> 00:19:28,440 today. And if you believe that rates 300 00:19:28,440 --> 00:19:32,360 will fall significantly in the future, you avoid locking in 301 00:19:32,360 --> 00:19:37,320 today's higher long term yields. The problem is the other side of 302 00:19:37,320 --> 00:19:40,440 that bed. When you borrow short, you have 303 00:19:40,440 --> 00:19:44,840 to keep rolling the debt over, and if rates don't fall, you 304 00:19:44,840 --> 00:19:48,200 find yourself refinancing at whatever rate the market is 305 00:19:48,200 --> 00:19:51,440 charging at the time. Given everything that we've just 306 00:19:51,440 --> 00:19:56,320 discussed, structural inflation, aging demographics, persistent 307 00:19:56,320 --> 00:20:01,040 fiscal deficit, there's no obvious macroeconomic reason to 308 00:20:01,040 --> 00:20:04,000 expect a dramatic decline in interest rates. 309 00:20:04,360 --> 00:20:08,080 The strategy makes sense if you believe that the pandemic error 310 00:20:08,080 --> 00:20:11,760 interest rate environment was normal and will return. 311 00:20:12,040 --> 00:20:16,080 Most of the evidence suggests that it was not and that it will 312 00:20:16,080 --> 00:20:19,040 not. There is one component of the 313 00:20:19,040 --> 00:20:23,040 inflation picture that both the Treasury and most traditional 314 00:20:23,040 --> 00:20:27,840 macroeconomic models tend to quietly set aside, and that is 315 00:20:27,840 --> 00:20:31,120 housing. Shelter costs make up more than 316 00:20:31,120 --> 00:20:35,600 1/3 of the Consumer Price Index, the single largest component of 317 00:20:35,600 --> 00:20:38,240 any category. If you read the research 318 00:20:38,240 --> 00:20:41,600 predicting a return to low inflation, you'll notice that 319 00:20:41,600 --> 00:20:45,200 housing is almost entirely absent from the analysis. 320 00:20:45,600 --> 00:20:50,440 That is quite an omission. In the year to March, US shelter 321 00:20:50,440 --> 00:20:56,160 costs rose by 3%, already above the Federal Reserve's 2% target, 322 00:20:56,440 --> 00:21:00,120 while overall inflation came in at 3.3%. 323 00:21:00,400 --> 00:21:05,240 And critically, the official CPI measure actually understates the 324 00:21:05,240 --> 00:21:09,120 real time pressure because it captures rents across all 325 00:21:09,120 --> 00:21:13,480 existing leases rather than what new tenants and new buyers are 326 00:21:13,480 --> 00:21:17,400 actually paying today. Anyone currently looking for 327 00:21:17,400 --> 00:21:20,760 somewhere to live knows that the number on the ground feels 328 00:21:20,760 --> 00:21:25,880 considerably worse than 3%. The reasons are structural 329 00:21:26,160 --> 00:21:30,240 Tariffs have driven up the cost of construction materials, the 330 00:21:30,240 --> 00:21:33,640 contraction in the labor force has tightened the supply of 331 00:21:33,640 --> 00:21:37,920 construction workers, and mortgage rates above 6% have 332 00:21:37,920 --> 00:21:40,400 created what economists call the lock. 333 00:21:40,400 --> 00:21:44,880 In effect, existing homeowners refused to sell because moving 334 00:21:44,880 --> 00:21:47,600 would mean surrendering the cheap fixed rate that they 335 00:21:47,600 --> 00:21:50,840 locked in years ago. The result is a market with 336 00:21:50,840 --> 00:21:55,720 almost no supply, rising costs of new construction and no 337 00:21:55,720 --> 00:21:58,200 obvious relief mechanism insight. 338 00:21:58,720 --> 00:22:01,680 New household formation still happens. 339 00:22:01,680 --> 00:22:05,120 People still fall in love and want somewhere to live. 340 00:22:05,400 --> 00:22:10,120 But increasingly that requires building a new home at precisely 341 00:22:10,120 --> 00:22:13,840 the moment when building one has never been more expensive. 342 00:22:14,040 --> 00:22:17,280 And as I've discussed in previous videos, the broader 343 00:22:17,280 --> 00:22:20,680 story of housing affordability across the developed world, 344 00:22:20,840 --> 00:22:24,480 where house prices have risen far faster than wages for three 345 00:22:24,480 --> 00:22:28,640 decades, is now creating a self reinforcing intergeneration 346 00:22:28,720 --> 00:22:32,640 operational problem that no government seems willing or able 347 00:22:32,640 --> 00:22:36,200 to solve. Older homeowners vote in large 348 00:22:36,200 --> 00:22:39,720 numbers and have direct financial interest in keeping 349 00:22:39,720 --> 00:22:42,960 prices high. Politicians who propose serious 350 00:22:42,960 --> 00:22:46,680 measures to increase supply are essentially asking their most 351 00:22:46,680 --> 00:22:51,440 reliable constituency to accept a fall in their net worth, which 352 00:22:51,440 --> 00:22:54,720 is one of the reasons that the problem has persisted for as 353 00:22:54,720 --> 00:22:57,960 long as it has. For the purposes of this video, 354 00:22:57,960 --> 00:23:00,120 though, the the key point is simpler. 355 00:23:00,600 --> 00:23:04,880 Housing inflation is structural, it's understated in the official 356 00:23:04,880 --> 00:23:09,360 data, and it's not going away. Which means that the single 357 00:23:09,360 --> 00:23:13,000 largest component of the inflation basket is working 358 00:23:13,000 --> 00:23:16,600 against anyone who's hoping for a return to 2%. 359 00:23:17,120 --> 00:23:20,840 If you look at all of these factors, the housing market, the 360 00:23:20,840 --> 00:23:24,560 tightening labor market, the trade barriers, and the fiscal 361 00:23:24,560 --> 00:23:28,880 deficits, you might assume that the public is fully aware of the 362 00:23:28,880 --> 00:23:31,240 inflation risk building in the system. 363 00:23:31,440 --> 00:23:35,400 According to a recent NBE, or working paper on inflation 364 00:23:35,400 --> 00:23:39,720 expectations, they are not. The researchers studied how 365 00:23:39,720 --> 00:23:42,960 ordinary people and businesses formed their inflation 366 00:23:42,960 --> 00:23:46,440 expectations, and they discovered a pattern they call 367 00:23:46,640 --> 00:23:51,480 the of selective inattention. It turns out that when inflation 368 00:23:51,480 --> 00:23:56,240 is low and stable, people simply do not pay attention to monetary 369 00:23:56,240 --> 00:23:59,000 policy. They ignore the Federal Reserve, 370 00:23:59,200 --> 00:24:02,200 they don't know what the inflation target is, and they go 371 00:24:02,200 --> 00:24:05,520 about their lives. This is entirely rational 372 00:24:05,520 --> 00:24:08,560 behaviour. You don't tend to read the terms 373 00:24:08,560 --> 00:24:11,960 and conditions of your home insurance policy until water's 374 00:24:11,960 --> 00:24:13,880 already pouring through the ceiling. 375 00:24:14,600 --> 00:24:19,000 But when inflation surges, as it did after the pandemic, people 376 00:24:19,000 --> 00:24:21,520 suddenly start paying very close attention. 377 00:24:21,800 --> 00:24:25,040 They check the news, they learn about the Fed, and they start 378 00:24:25,040 --> 00:24:28,520 tracking inflation data. The problem is that they're 379 00:24:28,520 --> 00:24:31,800 learning about monetary policy at the exact moment when the 380 00:24:31,800 --> 00:24:35,640 central bank appears to be failing, which means the only 381 00:24:35,640 --> 00:24:40,240 lesson they ever absorb is a -1. I mentioned earlier that 382 00:24:40,240 --> 00:24:43,480 inflation expectations are beginning to drift. 383 00:24:43,800 --> 00:24:47,680 The new research helps explain why this is so dangerous. 384 00:24:47,880 --> 00:24:51,440 When people expect higher prices, they demand higher 385 00:24:51,440 --> 00:24:53,960 wages. Businesses raise prices in 386 00:24:53,960 --> 00:24:57,280 anticipation. It becomes self reinforcing, 387 00:24:57,440 --> 00:25:00,720 which is precisely what happened in the 1970s. 388 00:25:01,320 --> 00:25:04,960 The paper points out that the recent trajectory of household 389 00:25:04,960 --> 00:25:09,280 inflation expectations looks almost identical to the lead up 390 00:25:09,320 --> 00:25:14,920 to the inflation surge of 1974, which is, generally speaking, a 391 00:25:14,920 --> 00:25:18,520 suboptimal baseline for long term price stability. 392 00:25:19,280 --> 00:25:22,640 This brings us to the political reality of central banking. 393 00:25:23,000 --> 00:25:27,040 If the Federal Reserve wants to bring inflation back down, it 394 00:25:27,040 --> 00:25:29,520 has to keep interest rates restrictive. 395 00:25:29,800 --> 00:25:33,640 But restrictive monetary policy makes government debt more 396 00:25:33,640 --> 00:25:38,240 expensive to service, slows the economy, and makes politicians 397 00:25:38,240 --> 00:25:42,360 deeply uncomfortable, particularly politicians who are 398 00:25:42,360 --> 00:25:45,840 running for re election. As Pradhan and Goodhart point 399 00:25:45,840 --> 00:25:50,080 out, in any lasting conflict between government and central 400 00:25:50,080 --> 00:25:54,400 banks, the central banks lose. This is not a partisan 401 00:25:54,400 --> 00:25:57,240 observation. It's been true under governments 402 00:25:57,240 --> 00:26:01,000 of every political stripe in every country for as long as 403 00:26:01,000 --> 00:26:04,440 central banks have existed. When fiscal conditions 404 00:26:04,440 --> 00:26:08,760 deteriorate and the debt keeps rising, the political pressure 405 00:26:08,760 --> 00:26:12,480 to cut rates becomes overwhelming, regardless of what 406 00:26:12,480 --> 00:26:16,080 inflation is doing. We are already seeing this 407 00:26:16,080 --> 00:26:19,800 tension play out. The current US administration 408 00:26:19,880 --> 00:26:23,520 has offered some rather direct feedback to the Fed chair on 409 00:26:23,520 --> 00:26:26,880 social media, initiated a Department of Justice 410 00:26:26,880 --> 00:26:30,960 investigation into the central bank's office renovations, and 411 00:26:30,960 --> 00:26:34,360 nominated Kevin Walsh to take over for the institution. 412 00:26:34,880 --> 00:26:38,640 Borsch has called for what he describes as regime change at 413 00:26:38,640 --> 00:26:42,280 the Fed, which is an unusual choice of words when discussing 414 00:26:42,280 --> 00:26:45,560 monetary policy. But it would be a mistake to 415 00:26:45,560 --> 00:26:49,560 treat this as a uniquely American or uniquely partisan 416 00:26:49,560 --> 00:26:52,120 problem. The research on central bank 417 00:26:52,120 --> 00:26:55,920 independence suggests that amongst the strongest predictors 418 00:26:55,920 --> 00:26:59,800 of whether a central bank will lose control of inflation or 419 00:26:59,880 --> 00:27:03,240 frequent turnover of its leadership and being pressured 420 00:27:03,240 --> 00:27:07,920 to buy government debt directly in Turkey and Argentina, we've 421 00:27:07,920 --> 00:27:11,440 seen what happens when politicians take full control of 422 00:27:11,440 --> 00:27:14,680 monetary policy. You get rapid turnover of 423 00:27:14,680 --> 00:27:17,880 central bank governors, the government forces the bank to 424 00:27:17,880 --> 00:27:21,800 buy its bonds, and the currency loses its purchasing power. 425 00:27:22,280 --> 00:27:25,680 The advanced economies are obviously in a very different 426 00:27:25,680 --> 00:27:28,360 position. They've deeper capital markets, 427 00:27:28,360 --> 00:27:32,320 stronger institutions, and the enormous advantage of borrowing 428 00:27:32,320 --> 00:27:36,120 in their own currencies. But the underlying mechanics of 429 00:27:36,120 --> 00:27:39,280 inflation do not change depending on the size of your 430 00:27:39,280 --> 00:27:41,560 economy. When a government runs 431 00:27:41,560 --> 00:27:46,360 persistent deficits and refuses to cut spending or raise taxes, 432 00:27:46,800 --> 00:27:50,280 the pressure to monetize that debt to quietly print the 433 00:27:50,280 --> 00:27:54,200 difference becomes very difficult for any central bank 434 00:27:54,200 --> 00:27:58,040 to resist indefinitely. It is, for all intents and 435 00:27:58,040 --> 00:28:02,640 purposes, a slow motion tax on everyone holding the currency. 436 00:28:03,080 --> 00:28:07,000 And unlike an actual tax, no one has to vote for it. 437 00:28:07,360 --> 00:28:11,920 For the last 30 years, the world essentially operated as one 438 00:28:11,920 --> 00:28:15,400 massive optimized factory. If something was cheaper to 439 00:28:15,400 --> 00:28:19,040 build in Germany or China or Taiwan, that's where it was 440 00:28:19,040 --> 00:28:23,360 built, and we relied on an open, peaceful ocean to deliver it. 441 00:28:23,720 --> 00:28:26,520 That system was extraordinarily efficient. 442 00:28:26,680 --> 00:28:30,040 It was also one of the great disinflationary forces of the 443 00:28:30,040 --> 00:28:33,000 modern era. But as the events in the Strait 444 00:28:33,160 --> 00:28:37,560 of Hormuz have demonstrated, an open and peaceful ocean is no 445 00:28:37,560 --> 00:28:40,480 longer a guaranteed feature of the global economy. 446 00:28:41,160 --> 00:28:45,160 The breakdown of international alliances and the return of 447 00:28:45,160 --> 00:28:49,720 geopolitical conflict means that countries are suddenly realizing 448 00:28:49,920 --> 00:28:53,240 that they cannot rely on their historical partners. 449 00:28:53,480 --> 00:28:57,640 This presents a rather practical problem for anyone who happens 450 00:28:57,640 --> 00:29:00,800 to rely on electricity, food or the Internet. 451 00:29:00,960 --> 00:29:05,480 Adam Posner's pointed out that Canada recently discovered it 452 00:29:05,480 --> 00:29:08,880 has almost no Internet infrastructure that operates 453 00:29:08,880 --> 00:29:11,400 independently of the United States. 454 00:29:11,760 --> 00:29:15,000 All of their cables and satellites run through their 455 00:29:15,000 --> 00:29:18,400 southern neighbor. For decades, this was perfectly 456 00:29:18,400 --> 00:29:20,240 fine. You don't worry about 457 00:29:20,240 --> 00:29:23,720 concentration risk when the relationship is stable. 458 00:29:23,960 --> 00:29:26,720 But in a world where the terms of any international 459 00:29:26,720 --> 00:29:31,520 relationship can shift rapidly, that kind of dependency starts 460 00:29:31,520 --> 00:29:35,760 to look like a vulnerability. And Canada is not unusual in 461 00:29:35,760 --> 00:29:38,880 this regard. Most countries have similar 462 00:29:38,880 --> 00:29:42,120 single points of failure that they never thought to worry 463 00:29:42,120 --> 00:29:46,000 about. So you have to build redundancy, 464 00:29:46,200 --> 00:29:50,920 and redundancy is expensive. Europe is facing its biggest 465 00:29:50,920 --> 00:29:54,920 geopolitical challenge since the Second World War Countries like 466 00:29:54,920 --> 00:29:58,600 Poland and the Baltic states are increasing their defence 467 00:29:58,600 --> 00:30:02,440 spending dramatically. Germany has launched new fiscal 468 00:30:02,440 --> 00:30:05,560 expansions to rebuild its military capacity. 469 00:30:06,040 --> 00:30:09,840 Across the globe, governments are being forced to duplicate 470 00:30:09,840 --> 00:30:13,720 supply chains, build redundant energy infrastructure and 471 00:30:13,720 --> 00:30:17,800 onshore manufacturing that they used to happily outsource. 472 00:30:18,240 --> 00:30:21,920 You are essentially taking money away from productive private 473 00:30:21,920 --> 00:30:26,000 investment and pouring it into government spending just to 474 00:30:26,000 --> 00:30:29,400 ensure that the lights stay on and the Internet keeps working 475 00:30:29,400 --> 00:30:33,240 when the next crisis hits. None of this adds to the 476 00:30:33,240 --> 00:30:35,520 productive capacity of the economy. 477 00:30:35,800 --> 00:30:40,360 All of it adds to the deficit, and this creates a cycle that's 478 00:30:40,360 --> 00:30:44,080 very difficult to break. More defence and infrastructure 479 00:30:44,080 --> 00:30:47,200 spending widens government deficits. 480 00:30:47,600 --> 00:30:51,280 Those deficits put pressure on the central bank to keep 481 00:30:51,280 --> 00:30:55,040 borrowing costs manageable. The central bank accommodates 482 00:30:55,040 --> 00:30:59,200 the politicians, as Pradhan and Goodhart argue they eventually 483 00:30:59,200 --> 00:31:02,960 will, by keeping interest rates lower than they should be. 484 00:31:03,320 --> 00:31:07,040 That fuels inflation. The inflation erodes living 485 00:31:07,040 --> 00:31:11,280 standards, which fuels populism, which further undermines the 486 00:31:11,280 --> 00:31:14,960 credibility of the very institutions trying to manage 487 00:31:14,960 --> 00:31:18,000 the crisis. For three decades, central 488 00:31:18,000 --> 00:31:20,440 bankers had the wind at their backs. 489 00:31:20,640 --> 00:31:25,120 Cheap labour, cheap goods, open trade routes and falling prices 490 00:31:25,120 --> 00:31:28,680 made the job look easy. Now the demographics have 491 00:31:28,680 --> 00:31:32,600 reversed, the trade routes are contested, the deficits are 492 00:31:32,600 --> 00:31:36,080 structural and the politicians are telling the central bank 493 00:31:36,080 --> 00:31:39,400 what to do. The wind hasn't just changed 494 00:31:39,400 --> 00:31:43,160 direction, it's blowing directly into their faces. 495 00:31:43,640 --> 00:31:47,400 Pradhan and Goodhart call this the age of the Unanchored 496 00:31:47,400 --> 00:31:52,040 Central Banker, an era in which the central bank can no longer 497 00:31:52,040 --> 00:31:56,600 single mindedly pursue low and stable inflation, not because 498 00:31:56,600 --> 00:31:59,840 central bankers have become less competent, but because the 499 00:31:59,840 --> 00:32:03,520 structural conditions that allowed them to succeed have 500 00:32:03,520 --> 00:32:07,280 been removed. At this point, the data suggests 501 00:32:07,480 --> 00:32:10,160 that the only people left on earth whose inflation 502 00:32:10,160 --> 00:32:14,840 expectations remain perfectly anchored at 2% is the Federal 503 00:32:14,840 --> 00:32:18,720 Open Market Committee itself, which is nice for them. 504 00:32:19,160 --> 00:32:22,640 For anyone who wants the detailed macroeconomic argument 505 00:32:22,640 --> 00:32:26,240 behind today's video, I'd highly recommend Pradhan and 506 00:32:26,240 --> 00:32:29,480 Goodheart's new book, The Unanchored Central Banker. 507 00:32:30,160 --> 00:32:32,400 Thanks for tuning into this week's podcast. 508 00:32:32,560 --> 00:32:35,640 If you found it interesting, I'd really appreciate it if you 509 00:32:35,640 --> 00:32:38,720 shared it with a friend, as there isn't really an algorithm 510 00:32:38,720 --> 00:32:41,720 for podcasts. They grow based on word of 511 00:32:41,720 --> 00:32:44,040 mouth. Have a great week and talk to 512 00:32:44,040 --> 00:32:45,600 you again soon. Bye.