The S&P 500 is currently sitting near an all time high.
Equity traders seem to have decided that a war in the Middle
East, one that has effectively closed the world's most critical
energy choke point, is simply a great opportunity to buy the
dip. And buying the dip has become
such a winning strategy in recent years that dips don't
really happen much anymore. The average consumer is a bit
less convinced. U.S. consumer sentiment has
recently fallen to a 74 year low.
To put that in perspective, those 74 years included the
assassination of JFK, the 1973 oil embargo, September 11th, the
global financial crisis, and a global pandemic.
And people are more miserable now than they were during any of
those times. That is not a great number if
you're an incumbent politician running for office.
The immediate cause of this collapse in sentiment is the
closure of the Strait of Hormuz, though as we'll see, the
problems run much deeper than that.
In late February, an assault on Iran shut down the transit of
roughly 20 million barrels of oil a day, about 1/5 of the
global supply. Martin Wolf, riding in the
Financial Times, points out that the Strait is a vital artery of
the world economy, a place in which one starts a war only
after careful consideration of goals, means and risks.
He goes on to say that's not what happened.
Brent crude has, as of the time of this recording, been pushed
above $125.00 a barrel. As I mentioned in last week's
video, oil prices feed directly into the cost of food,
fertilizer, and shipping, so that increase is rapidly working
its way into everything you buy. Politicians would very much like
to blame our current cost of living problems entirely on this
geopolitical bad luck. And while the energy shock has
certainly acted as a massive accelerant, several highly
credible economists had been warning that a surge in
inflation was sitting in the pipeline long before the 1st
missile was fired. The war merely exposed the
problem, according to a new book by Manoj Pradhan and Charles
Goodheart. For three decades, central
bankers have been taking credit for a structural decline in
global prices that had almost nothing to do with their policy
decisions. They had the wind at their backs
and mistook it for the power of their own legs.
Now that the windows changed direction, the job of central
banker has become one of the most difficult and politically
dangerous roles in public life. Pradhan and Goodhart argue that
from about 1990 until recently, the global economy was coasting
on what economists call a demographic sweet spot.
The baby boomer generation had entered the workforce, female
labor participation rose sharply, and China and Eastern
Europe joined the global trading system.
This essentially amounted to a once in history doubling of the
effect of global labor force, which is a very reliable way to
keep wages and prices from going up.
Central bankers looked at this massive structural gift of cheap
labor and cheap goods and concluded that their success was
down to their own financial genius.
To understand why this matters, we need to talk about something
called the Phillips Curve. It's one of the most important
relationships in economics, and for years people thought that it
was broken. The Phillips Curve is the idea,
dating back to 1958, that when unemployment is low and workers
are scarce, wages go up and prices follow.
When there's lots of spare labor, prices stay flat.
Simple enough. But for the last two decades,
central bankers kept interest rates at rock bottom.
Unemployment fell to historic lows in several countries, and
inflation barely moved. Economists started writing
papers about the death of the Phillips curve.
Central bankers took credit for having conquered inflation
through sheer competence. Pradhan and Goodhart argue that
the Phillips curve wasn't dead, China had just put it in a coma.
The author's insight is that we shouldn't be looking at
inflation as one big number. There are two separate inflation
dynamics running at the same time.
The 1st is a domestic services curve.
Your hairdresser, your plumber, your lawyer, the people who have
to physically be where you are. Their prices are driven by your
local labour market. When workers are scarce, those
prices go up. That relationship never broke
down. The second is a goods curve, and
for the last 30 years this one was essentially made in China.
When you offshore most of your manufacturing to a country where
labour is cheaper, the price of physical goods falls
relentlessly. And that goods deflation was so
powerful that it masked the fact that services inflation, the
domestic part, was ticking along quite normally the whole time.
What this meant in practice was that central banks in the US and
Europe were essentially outsourcing their inflation
targets to Chinese factories. Politicians got to enjoy solid
economic growth with low borrowing costs.
Workers in the services sector got steady pay rises and nobody
had to make any difficult decisions because cheap
televisions and cheap clothing from China were pulling the
average down. It was a great arrangement for
everyone. The workers who lost those
factory jobs didn't vanish. Most of them ended up in the
services sector, which is one of the reasons services inflation
never actually went away. But that era is now coming to an
end. The world's population is aging
rapidly, and the global labor force is beginning to shrink.
China is still flooding certain sectors with cheap goods.
European car manufacturers can tell you all about that.
But the structural force that kept global prices falling for
30 years is running out of Rd. China's own population is aging
faster than almost any major economy.
It's workers are moving out of export driven manufacturing and
into domestic services, and on top of that tariffs and trade
barriers are now actively blocking whatever cheap goods
China does produce from reaching western consumers at the old
prices. The The structural tailwind that
made central banking look easy for 30 years hasn't just faded.
It's being erased by demographics, by geopolitics,
and by deliberate policy. And if you're a central banker
operating without that tailwind, in an economy where workers are
scarce, where services inflation is persistent, and where your
government is running enormous deficits that it has no
realistic plan to pay for, the job starts to look very
different. If you think this structural
shift sounds like an abstract long term problem for future
generations to worry about, it's not.
The bill is already coming, due back in January, before the
Strait of Hormuz was closed, before Brent hit 125, Adam
Posen, the president of the Peterson Institute for
International Economics, and Peter Orszag, the CEO of Lazard,
published a piece arguing that US inflation could hit 4% by the
end of this year. That is double the Federal
Reserve's target. And their argument had nothing
to do with an energy shock. They were warned that the
ingredients for a resurgence in inflation were already in place.
The war has simply thrown gasoline on a fire that was
already burning. Their case rests on several
reinforcing pressures. The first is the lagged pass
through of tariffs. When a government announces a
massive new tariff, businesses don't raise their prices the
next morning. They work through their existing
inventory. They watch what their
competitors do, and they wait to see if the policy gets reversed.
But eventually the old inventory runs out.
Poznan Orszag note that businesses have now depleted the
stockpiles they built up ahead of the tariffs, and they're
beginning to pass those costs on to consumers in smaller
increments, which means the inflationary effect is still
building, not fading. Then there's the labor market,
which is tightening. When any economy loses workers,
whether through aging, emigration or policy changes,
the same thing happens. Labor is an input, just like
energy or raw materials. When it becomes scarcer, wages
rise and those costs get passed on to consumers.
Several Federal Reserve banks now estimate that the break even
employment level, the number of jobs the economy needs to add
each month to keep unemployment stable, has roughly halved since
early 2024. The labor market is considerably
tighter than the headline numbers suggest.
You might reasonably ask whether automation and AI could fill the
gap, and over time, they possibly will.
In some sectors, as Posner has argued, the history of
technological disruption suggests that the productivity
gains tend to arrive before the deflationary effects do.
In the near term, scarce workers mean higher wages, and higher
wages in the services sector means higher prices at the
dentist, the care home, and the mechanic.
On top of that, fiscal policy remains remarkably loose. the US
government is expected to run a deficit exceeding 7% of GDP this
year, which is the sort of number you usually only see
during a war or a major recession, not during a period
of full employment. And financial conditions are
much more accommodating than the Federal Reserve's headline
interest rate would suggest. Credit spreads are tight,
household wealth is at record levels, and private credit
markets are supplying nearly $2 trillion of alternative
financing that sits completely outside the traditional banking
system. As Posen put it on the Odd Lots
podcast a few months ago, the Fed has tightened, but the
economy hasn't really noticed. Finally, and this may be the
most important piece, inflation expectations are beginning to
drift. When people experience price
increases on highly visible frequent purchases, eggs,
gasoline, home repairs, they start to expect higher prices in
the future. They demand higher wages.
Businesses raise prices in anticipation of higher costs.
It becomes self reinforcing. This is exactly what Paul
Volcker warned about in 1979 when he said that inflation
feeds in part on itself. The problem today is that after
the pandemic surge, inflation never truly returned to 2%.
We're entering this new energy shock with an economy that was
already primed for higher prices, which is not an ideal
starting position. This brings us to the question
of who actually pays for all of this, because the inflation
problem and the government spending problem are not
separate issues. They are the same problem.
To understand why government deficits are expanding at such a
rapid pace, we have to look back to the 1960s, when an economist
named William Baumol asked a fairly simple question.
He wanted to understand why a string quartet playing Beethoven
should be paid any more today than they were 100 years
earlier. The instruments, he argued, are
exactly the same. The sheet music is the same, the
number of people required to play the piece hasn't changed,
and the musicians productivity has not improved at all.
The answer, it turns out, is that the rest of the economy had
become more productive, and in such an environment, if you
didn't pay musicians a higher wage, they would simply give up
the violin and go work somewhere else.
So to keep the quartet playing, the concert venue has to pay
them more and ticket prices have to go up.
This concept is known as balm oil's cost disease, and while
it's very useful for explaining why concert tickets are
expensive, it also explains the structural nightmare currently
facing global government budgets.
I should clarify that when economists talk about a lack of
productivity in certain jobs, they aren't insulting anyone's
work ethic. In economics, productivity just
means output per hour. A factory worker with a new
machine can build 10 times as many cars today as they could 50
years ago, but a nurse, no matter how hard they work, can
still only care for one patient at a time.
This type of work is strictly constrained by the linear near
nature of time, which economists generally find quite
frustrating. As Pradhan and Goodheart point
out, the classic examples of balm oil's Cos disease are
education and healthcare. They are highly labor intensive
services that are provided in person and are thus famously
resistant to productivity gains. And while an aging population
might not need much in the way of primary schooling, they do
require an exponential increase in medical care.
As the proportion of elderly people rises, so does the
incidence of neurodegenerative diseases and the complex
comorbidities that come with living longer.
And despite what our tech elites might like to tell us, your
grandparents are highly unlikely to be satisfied with a robot
visiting them in the care home. Japan has actually been trying
that approach for years, spending billions on healthcare
robotics, and only 2% of its caregivers regularly use them.
The elderly require human carers, and because those carers
have the option of working in other increasingly productive
sectors of the economy, you have to pay them steadily higher
wages to maintain the exact same level of care.
You are essentially paying more and more for the string quartet,
except the quartet is your entire healthcare system, and
the audience is getting older by the day.
This all brings us to the fiscal problem.
Because healthcare spending is structurally locked in to rise
much faster than GDP, governments are staring down the
barrel of massive structural deficits that have very little
to do with which party happens to be in power.
In the United States, the nonpartisan Committee for a
Responsible Federal Budget estimates that the One Big
Beautiful Bill Act passed by the current administration will add
roughly $4 trillion to the national debt over the next
decade. And there's also the well known
Social Security Cliff approaching in 2033, when the
trust fund that pays retirees is expected to run dry.
Pradhan and Goodhart believe, and I think most honest
observers would agree, that when that moment arrives, the
politicians of the day will bail the system out rather than
impose a 24% cut in benefits on the most reliable voting bloc in
America. If you ask a politician how they
plan to pay for all of this, they'll invariably point to a
spreadsheet showing that their policies will generate a massive
boom in GDP growth. This boom will supposedly lead
to huge primary surpluses at some vaguely defined point in
the future. This sounds great, except that
these promised future surpluses almost never actually
materialize. They serve as a convenient
accounting fiction, allowing the current administrations to spend
money today while leaving the bill for whoever happens to be
sitting in office a decade from now.
The result is a slow, grinding, structural deterioration in the
public finances of almost every major economy.
And when governments can't or won't fix their fiscal problems
through spending cuts or tax increases, the pressure
inevitably lands on the one institution that can still print
money. If governments are unwilling to
cut spending or raise taxes, they have to find more creative
ways to manage the debt. In the United States, Treasury
Secretary Scott Percent has chosen a particular approach,
actively shifting the government's borrowing towards
the short end of the yield curve, issuing more Treasury
bills and fewer long dated bonds.
There's a certain irony in this. During the previous
administration, Besant was among the most vocal critics of Janet
Yellen for doing essentially the exact same thing.
His argument was a serious one, that the Treasury market derives
its special status precisely from not being managed for short
term convenience. the United States government can borrow
more cheaply than almost any other entity on earth.
Because the Treasury market is the deepest, most liquid, and
most stable asset market in the world.
Investors accept lower yields in exchange for that reliability.
When you start gaming the maturity structure for political
advantage, you erode the very thing that makes U.S. debt
special and that tends to show up eventually in higher
borrowing costs. It was a compelling critique at
the time, and it remains A compelling critique today.
Which makes it all the more remarkable that the man who made
it is now doing precisely what he warned against.
The logic behind the strategy is straightforward.
Short term rates are lower, so borrowing short saves money
today. And if you believe that rates
will fall significantly in the future, you avoid locking in
today's higher long term yields. The problem is the other side of
that bed. When you borrow short, you have
to keep rolling the debt over, and if rates don't fall, you
find yourself refinancing at whatever rate the market is
charging at the time. Given everything that we've just
discussed, structural inflation, aging demographics, persistent
fiscal deficit, there's no obvious macroeconomic reason to
expect a dramatic decline in interest rates.
The strategy makes sense if you believe that the pandemic error
interest rate environment was normal and will return.
Most of the evidence suggests that it was not and that it will
not. There is one component of the
inflation picture that both the Treasury and most traditional
macroeconomic models tend to quietly set aside, and that is
housing. Shelter costs make up more than
1/3 of the Consumer Price Index, the single largest component of
any category. If you read the research
predicting a return to low inflation, you'll notice that
housing is almost entirely absent from the analysis.
That is quite an omission. In the year to March, US shelter
costs rose by 3%, already above the Federal Reserve's 2% target,
while overall inflation came in at 3.3%.
And critically, the official CPI measure actually understates the
real time pressure because it captures rents across all
existing leases rather than what new tenants and new buyers are
actually paying today. Anyone currently looking for
somewhere to live knows that the number on the ground feels
considerably worse than 3%. The reasons are structural
Tariffs have driven up the cost of construction materials, the
contraction in the labor force has tightened the supply of
construction workers, and mortgage rates above 6% have
created what economists call the lock.
In effect, existing homeowners refused to sell because moving
would mean surrendering the cheap fixed rate that they
locked in years ago. The result is a market with
almost no supply, rising costs of new construction and no
obvious relief mechanism insight.
New household formation still happens.
People still fall in love and want somewhere to live.
But increasingly that requires building a new home at precisely
the moment when building one has never been more expensive.
And as I've discussed in previous videos, the broader
story of housing affordability across the developed world,
where house prices have risen far faster than wages for three
decades, is now creating a self reinforcing intergeneration
operational problem that no government seems willing or able
to solve. Older homeowners vote in large
numbers and have direct financial interest in keeping
prices high. Politicians who propose serious
measures to increase supply are essentially asking their most
reliable constituency to accept a fall in their net worth, which
is one of the reasons that the problem has persisted for as
long as it has. For the purposes of this video,
though, the the key point is simpler.
Housing inflation is structural, it's understated in the official
data, and it's not going away. Which means that the single
largest component of the inflation basket is working
against anyone who's hoping for a return to 2%.
If you look at all of these factors, the housing market, the
tightening labor market, the trade barriers, and the fiscal
deficits, you might assume that the public is fully aware of the
inflation risk building in the system.
According to a recent NBE, or working paper on inflation
expectations, they are not. The researchers studied how
ordinary people and businesses formed their inflation
expectations, and they discovered a pattern they call
the of selective inattention. It turns out that when inflation
is low and stable, people simply do not pay attention to monetary
policy. They ignore the Federal Reserve,
they don't know what the inflation target is, and they go
about their lives. This is entirely rational
behaviour. You don't tend to read the terms
and conditions of your home insurance policy until water's
already pouring through the ceiling.
But when inflation surges, as it did after the pandemic, people
suddenly start paying very close attention.
They check the news, they learn about the Fed, and they start
tracking inflation data. The problem is that they're
learning about monetary policy at the exact moment when the
central bank appears to be failing, which means the only
lesson they ever absorb is a -1. I mentioned earlier that
inflation expectations are beginning to drift.
The new research helps explain why this is so dangerous.
When people expect higher prices, they demand higher
wages. Businesses raise prices in
anticipation. It becomes self reinforcing,
which is precisely what happened in the 1970s.
The paper points out that the recent trajectory of household
inflation expectations looks almost identical to the lead up
to the inflation surge of 1974, which is, generally speaking, a
suboptimal baseline for long term price stability.
This brings us to the political reality of central banking.
If the Federal Reserve wants to bring inflation back down, it
has to keep interest rates restrictive.
But restrictive monetary policy makes government debt more
expensive to service, slows the economy, and makes politicians
deeply uncomfortable, particularly politicians who are
running for re election. As Pradhan and Goodhart point
out, in any lasting conflict between government and central
banks, the central banks lose. This is not a partisan
observation. It's been true under governments
of every political stripe in every country for as long as
central banks have existed. When fiscal conditions
deteriorate and the debt keeps rising, the political pressure
to cut rates becomes overwhelming, regardless of what
inflation is doing. We are already seeing this
tension play out. The current US administration
has offered some rather direct feedback to the Fed chair on
social media, initiated a Department of Justice
investigation into the central bank's office renovations, and
nominated Kevin Walsh to take over for the institution.
Borsch has called for what he describes as regime change at
the Fed, which is an unusual choice of words when discussing
monetary policy. But it would be a mistake to
treat this as a uniquely American or uniquely partisan
problem. The research on central bank
independence suggests that amongst the strongest predictors
of whether a central bank will lose control of inflation or
frequent turnover of its leadership and being pressured
to buy government debt directly in Turkey and Argentina, we've
seen what happens when politicians take full control of
monetary policy. You get rapid turnover of
central bank governors, the government forces the bank to
buy its bonds, and the currency loses its purchasing power.
The advanced economies are obviously in a very different
position. They've deeper capital markets,
stronger institutions, and the enormous advantage of borrowing
in their own currencies. But the underlying mechanics of
inflation do not change depending on the size of your
economy. When a government runs
persistent deficits and refuses to cut spending or raise taxes,
the pressure to monetize that debt to quietly print the
difference becomes very difficult for any central bank
to resist indefinitely. It is, for all intents and
purposes, a slow motion tax on everyone holding the currency.
And unlike an actual tax, no one has to vote for it.
For the last 30 years, the world essentially operated as one
massive optimized factory. If something was cheaper to
build in Germany or China or Taiwan, that's where it was
built, and we relied on an open, peaceful ocean to deliver it.
That system was extraordinarily efficient.
It was also one of the great disinflationary forces of the
modern era. But as the events in the Strait
of Hormuz have demonstrated, an open and peaceful ocean is no
longer a guaranteed feature of the global economy.
The breakdown of international alliances and the return of
geopolitical conflict means that countries are suddenly realizing
that they cannot rely on their historical partners.
This presents a rather practical problem for anyone who happens
to rely on electricity, food or the Internet.
Adam Posner's pointed out that Canada recently discovered it
has almost no Internet infrastructure that operates
independently of the United States.
All of their cables and satellites run through their
southern neighbor. For decades, this was perfectly
fine. You don't worry about
concentration risk when the relationship is stable.
But in a world where the terms of any international
relationship can shift rapidly, that kind of dependency starts
to look like a vulnerability. And Canada is not unusual in
this regard. Most countries have similar
single points of failure that they never thought to worry
about. So you have to build redundancy,
and redundancy is expensive. Europe is facing its biggest
geopolitical challenge since the Second World War Countries like
Poland and the Baltic states are increasing their defence
spending dramatically. Germany has launched new fiscal
expansions to rebuild its military capacity.
Across the globe, governments are being forced to duplicate
supply chains, build redundant energy infrastructure and
onshore manufacturing that they used to happily outsource.
You are essentially taking money away from productive private
investment and pouring it into government spending just to
ensure that the lights stay on and the Internet keeps working
when the next crisis hits. None of this adds to the
productive capacity of the economy.
All of it adds to the deficit, and this creates a cycle that's
very difficult to break. More defence and infrastructure
spending widens government deficits.
Those deficits put pressure on the central bank to keep
borrowing costs manageable. The central bank accommodates
the politicians, as Pradhan and Goodhart argue they eventually
will, by keeping interest rates lower than they should be.
That fuels inflation. The inflation erodes living
standards, which fuels populism, which further undermines the
credibility of the very institutions trying to manage
the crisis. For three decades, central
bankers had the wind at their backs.
Cheap labour, cheap goods, open trade routes and falling prices
made the job look easy. Now the demographics have
reversed, the trade routes are contested, the deficits are
structural and the politicians are telling the central bank
what to do. The wind hasn't just changed
direction, it's blowing directly into their faces.
Pradhan and Goodhart call this the age of the Unanchored
Central Banker, an era in which the central bank can no longer
single mindedly pursue low and stable inflation, not because
central bankers have become less competent, but because the
structural conditions that allowed them to succeed have
been removed. At this point, the data suggests
that the only people left on earth whose inflation
expectations remain perfectly anchored at 2% is the Federal
Open Market Committee itself, which is nice for them.
For anyone who wants the detailed macroeconomic argument
behind today's video, I'd highly recommend Pradhan and
Goodheart's new book, The Unanchored Central Banker.
Thanks for tuning into this week's podcast.
If you found it interesting, I'd really appreciate it if you
shared it with a friend, as there isn't really an algorithm
for podcasts. They grow based on word of
mouth. Have a great week and talk to
you again soon. Bye.