In a period of monetary tightening, when we’re in the part of the cycle where policymakers see inflation falling, you often see:
- a perceived upcoming pause in policy tightening, which usually gets…
- some type of asset market rally, which generally…
- reinforces the too-high inflation, which generally leads to…
- additional tightening (higher interest rates), which will usually lead to…
- another drop in markets
Drops in Corporate Earnings to Lower Inflation
In the US and most developed markets, to get wage growth down to a level where 2% overall inflation is realistic and the U-3 unemployment rate is around 3%, the math is such that you need a 2-3% rise in the unemployment rate relative to that.
This is because this 2-3% rise in unemployment equates to about a 20% drop in corporate earnings.
The drop in earnings is the thrust that forces companies to cut costs, which gets the layoffs to get the necessary rise in unemployment.
That translates to another 4-5 million workers that still need to be laid off in order to get wage inflation down to get overall inflation down (sustainably).
If they don’t do that, then we just have the inflation issue linger around longer. Inflation is can be self-sustaining at a point because the income being paid out in excess of output turns into spending, and the spending is somebody’s income, and so on.
For monetary policymakers to crack inflation…
To crack that cycle:
- real (inflation-adjusted) interest rates need to rise to…
- get private credit creation to drop, which…
- produces less spending, which…
- produces a weakening in the economy, which…
- will get corporate earnings down, which…
- will get layoffs up
And not only that, but once they get the layoffs, you need to hold that higher level of unemployment for a period of about 18 months to get inflation down to a more reasonable 2-3% rate on an annual basis.
That’s because there’s a lag between when they tighten monetary policy (higher real interest rates) and how that eventually feeds into a decline in wage growth.
If they measure that lag, they know that they need to hold that level of higher unemployment for about 18 months if they’re serious about getting back to normal inflation rates, normal spending relative to output, and appropriate nominal interest rates relative to nominal output.
And it’s important to note that this ~20% fall in earnings (or whatever is appropriate to restore proper equilibriums) is usually not currently discounted into markets, which means it’s not reflected in the prices of the asset markets it impacts.
Also, market pricing currently may generally discounts short-term interest rates being cut, which may not be likely (i.e., another drag on all asset markets) when the inflation issue is a bigger problem than the economic weakness.
Why It’s Getting Harder to Re-establish Lower Interest Rates (that were pervasive during the 2010s)
As for the logic why, if we take the United States, first you have the fiscal deficit of about 5% of GDP. They sell bonds to plug that gap.
Selling bonds pressures interest rates higher when there isn’t the demand for them because falling prices for credit assets increase their yields (the interest rates paid on them).
Monetary policy actions to fight inflation
Then the Federal Reserve is selling around 5% of GDP per year in bonds through their quantitative tightening program as they try to get short- and long-term rates up to fight inflation.
You have a trade deficit where the US imports more than it exports to the world, so this increases the external financing need and is another funding gap that needs to be plugged (or you need a devaluation in the currency, which would also be inflationary).
Then commercial banks are also selling bonds. When all the money was printed during Covid-19, a lot of that went into bank deposits and there was no loan demand, so the banks bought Treasury bonds.
Now they’re holding too many bonds and not enough loans, so they’re going to want to make loans and sell their bonds.
So there’s an impetus for credit growth to continue in the private sector even when the Fed is draining liquidity in the financial system, which reinforces the higher inflation rate.
Where is the demand for the bonds?
Then you look at the range of prospective buyers for all these bonds that are being sold into the market (e.g., pension funds, insurance companies, sovereign wealth funds, foreign central banks, etc.) and it’s very likely there are not enough buyers based on what they’re currently holding and what they’re motivated to do, which means we get a further rise in interest rates.
The easiest thing to give out in such a scenario – and what’s necessary – is private credit, which produces a fall in the growth rate.
So there’s likely to be a drag on asset prices from both the earnings side and the interest rate side.
The effect this has on any given asset (stock, house, bond, company, etc.) is very idiosyncratic, and it’ll affect some assets a lot in a bad way (e.g., companies that don’t produce earnings and/or are sensitive to interest rates) and some not as much.
What’s the Answer for Portfolios and Asset Allocation?
You get a mixture of three different things, depending on the policy response, which we don’t know.
- Higher interest rates
- Too-low growth, and
- Too-high inflation
We don’t know the mixture of the three because it depends on the policy decisions that will be made.
Does Inflation Cause a Currency to Weaken?
It depends. Currencies are measured in relative terms.
Even in an inflationary environment, a currency can strengthen against most currencies because real interest rates (i.e., inflation-adjusted interest rates) on money and credit assets may increase faster relative to what was discounted into the market pricing.
In other words, if the interest rate people receive on their money continues to at least match the inflation rate, then their purchasing power is at least holding steady.
If the interest rate they receive on it is lower than the inflation rate, they are losing purchasing power and are incentivized to move their money into other currencies and inflation-hedge assets (such as gold), which lowers demand for the currency and causes it to fall in value.
It’s very possible in an inflationary environment you can go from negative real interest rates to positive real interest rates, which is positive for the currency.
But longer-term, the fundamentals are against the dollar because as a country we spend more than we earn and have liabilities that are above our assets.
The current account is also a drag on the dollar, which has to do with the trade balance.
We import more than we export. As net imports rise, this involves selling dollars to get the goods, which increases the external financing need and requires offsetting flows to keep the currency steady.
With the financing need getting bigger, the currency will be vulnerable.