The Unbearable heat of Imported Inflation
Will the Interest rate hike enable the 40-year high US inflation to cool off?
Can The Federal Reserve afford to increase the interest rates in a meaningful manner to curb Inflation?
Can Cheap liquidity ever dry up in foreseeable future?
“The only thing that we learn from history is that we learn nothing from history.” These are the famous words from the German philosopher Georg Hegel.
Whether economic turmoil, Whether Social chaos, Whether Pandemic, seldom one has learned from the past and has acted upon with Prudence in the present.
Today the context is economics and US Fed is in question and the action it will take.
The world, especially the financial markets across geographies is eagerly waiting as well as speculating about the forthcoming action which Fed will take with regards to the Policy rates.
What will happen next?
In the first week of January 2022, data arrived for December 2021, about US retail Inflation (CPI) which hit a 40 year high of 7%. It was the 7th consecutive month in a row when retail inflation stayed above the 5% mark. Markets panicked, expectations and notions started building up of an interest rate hike in the first quarter of CY 2022.
Whatever action, (Hawkish, Dovish, Neutral) the Federal Reserve will take in the forthcoming future and number of times, it will take with all its wisdom, there are surely some lessons to be learned from events that played out four decades back, that led to the high, very high Inflationary pressure of 13.50% — 14% in 1980.
In the 80s, the US economists and thus US Federal government were of the view that employment generation is the single biggest objective through which the economy can remain buoyant. On the hind side, the US always looked back at the horrendous past and experience of the Great Depression, and thus the belief got built that the only thing that enabled the country to chug out of crisis and facilitated it to proceed on the path of progress post World War II was 3 essentials or 3 underlying Principles.
Reasonable Credit at a reasonable cost,
Higher per capita consumption.
The idea soon found its way into US lawmakers’ policy documents. Hence, since the 1940s everything was aligned to the above 3 essentials. Policy action was initiated such that Taxation and tax collection got in sync with the spending from the government, thereby creating aggregate demand in the country.
As the country gradually came out of the Great Depression of 1929, the US Congress in 1946, enacted the Employment Act, which bound the federal government has the prime responsibility of generating enough employment for its citizens amongst other necessities that need to be provided for.
As the US economy prospered with the formation of GATT in 1948, International trade and rapid innovation, along with fast track industrialization, production continued to soar. And, so did the demand for labor, thus the rise in wages that led to a surge in consumption, and thus inflation swelled up.
The Phillips Curve which showed the inverse relationship between unemployment and inflation kept confirming and giving confidence to the Policymakers that they are on the right track until one day something unexpected happened.
An oil embargo by the Organization of Arab Petroleum Exporting Countries (OPEC) and a decline in oil production due to the Iranian Revolution and the Iran–Iraq War in 1979 led to a massive shortage of fuel and thus pushed the energy prices northward. This contributed to inflation hitting a 14% mark in the 1980s.
Paul Volcker became the Chair of the Federal Reserve and began his well-known campaign of hiking interest rates to bring inflation under control. Volcker with his shock therapy increased the interest rates rapidly.
Over the course of 1980, interest rates spiked, fell briefly and then spiked again. Lending activity fell, unemployment rose, and the economy entered a brief recession between January and July of 1980. Inflation fell but was still high even as the economy recovered in the second half of 1980.
But the Volcker’s Fed continued to press the fight against high inflation with a combination of higher interest rates and even slower reserve growth. The economy entered recession again in July 1981, and this proved to be more severe and protracted, lasting until November 1982. Unemployment peaked at nearly 11 percent (3.9% as of 7th Jan 2022 data for Dec 2021).
The above was history, nearly four decades back, but this time, the scenario is even more arduous. The US economy is more leveraged than any time in the past history and Wealth is concentrated in fewer hands than any time before in the history of the US.
On top of that, the exports from China to the US have multiplied manifold. US Imports from China accounted for ~19% of overall imports in 2020, and in value terms US Imports are up by 325% from 2001 (in nearly 2 decades.) It’s important to keep in mind that inflation in those 20 years in the US has been benign and despite benign inflation value of imports has jumped 325%.
From electricals to chemicals, to toys, to rubber, to plastics, to ceramics, to beddings, to sports equipment, to furniture, almost everything that a common American consumes on a day-to-day basis gets exported by China to the US.
This begs the question, if this arrangement was working fine for 2 decades, what went wrong now?
The answer lies in IMPORTED INFLATION.
China’s Private debt to nominal GDP stood at ~183% in March 2021 and one witnessed the collapse of Chinese debt markets with EverGrande, Fantasia, Sinic Holdings going bust (3 largest overseas debt holders in Chinese Real Estate Space defaulting on International bonds/borrowings sending Dollar yields to 25% +).
Series of Credit defaults along with bludgeoning debt pushed the Chinese lawmakers to act fast to cool off the economy. As the supply-side got hit, inflation climbed in the US as demand remained buoyant whilst China continued to produce less.
Surging Commodity, raw material, energy prices only added fuel to fire. A lot of people found Equity markets, crypto assets, and Gig economy to be the new income source that led to the Great Resignation thus creating a shortage of both blue collared and white collared workers, pushing wages northward.
Covid and lockdowns further disrupted the supply chains and replaced the items in cargo and containers from B2B to B2C products and items (The margins and profitability in transporting B2C items are nearly 3 times higher as compared to B2B).
Another conundrum the US is facing is the rising retail debt on US Households.
Data as per Experian’s 2020 Consumer Credit Review
This debt is against the Median US household Yearly Income of USD 67,521 in 2020.
In such a scenario, increasing interest rates in a significant manner — beyond 10 basis points to 25 basis points– (Up to 25 basis points is understandable to give a direction to the Interest rate cycle) can prove to be dangerous and catastrophic.
It will push borrowing rates for the US Federal Government which is one of the biggest borrowers currently and which will continue to borrow heavily in the foreseeable future.
Impending borrowing by US Federal government is essential as this money is needed to rebuild America as well as to support the common American who is anyways reeling under high pressure of debt and under Covid challenges.
US economy also is cooling off with Q3 2021 real GDP inching up by 2.3% as against 6.7% in Q2 2021. Thus the major increases in Policy rates don’t seem to be an option, as well as leaving Inflation unattended also can’t be the choice one can opt for.
What lies ahead of the US Fed and thus the other economies and thus the global capital markets is: A tight walk on a thin rope, where any misbalance can revive the memories and scenario Hyper Inflation or Deep Double Dip Recession of the 1980s yet again.
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