Rabobank: There Are Just Two Solutions To This Inflation Shock – One Is Extremely Painful, The Other One Is Worse

By Michael Every of Rabobank

Fiddle Didi in Shangri-LaLaLand

Apologies, but this is going to be an inflated Daily today: hopefully it still adds value rather than subtracting it.

Today has the BOE’s inflation attitudes survey (“I don’t like it”), but the market’s primary focus is going to be US CPI. As should have been expected from recent comments on the topic from the White House showing they don’t understand how inflation works, and from Larry Summers showing how a part of it (OER) does, the whisper is upside of the consensus 0.7% m-o-m, 8.3% y-o-y headline and 0.5% m-o-m, 5.9% y-o-y core. Real average weekly earnings are thus seen -3.4% y-o-y, a trend the OECD is also picking up on as an “I don’t like it”. Then we get US Michigan consumer sentiment for June, where the expectation is for a slight decline to 62.9 from 63.3, with expectations seen up from 55.2 to 55.3. With US gas prices over $5?! In terms of inflation expectations, the 1-year ahead figure is expected unchanged at 5.3%. There is no forecast for the 5-10-year figure, which has remained well-anchored around 3% so far.

So, perhaps a further unwelcome market surprise after one stemming from the ECB yesterday? See here for more post-meeting comment, but in short it was the usual “a camel is a horse designed by a committee” aesthetic. While the BOC went 50bps (and its Governor warned “Some Canadians who took out mortgages in 2020 and 2021 could see monthly payments jump by 45% in 2025-6 as rates rise.”), the Fed went 50bps, and even the RBA went 50bps (when *this* is what the economy looks like), the ECB only promised to deliver 25bps next month: you wait for the delivery, as with many goods nowadays. It may go 50bps in September after everyone has had fun on the beach for a few weeks, if it’s still absolutely necessary at that point. There was also little detail on the vaunted support mechanism for Eurozone peripheral yields.

The consequences are that the market is going to test the ECB again: German 10 year yields went up from 1.35% to 1.43%; Italian 10s from 3.36% to 3.60%. “Lo spread” is back(?) When the ECB acts, we will find out how much EUR doesn’t like what Italian bonds then do – which will push inflation higher. Especially with US gas flows interrupted, which will be the case for at least three weeks; and the geopolitical spat with Algeria looks more serious than many took it at first glance – apart from gas flows, all commercial contacts with Spain have now been frozen.

Elsewhere, we saw what looked like a lighter-touch approach from regulators towards Ant Financial and Didi. However, as the Asia Nikkei notes, “Didi Global will trade on the NYSE for the last time on Friday, ending a wild 11-month ride on the prestigious US market while leaving investors in the lurch about its future direction.” Which sums up the whole Chinese market. Yes, some tech is up 50% from its low, but it’s still down over 60% from its high. Does anyone think this is a Damascene conversion back to ‘ra-ra-ra markets’?

Yet ra-ra-ra there is. Parts of Shanghai are back in lockdown despite the ‘victory’ over Covid and low official positive test numbers – might Chinese officials goal-seek Covid test results the same way they do “dodgy” GDP numbers? (And the same way the Fed just produced a dodgy Q1 household wealth number showing little negative impact?) Regardless of that Covid backdrop, ‘Hong Kong invites global financiers to two-day November summit in much-heralded bid to reclaim city’s spot in world finance’: so, “Come for the neoliberal financialization: Stay for the Marx-Lenin-Mao-Xi Jinping Thought!”  And stay in quarantine even longer if you catch Covid.

But back to inflation. In China we saw CPI and PPI data, with the former 2.1% y-o-y, unchanged vs. April, while PPI fell back to 6.4% y-o-y from 8.0% despite the commodity price spike being seen everywhere globally. Isn’t it amazing how producing far too much relative to local demand, subsidising coal (and other things), holding vast state stockpiles of many key goods, and being able to lean on producers (and statisticians) all helps keep inflation low?

Relatedly, please also look at ‘Corporations aren’t greedy enough: Economists are divorced from reality’), which does a better job of explaining US inflation to markets, the White House, and Congress than anything else you will read today. The summary is that political debate over inflation has settled into neoliberals blaming too much fiscal stimulus and progressives blaming Covid, Ukraine, and “corporate greed”. If the former are correct, we can no longer have real fiscal stimulus. No Build Back Better at all. If the latter are correct, there is nothing anyone, even the Fed, can do about inflation without (geo)political upheaval.

Importantly, another key factor is that the largest US firms are *not* growing alongside bumper profits because “shareholders prefer that companies return cash rather than invest… Economic theory assumes that companies are managed to maximise individual firm profits and, therefore, that they will invest to expand operations as long as expected returns exceed the cost of capital, and that they will compete with each other until profit margins approach zero. But economic theory has refused to grapple with the fact that maximising shareholder returns is not identical to maximising firm profits.”

Oligopolies and monopsonies mean firms can make more money by *not* expanding: “This trend has led to an erosion of productive capacity and supply buffers, which has become painfully evident in recent years… The result is a bifurcated economy with high-margin “superstar” firms on one side and low-profit “commoditised” firms on the other. In an inflationary environment, this means that firms with large profit cushions… have the pricing power to maintain high margins. Firms without pricing power, like small-business restaurant franchisees, often have no profit cushions and must raise prices out of necessity.”

So, yes, we have echoes of a 70’s-style wage-price spiral: look at strikes across EU airports; I was told an HR manager at Ben Gurion airport in Israel needs to hire 30 workers, but only managed to get three; and The American Prospect asks ‘Will today’s unions invest big-time in the young workers now beginning to rebuild American labour? Or will they remain AWOL and ensure the movement’s continued decline?’

At the same time, we also have the threat of a “profit-price” spiral. The telling precedent is the tobacco industry: “Since [US] cigarette consumption began dropping in the Eighties, the basic model of tobacco companies has been to offset sales volume declines with price increases. This strategy works because tobacco companies face little competition due to industry concentration and regulations prohibiting advertising. Thus cigarette price inflation has averaged about 7% per year since 1997, while overall inflation during that time has been slightly above 2%.”

Raising rates will not deal with structural inflation: yet lowering rates will only exacerbate it for two reasons: first, because the state won’t invest *productively*, savers are penalised, and productive private investment is discouraged versus financialization and asset-price speculation; second, because the US is now in a geopolitical fix where others are trying to ‘tobacco’ it, and the only way to resist is to flush financialization out of commodities via high US rates/US dollar.

The article echoes an old view here: that the US needs supply-side reform, which is what cured 70’s inflation. However, it now needs an *inverse* 70’s reform that favors onshoring and industrial policy to increase supply. Yes, that is inflationary as a one-off shock. Yet the alternative is permanently higher inflation *and* loss of geopolitical power. At the same time,

“Also required is the recognition that fundamental assumptions of economic theory –and the ideological approaches they inspire– no longer match the realities of America’s financialised economy.”

Is this unrealistic? If so, it’s a stance echoed by people deeply versed with reality in D.C. No, not Congress! The people at the US-China Competition in Global Supply Chains Hearing telling them what they should be doing. Key quotes from the expert testimony heard included:

“China is responsible for over 1/3 of US imports of critical technology goods. However, US import dependence on China for these goods is even more pronounced when looking at specific critical tech industries and  interpreting trade statistics more carefully. The goal of US critical tech supply chain policies should be to ensure that for each segment of those supply chains there are at least three manufacturers domestically or in friendly countries that are able to meet 50% of current and forecast domestic demand.”

“It would be naïve to think that countries such as South Korea and Taiwan became semiconductor hubs solely because of government incentives, and that if those incentives were matched by other (Western) regions, the supply chain would “re-shore.” If end-customer industries, such as automotive, mobile, and ICT, are not incentivizing geographic diversification through strategic procurement decisions (being willing to pay more), not much will change.”

“The policy question is, what is better: a Chinese semiconductor ecosystem that is mostly self-reliant but several generations behind the global cutting-edge or one that continues to rely strongly on Western technology but is competing successfully in some markets?”

“PRC dominance in the rare earth industry is a matter of policy, not geography: Export controls, production quotas, state investment in basic research, nationalization of the industry, and most recently state consolidation into a vertically integrated mega-firm. The US government can help ameliorate supply chain vulnerabilities in rare earths by emulating Japan’s model of public-private funding for new mining and separation facilities that help overcome initial political and environmental risks.”

“Until about 1980, the US had at least balanced trade and was self-sufficient in a broad range of products and industries. Now, the US trade profile looks more like that of a developing country than the Arsenal of Democracy. The federal government needs an industrial policy instead of what has been, in effect, a deindustrialization policy.”

“It is important that we frame our R&D and innovation ecosystem as a critical supply chain input and a national asset. Yet this is an area that is the least protected and the most vulnerable to China’s predations. End-user entities within China’s research enterprise matter, and real national security concerns can arise from the open collaboration they enjoy with US institutions.”

Can one rely on the White House or Congress to act? The America COMPETES Act to spend $52bn on high-end semiconductor production just stalled between the House and Senate versions. Nonetheless, it will pass in time, and the industry *is* returning to the US.

Moreover, President Biden just tweeted, “One of the reasons prices have gone up is because a handful of companies who control the market have raised shipping prices by as much as 1,000%. It’s outrageous – and I’m calling on Congress to crack down on them.”  That is not what his own FMC investigation concluded, and comes as spot freight rates are declining (for now). So, the same clarity displayed in the president’s appearance on the Jimmy Kimmel show?

However, Congress just agreed to pass the Ocean Shipping Reform Act following the milder senate version. That sees the US re-regulate global maritime trade to its benefit, as we predicted last year, despite the industry saying “never gonna happen”. Watch this space as the implications become clear to markets.

Relatedly, given maritime commercial power underpins military power, Singapore’s annual defence-related Shangri-La Dialogue is kicking off today.

That is as Iran removed another 27 cameras from its nuclear facilities, prompting IAEA warnings; after Israel drilled for an air attack on Iran; PM Bennett made a surprise flying visit to the UAE despite his government being close to collapse; and the US Congress proposed an Arab-Israeli air-defence pact vs. Iran ahead of President Biden’s regional visit. Is this pre-February 24 all over again? Hopefully, and probably, not. Indeed, the Israelis are still trying to see the funny side of it, with Iran boasting it had successfully killed a Mossad agent named ‘Asa Flotz’, which in Hebrew is a derivate of ‘to fart’, suggesting somebody is playing a game with Tehran. (You get a lot of this regionally: remember Israel-trained shark attacks in Egypt back in 2010?) Regardless, markets would be foolish to dismiss the very fat tail risks involved as just a joke. Again.

Türkiye’s President Erdogan, running for a (probably) unconstitutional third term, also tweets, “We warn Greece once more to avoid dreams, statements and actions that will lead to regret, as it did a century ago, and to return to its senses. Türkiye will not relinquish its rights in the Aegean and will not refrain from using the powers granted to it by international agreements for the armament of the islands when necessary.”

Russia’s President Putin has shifted from talk from Nazis and NATO to boast that he is following the Peter the Great in ‘taking back our lands’, and the Russian Duma has proposed legislation to remove recognition of Lithuania’s exit from the USSR.

All that aside, the primary conversation in Singapore will be about China. The US sees Beijing’s recent muscular stumble in the Pacific has an opportunity to rebuild bridges there for once, rather than making its own very muscular stumbles. The US and Chinese military chiefs will meet in person at the event: let’s see if guard rails are put in place, or things go off the rails. Inauspiciously, the US Ambassador to China just said bilateral relations might be at the lowest level since 1972. Any further back in time and we are pre-Nixon and the paradigm that saw US firms flood into China in the first place. And it’s not only the US heading that way: yesterday saw The Global Times warn ‘China-EU economic ties on brink of an ideological confrontation trap’, insisting the EU sign the definitely-stalled EU-China CAI deal, and walk away from the US.

Meanwhile, Japanese PM Kishida is set to flag he is to boost national defence spending to 2% of GDP, making Japan the third largest military spender in the world in dollar terms (at least until JPY hits 200), as well as launching a new 20-nation strategy for maritime security in a “free and open Indo-Pacific.” Which will not involve China in any positive sense.

I know this is seems irrelevant to those focused on whether headline US CPI will be 0.7% or 0.8% today; but to not see the underlying links between geopolitics, national politics, supply chains, inflation, and where rates ultimately end up is to say ‘fiddle Didi’ in Shangri-LaLaLand. As many were happily still doing on 23 February.

Happy Friday.