Charts of the Month

CHART 1 – US FINANCIAL CONDITIONS ARE VERY TIGHT

Why is the Federal Reserve cutting interest rates when headline CPI is still above its 2% target?

The answer lies in the chart below.

It shows the current Fed funds rate (blue line) against US core CPI inflation (red line). The latter strips out volatile food and energy prices from the headline measure, which supposedly provides policymakers with a more stable measure of underlying inflationary pressures.

For over 20 years it’s been rare for the cost of borrowing to exceed core CPI.

In fact, until recently, it’s only happened twice before and both episodes were marked by extreme economic and market weakness. Firstly, in the mid-2000s, which culminated in the Great Financial Crisis. Then again in late 2018 when rising rates triggered a big US stock market sell-off.

So with the Fed funds rate currently residing at 5% and core CPI a little over 3%y/y, policymakers will be well aware that financial conditions are extremely tight for the more indebted companies and households.

Which is why we should expect this gap to close further over the coming months. Likely via a combination of falling interest rates and a rebound in core CPI.

CHART 2 – CHINA’S DEFLATIONARY IMPULSE

China is the world’s second largest economy and remains a key influence on global trade so it continues to set the tone for global growth and inflation trends.

Right now, it is back to exporting deflation.

The chart below shows a recent collapse in Chinese M1 money growth (blue line) which, in turn, reflects the government’s ongoing clampdown on the property sector.

This is a complex indicator with many moving parts but, in simple terms, it reflects the amount of money washing around the economy. When the metric is rising, economic actors tend to have more money at hand and that usually results in stronger growth and higher inflation than would otherwise be the case.

The converse is also true.

When it’s in negative territory, like now, it suggests Chinese growth is weak and that usually results in a lower demand for goods and services, especially raw materials and other commodities.

Which is why the annual change in the WTI oil price (red line) has been so closely linked to Chinese M1 money growth over the past 20 years. And this helps to explain why resource markets are currently under pressure; the oil price has fallen from U$90/bl to U$70/bl over the past year.

Chinese demand (or lack thereof) remains a major influence on global commodity prices and, until domestic monetary conditions improve, inflation rates across the world are likely to remain contained.

CHART 3 – FOLLOW THE PPI PIPER

Where US producer prices (PPI) go, consumer prices (CPI) tend to follow.

The chart below shows US CPI (blue line) versus US PPI (red line) over the past 10 years. There is an incredibly tight correlation between the two lines with the CPI measure typically lagging the movement in PPI by just 1 month.

This should come as no surprise.

The PPI index captures changes in the input costs of goods and services across the economy so they are heavily linked to how consumer prices are evolving just a few weeks later.

And with global commodity prices softening due to slowing GDP growth (particularly in China) US PPI is unlikely to strengthen meaningfully anytime soon.

This should embolden the Federal Reserve (and other Central Banks) to carry on cutting interest rates well into 2025, arguing for lower short-dated bond yields and a bid for longer-duration risk assets.

However, there will come a point at which the lower borrowing costs ignite a rebound in economic activity and that tends to lead to rising inflation.

This is unlikely to be a near-term threat, but something investors should consider as we head into the third year of this equity bull market.

CHART 4 – THE 1970s REDUX?

Whilst cooling growth and inflation rates are giving the Central Banks covering fire to lower interest rates, they are likely sowing the seeds for a resurfacing of inflationary pressures within the next 1-2 years.

During the early 1970s, the US economy (and many others) experienced a second wave of inflation soon after the Federal Reserve began cutting interest rates which, in turn, came about because policymakers felt they had vanquished the first inflationary scare in the late 1960s.

In reality, acute price pressures had become embedded in the economy so the loosening of financial conditions added fuel to fire, sparking a spike in inflation that saw CPI surge to 12% by November 1974. A final, more sinister, wave emerged in the latter part of the decade before the Volcker Fed implemented a series of aggressive rate hikes, in the early 1980s, that ultimately caused inflation’s demise.

The prevailing economic situation is vastly different to back then with higher debt loads, greater international trade and less trade union power all arguing against a repeat of the 1970s trends.

But there is a strong argument that headline CPI rates are in the process of hitting a nadir around current levels which, significantly, remain above the Central Banks’ target rates.

This suggests we are in a new regime for monetary policy.

One where policymakers are prioritising financial stability and their Government’s abilities to refinance its debts over growth and inflation targets.