Deflation And Slowing Growth: Why 2023 Will See Both Continue And Cause Fragility

Back in the summer of 2022 – I wrote that I believed inflation had peaked and would come down for the rest of the year.

That’s because when ignoring much of the noisy data, price pressures started rolling over in early June. Especially in oil and commodities like lumber.

And this was contrary to the crowd’s opinion, which expected inflationary pressures to further increase.

But six months later, it appears that inflation really did peak. And is now in steady decline.

Just take a look at today’s consumer price index (CPI) reading for December 2022.

The month-over-month headline rate actually came in negative 0.1% – the first time in over two-and-a-half years.

Meanwhile, the ‘core-CPI’ (excludes food and energy prices) only rose 0.3%, up 5.7% from a year earlier – which is the slowest pace since December 2021.

It’s clear that – at least for now – inflation is cooling.

But I believe this trend will only continue. Leading to outright deflation (i.e. negative price growth) in 2023 as supplies rebound and global growth slows further.

Here’s why. . .

The Three Factors That Drove Inflation Continue Reversing – And Fast

One of the most important yet underrated economists – Ludwig Von Mises – once said that a deflationary bust will always follow an inflationary boom.

Or said another way: the bigger the boom, the bigger the bust.

Thus to understand why deflation is now spreading, it’s necessary to understand why inflation rose in the first place. . .

Here’s some context: back in March 2020 – once COVID hit everywhere – we witnessed the global elites scramble as they tried to minimize the potential blowback.

But their policies were extremely inflationary.

There were three main causes:

First – supply chains were stuck at a standstill as economies worldwide ground to a halt. Thus curtailing the outflow of goods. And like we learned in economics-101, a sudden decline in supply – all else equal – leads to higher prices (this is known as ‘cost-push’ inflation).

Second – governments (the fiscal side) pumped a sensational amount of liquidity into the system. Things like student-loan pauses, mortgage forbearance pauses, PPP loans, direct stimulus checks, tax credits, etc. This all led to greater purchasing power. And thus created artificial demand as spending capacity soared (this is known as ‘demand-pull’ inflation).

And Third – central banks (the monetary side) began easing aggressively. They did things like cutting interest rates to zero, pumping reserves into banks through quantitative easing (QE), indirectly buying corporate bonds, buying over $2 trillion dollars’ worth of mortgage-backed securities (MBS), etc. These policies kept credit easy and asset prices artificially high – especially in real estate (this is known as ‘monetary‘ inflation).

Central banks were effectively pouring gasoline on an ongoing fire. . .

Thus between 2020 and 2021, these three factors – supply side, demand side, and monetary – were all spurring inflation.

But since late 2021, these factors are now in reverse. . .

Supply chains have recovered. Allowing the flow of goods to move smoothly through the global economy.

For instance, take a look at the Freightos Baltic Index (aka global container freight rates) – it’s plunged over 75% in the last year.

This is a significant decline. And one that is net deflationary.

Meanwhile – after a huge boost in 2020-21 – there’s been a contraction in the ‘fiscal impulse’ (aka how much government policy contributes to real growth) since the summer of 2021. And it’s projected to remain so for the next seven quarters straight (until Q3-2024).

Put another way, current government policy is now taking away from real growth (like a reverse stimulus) . . .

And finally – over the last year – the Fed’s aggressively tightened monetary policy.

In fact, they’ve forced the Fed funds rate (the interest rate the Fed uses to influence short-term borrowing costs) up at its fastest pace in decades.

They’ve also started unwinding their bloated balance sheet through quantitative tightening (QT). Meaning they’re pulling reserves out of the banking system.

And because of this tightening, M2 (aka liquid money supply) growth year-over-year has plunged negative for the first time in 60 years.

This is putting pressure on both asset prices and marginal spending power for consumers. Which isn’t positive for growth.

Thus these three key factors that spurred inflation post-COVID are now weighing down price pressures.

And this deflationary wave will continue throughout 2023 – especially as growth remains anemic. . .

Leading Indicators Point to Slowing Growth in 2023 – And Therefore Deeper Deflation

It’s important to remember that monetary policy acts with lag effects. Meaning that once the Fed eases/tightens, it’ll take many months (even years) for it to trickle through asset markets and the economy.

And this is why the Fed’s stuck chasing their own tail.

Or said another way – they shut the stable door after the horse escapes.

Because the Fed is reactive when setting policy; not proactive.

Thus by the time there’s a recession and deep deflation, they’re already far too late.

That’s why I believe there’s still significant downside momentum for the global economy over the next year. Because the Fed’s tightening into a slowdown.

To put this into perspective – take a look at the J.P. Morgan Global Manufacturing Index – which recently fell to a 30-month low in December.

The production of various goods has declined steadily since Q2-2021 – a full nine months before the Fed even began raising interest rates. . .

And according to the most recent JPM Global Manufacturing report – price pressures for both input costs and output prices eased to 26-and-24-month lows.

Keep in mind that PMIs are leading indicators (aka economic signals that show where the overall economy’s heading).

And if history means anything, this further decline in the global PMIs indicates further downside for global growth.

Meanwhile – the Conference Board’s Leading Economic Index (LEI – a basket of key leading indicators) has plunged negative year-over-year.

And the pace of contraction is only building.

The LEI’s now down 3.7% over the last six months (May and November 2022). A much steeper rate of decline than its 0.8% contraction over the previous six-month period, (November 2021 and May 2022).

Thus there continues to be a lack of economic momentum needed to spur any meaningful growth.

Beware: Deflation In A Credit Based System Isn’t Sustainable

So – in summary – I expect deflation to deepen and that the financial system will grow more fragile.

That’s because as of now, I don’t see any meaningful ‘push’ for global growth to rise.

If both fiscal and monetary policies (the two main spigots of liquidity) are further subtracting from growth, where will any upside come from?

And until this changes – prices, growth, and corporate margins will sink.

And this creates a bit of a problem.

Because if there is prolonged deflation – then the credit-driven world economy grows increasingly fragile.

Why?

Well, deflation in a system that’s dependent on debt and rising asset prices is unsustainable.

For example: if asset prices fall, yet debts stay the same – individuals and corporations will suffer in real terms.

That’s why – historically – big deflationary busts are what really wreck economies and financial systems.

Just some food for thought.

*Note: because I expect growth will slow and deflation to proliferate, I have been buying long-bond optionality since early November. I plan to hold because as deflation amplifies, real bond returns will increase. Thus bond prices will increase.

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