After decades of low and stable inflation, and correspondingly ever lower interest rates, 2021 saw the start of a major move up in price levels around the world. Rates of inflation had reached the highest levels in the US in forty years by June of last year.
The textbook response from central banks to elevated levels of inflation is to raise interest rates. It is by raising interest rates (and consequently the cost of debt) that acts as a break on the economy and so should cool down inflation.
Higher interest rates make capital and liquidity in the economy, all else equal, more scarce via higher cost of debt and financing capital (higher rates). This tightening in financial conditions makes it more expensive to fund capital investments, consumer spending, etc. This eventually results in a slowdown in the economy which helps to bring inflation under control via lower demand for goods and services. As aggregate demand declines, inflation comes down, and we move into the stage in the business cycle where central banks can start talking about cutting interest rates.
This is how it’s supposed to work in theory at least.
Well… it feels like it has been a while since interest rates started rising in most countries. This begs the question for us as investors: have financial conditions tightened enough yet to consistently crimp demand and bring down inflation? In other words: are we there yet?
Some of the important economic data is pointing in the right direction for a fall in aggregate demand. The US treasury yield curve is now as inverted as it has been since 2007. What does that mean? We’ll save an explanation of the yield curve for another episode, but the best way of thinking about ‘yield curve inversion’, is that as a lead indicator for the economy, it has a high hit rate when it comes to predicting economic slowdowns. And it is currently flashing red for a slowdown in demand.
Here’s another economic data point. M2 money supply growth in the US is now negative. Again, we’ll save the detailed explanation for another episode of this metric, but suffice it to say that when this measure of liquidity in the US economy goes negative, that has historically been an indication that economic demand will slowdown in the future.
But… and this is a big but. There is evidence elsewhere in markets that financial conditions are not yet tight enough to bring demand and inflation down sustainably. Several widely followed indexes of financial conditions appear to indicate we remain in ‘loose’ territory. These indexes measure a range of data points to try and show how tight or loose overall financial conditions are in the wider economy. We would expect to see these indexes clearly moving into ‘tighter’ conditions if the interest rate rises of the past 12 months were fully flowing through into the economy.
Further, there are other important indicators in markets which further support the view that conditions remain ‘loose’ and have not tightened all that much just yet. Speculative manias in asset prices of the past have usually coincided with very loose monetary and financial conditions, only ending when financial conditions tighten. When we look at the most recent speculative bubbles, in some areas of the stock market and crypto-currencies, we see that prices have risen year-to-date in 2023. And they have risen by a lot! Bitcoin is up +31%, Tesla share price +68%, so far in 2023 (just over two months). That does not sound like a major tightening in financial conditions to us.
Further, there are other signals of a major tightening that you should expect to see at that stage of the business cycle. Businesses with high levels of debt having to file for bankruptcy, for example. There is a notable dearth of news stories like this.
The short answer to the leading question in the title of this episode, therefore, is a resounding ‘no’. We’re definitely not there yet on financial conditions in the economy to be able to confidently say that we are ‘tight’ enough to have confidence in demand declining and bringing down inflation.
Recent hot inflation data releases in Spain, Australia, and the US, support this view.
In fact, current financial conditions are still loose. It takes time for higher rates to feed through into properly tight financial conditions. It will come though, the US Federal Reserve is telling us that a major tightening will happen.
We can hear you asking the next question: how will we know when are there?
There will be some big clues to watch out for. Bitcoin and other crypto-currency prices are a good place to start. So long as those prices are going up or staying flat, we’re still in ‘loose’ territory. Watch out for those prices dropping dramatically as an indicator that we may, finally, be approaching an end game for tightening in financial conditions, and as such, an end game for higher inflation and higher rates.