Demand destruction? Two reasons to be skeptical

Thursday, October 20, 2022 11:24 a.m.


CFA Institute Contributor

These are articles written by professionals for investment professionals. These are contributions from outside subject matter experts who do not work for the CFA Institute, but who may be CFA charterholders as well as members of a CFA Society. All are experts in their field and strive to provide useful information that helps investment professionals make better decisions.

World central banks have made a ‘all-in‘ efforts to accelerate the tightening of monetary policy in order to dampen demand. But weaker economic data in the eurozone and United States exacerbated fears of recession.

As the outlook for growth dims, many expect the destruction of demand to lead to lower inflation. In other words, tighter monetary policy and the higher financing costs associated with it will reduce demand and offset supply shortages resulting from geopolitical instability and supply chain disruptions. This view is based on the belief that inflation outcomes are largely determined by central bank policies.

However, what US Federal Reserve Chairman Jerome Powell described in 2019 as “muted‘ the inflation of previous years, especially during the oil crash from 2014 to 2016, demonstrated the insensitivity of inflation to demand-side policies. Even the European Central Bank’s (ECB) quantitative easing (QE) in 2015 failed to stimulate demand in a way that reduced excess supply.

The Fed’s dovish policy stance in the decade before the pandemic pushed the Atlanta Fed Wu-Xia Shadow Federal Funds Rate below zero several times. Yet the Fed’s favorite price measure – personal consumption expenditure (PCE) – has been less sensitive to such policy shifts than it was at the end of the Cold War or China’s entry into the EU. World Trade Organization (WTO) in 2001, among other catalysts.

Personal Consumption Expenditure vs. Shadow Federal Funds Rate

Sources: Federal Reserve Bank of Atlanta, US Department of Commerce, Kekselias, Inc.

Similarly, the recent quantitative easing and rate hikes have not created enough demand destruction to counter the geopolitical commodity scarcity. Instead of following central bank policy over the past two decades, inflation has largely co-evolved with commodity prices, or with demand and supply factors.

Eurozone, US and UK inflation vs. commodity index

Sources: Eurostat, UK Office for National Statistics, US Federal Reserve, Bloomberg, LP, Kekselias, Inc.

This casts doubt on the “rate-determines-activities-determines-inflation” framework and suggests that national monetary policy alone cannot raise or dampen inflation. Other factors must come into play.

1. Tax expenditures = higher demand

Given EQs long and variable trickle-down effect, pandemic-era policies have sought to counter the demand shortfall by expanding balance sheets and through fiscal stimulus, or by printing money and sending checks directly to households. This drastically reduces the transmission time between central bank easing and realized inflation. The deployment of ‘helicopter money‘ quickly revived the request.

As the pandemic-related disruptions eased, the planned fiscal tightening never materialized. Instead, fiscal-monetary cooperation has become the norm and Cash payment a regular political tool. Following his Eat Out to Help Programfor example, the British government announced in May this year £15billion package to send £1,200 in support payments to millions of households. As UK energy prices soared, Liz Truss, the British Prime Minister, proposed an emergency budget spending package to ease the financial stress of the public.

On the other side of the Atlantic, many American states have announced stimulus payments to ease the pain of high inflationand President Joe Biden introduced a student loan relief program.
The lesson is clear: central banks are no longer the only players in terms of economic recovery.

2. Geopolitical events = supply disruptions

As multinationals regionalising, near-shore and re-shore supply chains and prioritizing resilience and redundancy over cost optimization, the scarcity of energy in the Eurozone has created further disruptions. German chemical production is expected to fall in 2022, which could overseas export inflation.

As geopolitical instability contributes to domestic economic challenges and more fiscal stimulus is rolled out, inflation could be much less responsive to traditional monetary drivers. In such circumstances, a rigid framework that equates tight monetary policy and high prices with demand destruction and disinflation will no longer apply.

For investors assessing portfolio risk, such conditions can offset disinflationary pressures from slowing growth.

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By Victor Xingfounder and portfolio manager of Kekselias, Inc., and former fixed income trading analyst at Capital Group Companies, specializing in monetary policy, inflation-linked bonds and interest rate markets.

All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / desperado

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