When A Great Deflationary Bear Starts Turning Inflationary
Over the past four years one of the dominant "deflationists" has been Gluskin Sheff's David Rosenberg. And, for the most part, his corresponding thesis - long bonds - has been a correct and lucrative one, if not so much for any inherent deflation in the system but because of the Fed's actual control of the entire bond curve and Bernanke's monetization of the primary deflationary signal the 10 and certainly the 30 Year bond. The endless purchases of these two security classes, coupled with periodic flights to safety into the bond complex have validated his call. Until now.
In his latest letter the Gluskin Sheff strategist appears to be on the verge of a "tectonic shift" in his outlook and appears on the verge of transitioning to an inflationary view. The catalyst? The same one we have been highlighting for the past year - the central-planning induced breach of one of the most fundamental economic principles in the face of Okun's law, which traditionally has been the basis for the Fed's belief that based on current reads of output and GDP, the amount of slack in the system is still a very recessionary 6%, and that with further relentless monetization this output gap may be closed further resulting in a drop in the unemployment rate to the Open-Ended QE's target of mid-6%. However, as we also pointed out previously, this does not jive with the recent surge in labor costs and drop in productivity, both of which are indicative of far less slack in the system and a far smaller output gap, than the Fed believes is present.
Naturally, the logical conclusion is that with the Fed injecting $85 billion in deferred inflation into the system and with the output gap substantially less than forecast, the reflationary inflection point is certainly closer than many have feared. Certainly closer than a great deflationist such as Rosenberg has feared. From his latest letter:
What if the Fed is operating under a false presumption that the CBO's estimate of the output gap is accurate at 6%? And what if the pace of job creation of the past three months is the new normal and that the average pace of the cycle to date is yesterday's story? Well, that would mean that we get to the 6.5% unemployment rate — assuming that the participation rate continues to behave in the manner it has over the past few months — by early 2014. And unless the Fed changes the goal posts again, that would mark the end to this period of ultra-accommodation — aimed at monetizing debts for borrowers and generating asset inflation for risk-toking investors.
Of course, to be talking about inflation today sounds ridiculous, and until recently, I agreed with that. Maybe it's partly because having been in this business for three decades and seeing the Fed make policy mistake after policy mistake — tightening too far in rate-hiking cycles and invariably overstaying its welcome during the easing phases... So this wedge between real growth and real rates is the liquidity excess that is filtering through into the financial markets, triggering excesses in some cases (like in the credit markets).
Again, this is coming home to roost now with respect to deteriorating productivity trends. At the same time, the latest data on earnings from the payroll reports show an uptick in wage growth. This is happening even with a jobless rate of 7.7% and a U6 rate of 14.4%. One would ordinarily believe that we have tremendous slack in the labour market looking at these figures. But maybe the pool of available skilled labour has already been largely drawn out.
If the output gap is actually closer to 2% or 3%, which is quite conceivable, actually, then we are talking about an equilibrium Taylor-based funds rate of 0% — not the de facto -2% that the Fed is targeting via its unconventional easing experiment — and as such, maybe adding more securities to its balance sheet is providing too much juice to the system and risks building an inflationary process in the future. As Herb Stein famously said, anything that can't last forever by definition won't. At some point something will change, and if history is any indication, it is the cyclical view on inflation and how the Fed responds, or whether it will let itself further behind the curve (of course, when the central bank is influencing the price signals by buying up the entire long end of the yield curve) [ZH: someone gets it].
I am not totally changing my view and l am probably way too early as I am talking for the first time in a long time about inflation. I am only detecting some tectonic shifts. Productivity waning. Wages on the rise. This means rising unit labour costs which in turn have their own correlation with inflation — like an 87% correlation (and 84% with the core CPI rate). As a long-term bond and income bull, I am not about to throw in the towel. But to reiterate, I am no longer in this profession of identifying probabilities, in the same comfort zone as I once was. Stay tuned as my thoughts evolve on this file.
And this of course is the Fed endgame: there are tens of trillions in excess debt that can only be inflated away (absent an outright default) and the Fed, as is to be expected, demands inflation, and will get inflation one way or another: whether supply-push, demand-pull, or outright currency obliteration. The problem then will be when does the Fed admit and acknowledge that inflation has set in (besides the obvious bubbles in equity, credit and real estate which Bernanke and Company are so unable to notice in real time). How much longer after inflation has set in does the Fed continue injecting tens of billions in liquidity each month, which is the only reason the stock market has levitated as it has? But the biggest question is what happens if and when Bernanke, like Rosenberg, finally sees the light and says no more to the liquidity Kool-Aid... or even if that will ever happen?
Because if Rosenberg is right, and he certainly agrees with us that achieving a 6.5% unemployment rate with labor costs already rising is virtually impossible driven solely by rising risk asset prices in the current regime, a major regime change is just around the corner.