One Number To Rule Them All

There is one number that will determine the fate of the world and its financial markets.  In the United States, that number is the Core PCE inflation number, or at least expectations of what that number might be in the future.  This number or its expectations will determine the posture of the Fed.  Analogous numbers in Europe and Asia will determine the posture of the other central banks who have flooded the world with simply unfathomable amounts of money and money-like liquidity.  That amount of liquidity and its effect on asset markets (Note to Avi Gilburt – <sarc>no, clearly central bank liquidity has no effect on asset prices</sarc>) can be summarized in the following chart:

Note that the QE line does not include asset purchases of the PBoC, the BoE, or the SNB.  If it did, the number would be more like $20 Trillion, not $14.x.  Central Banks undertook to inflate their balance sheets in fear of a debilitating debt deflation they thought might return the world to Great Depression like circumstances.

The human mind cannot really comprehend numbers in the Billions, never mind Trillions, or 3 orders of magnitude more.  Perhaps this is one reason we now inhabit a La-La-Land of asset prices and the lowest volatility in recorded history for most asset classes.  Another reason of course is that low levels of inflation diminish the discounting of forward cash flows such that the current numbers are closer to the forward numbers.  This then suffices to demonstrate the validity of the title of this post.  Central Banks have been able to get away with the gargantuan purchases of sovereign bonds, corporate and agency bonds, and in some cases equities themselves because the one constraint that would prohibit them from doing so has been low and tame for many years now.  And that one constraint on the actions of Central Banks is inflation.  In the US the Fed’s preferred measure is PCE Core Inflation.  Lets take a graphical look at that:

As you can see, since the GFC Core PCE has been running between 1 and 2 percent annual change.  And really that has been the range with the exception of a couple years just before the Great Carnage, since the mid to late 1990s or 20 years now.  Reasons include the great outsourcing of labor to the East which produced a one time massive downward adjustment in global labor prices, as well as demographic changes throughout the world stunting population growth, and technological change which caps goods prices.

The question going forward is whether inflation will rise to a level that will force Central Banks to rein in their profligate spree of asset purchasing, or even force them to divest the assets they have accumulated.  In the US, the Fed has started a program of letting up to $50 Billion a month of bonds roll off their balance sheet as they mature.  Prior to the start of this “normalization” campaign the Fed replaced any assets that matured in their portfolio with fresh purchases to keep the level of the balance sheet even.  Starting last quarter they allowed $10 Billion to roll off (~$6 Billion Treasuries and $4 Billion Agency MBS).  This quarter it will be $20 Billion.  It rises over the next 3 quarters until it reaches $50 Billion in Q4 2018.  They are divesting domestically already in teensy tiny amounts growing to merely small amounts.

So IF PCE stays where it is or lower, the Fed will be free to stop divesting or even turn back to LSAP if the stock market ever goes down a couple of percent (at this point even a couple percent will feel like an earthquake) in order to validate the central bank put on asset prices and ensure moral hazard continues to permeate every corner of the world.  However if it goes higher, or the expectation evolves that it will go higher, they will continue to divest or may even have to pick up the pace while simultaneously raising Fed Funds and IOER higher than the 5 quarter point clicks they have done already in the last 2 years.  Similar logic applies to the other major central banks.  Japan and Europe have had inflation rates, measured generally as consumer inflation, in the 0-1% range for Japan and the 1-1.5% range for Europe.  Northern European countries run a little higher and Southern ones a little lower.  What might cause inflation to rise durably is a matter of debate.  Tight labor markets, rising commodity prices.  Who knows.  The recent drop in the dollar may cause inflation to rise in the US as the prices of imported goods rise allowing domestic prices to rise as well.  That of course would have the opposite effect in the world ex the US.  Given the amount of debt creation in China, it is a wonder prices have not risen there.  Food inflation is the one thing the CCP will not abet because it tends to a decrease in social harmony and ultimately threatens the CCP.  What IS certain is that at the end of the day, the direction of the little blue line in the first graph above will be determined by what happens to the blue line in the second graph above, or emerging expectations of what will happen to it. One number to rule them all.

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