#960 - The Hidden Dangers of Disinflation With Daniel Lacalle

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0:35Strong print on GDP this morning, but other hidden dangers from disinflation slowing, lurking beneath the surface. Welcome to Real Vision Daily Briefing. It's Thursday, January 25th, 2024. I'm Ash Bennington, joined today by Daniel Lacalle, Chief Economist at Tresses. Daniel, welcome back. Thank you so much. It's a great pleasure to be here. Thanks for having me, Ash. Well, we always appreciate it when you come and join us. Lots to talk about today. Lots happening overall on the macro front. So your timing is perfect. Daniel, let's start out big picture, 50 ,000 foot overview. Where do you see us right now?

1:09Well, right now, the economy is showing a strong level of growth that is helped fundamentally by three things. Now, on the one hand, obviously, a massive increase in public debt, but also in consumer debt. The second is that the economy continues to have the tailwind of the services sector bounce after the reopening, which is quite strong. And the third one is that the official disinflation process is certainly helping the real GDP figure. The deflator of GDP is supporting a higher print on GDP than what probably citizens are feeling in their pockets. No, because CPI and obviously the GDP deflator tend to be significantly lower than what we lose in purchasing power of our currency.

2:15So in general, what we can say is that the United States economy is significantly stronger than obviously the absolutely atrocious situation of the euro area. but that the slowdown is quite evident. We have to remember that in today's print, in today's GDP print, there is a very significant, let's say, help from inventory revaluation, a very significant help from a level of government spending that seems to have consolidated the excessive level of increase that was generated throughout the pandemic. So those factors sort of disguise the slowdown. And I think that the slowdown is quite evident, particularly in fixed investment and in the, let's say, the productive sector.

3:16The manufacturing sector is very weak, etc. Well, it's always cold comfort to be the cleanest shirt in the pile of dirty laundry here in the United States in terms of economic performance. Let me zero in on something, because I think this has caused a great deal of pain to individuals and households in addition to investors. Let's talk about that inflation piece. You mentioned this idea of whether you're using a GDP deflator, CPI, PCE. It seems to understate the rate of inflation that consumers actually feel. Two questions for you on this. Number one, why is that the case? Why are these indicators not indexing for the actual rate of purchasing power decline, number one?

3:59And number two, do you have a formula or a sense of what the proportion is that it's understating it by? How do you get there? And how do we get a sense of what the real decline in purchasing power from inflation is? Okay. The reason why CPI and the official measures of inflation tend to underestimate inflation is quite simple. It's because they create a basket of goods and services that include the essential goods that we purchase on a daily basis, what we call the non-replaceable goods with things that we purchase from time to time. For example, food, energy, we purchase on a daily basis. Technology, hospitality, we purchase more depending on the month, different elements or less.

4:57So one thing that I like to look at is at the pace of increase in non-replaceable goods and services. And if we look at the accumulated inflation since 2019 in the United States, it's a staggering 21%. So to think that we have won the battle against inflation is a bit of a joke. But if we look at the increase in non-replaceable goods and services, healthcare, energy, the increase in, for example, insurance, in shelter. If we look at all those things, the increase is actually about 30 to 35 % higher. So in general, if you look at, for example, the latest CPI print, What do we see? We have seen a significant decline in the energy component, absolutely.

5:57But if you look at the December CPI print, all prices continue to rise month on month, despite the fact that we have seen interest rate hikes and a reduction in money supply. So there are different measures of what we would call the shadow inflation or an alternative measure of inflation. The one that I like to look at basically measures inflation the way without the changes in the basket that we have seen since 2008, 2019, 20, because most of those changes basically reduced the weight of the things that we purchase on a daily basis. And therefore the rate of inflation that they reflected. Exactly, exactly.

6:49So usually the CPI tends to underestimate the loss of purchase and power of those of us that have to, let's say, spend more on what are considered essentials. And that's why there is a very wide difference between the CPI and the measures of inflation of the lower incomes. Because as you spend more, for example, on food, on energy, et cetera, than on technology, hospitality, et cetera, inevitably, there's going to be an impact on your inflation. So the shadow inflation in the United States that I look at is running basically at almost double the level that we have in the CPI print. So it's around 5.76 % more or less.

7:45That's annual rate. So let's talk about this. There's so much here on inflation. One point that I just want to make is when you talk about health care, and I would also add to that education. These are secular 30-year-plus stories that have significantly eroded the purchasing power and, frankly, the economic position of working-class, middle-class Americans for decades, literally decades. But to focus on exactly what we're talking about here, and I know this may be a little bit basic for some people, but I want people to understand what inflation really is. Inflation is a rate. It is a rate of change.

8:19You can think of this like a speed that you drive in your car. If you're driving 60 miles per hour and you go out and you drive for four hours and then you decrease your speed to 30 miles per hour, what really matters is kind of the distance that you've covered over five hours. Those prices don't go back down. So when people say, well, you know, inflation, it's slow dramatically. It's about 3%. What's the big deal? The big deal is exactly what you pointed out earlier, which is that over a period from 2019, basically from the pandemic phase, you've lost. Just if you accept, and you may not, you may say it's actually higher than that if you look at alternate methods, some shadow measures of inflation.

8:58But if you just accept the CPI print data, I mean, I went up on Fred yesterday and indexed it to the low from the pandemic, which I think was like May, spring of 2020. You've lost 20 % of your purchasing power. 20 % of your purchasing power. That's like if you're a guy or gal making$50 ,000 a year, it's like your boss came to you and said, we're only going to pay you$40 ,000 a year. Hope that's okay with you. For a lot of families, obviously, that's not. And this causes potential risk of macroeconomic instability. It poses potential risk to growth, to the employment market. I mean, all kinds of things that can sort of daisy chain forward from that.

9:38I mean, this really is a story of significant, significant pain here in the United States and elsewhere in the world where we see similar phenomena. Absolutely it is. Absolutely it is. And that's why I get so angry we're now here that inflation is coming down as if it was prices coming down. Because I always say to my students, if I gain 10 pounds a year and then I gain four, I haven't lost any weight. We need to understand the cumulative level of inflation. More importantly is the changes in the calculation of CPI are also relevant, and those are not adjusted backwards. When the Bureau of Statistics changes the CPI components and their weight, they don't give you an alternative table of what has happened with the previous measure and the current.

10:34You just basically assume that what you're comparing, the 3.1 % that you're comparing today, is equivalent to the 9 % that you had a couple of years ago. And no, they're not. So all of those elements, that's why it's so dangerous to pursue inflationary policies, printing money, massively increasing government spending, as we saw throughout the pandemic. and then deciding to offset that increase in inflation by hiking rates and by reducing the quantity of money rapidly. Because on the way in, the size of government rises dramatically and the loss of purchasing power for citizens is very, very quick.

11:27But on the way out, when rates start to rise and when liquidity starts to contract, the ones that are suffering the impact of the normalization of monetary policy are citizens, are small businesses and families. So in so-called monetary expansion periods, the huge beneficiary, the biggest beneficiary is government size in the economy and government spending and obviously government debt. On the way out with rate hikes and monetary contraction, the biggest winners are also the size of government in the economy and government spending, while the entire burden of the disinflation process falls on the shoulders of small and medium enterprises and of families.

12:22Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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13:34By the way, when I did this exercise of indexing to 2019 to see how much inflation there had been, this wasn't because I'd read a scholarly work on macroeconomics. It was because I went to the grocery store and I bought six rolls of paper towels and they charged me 30 bucks for it. And there was a moment there where you go, obviously something is happening here. It's been cumulative over time, and it's a significant problem. Daniel, I want to take a look at a clip because this dovetails so perfectly into what we're talking about here right now. This is a conversation, how to invest in a world in transition on the Real Vision Essential tier.

14:05This is Nick Lawson you're going to hear from, a recent interview with Samuel Burke. Let's take a look at the clip. And I think that zero interest rates has meant that you had, for that period, a sort of dichotomy between, and it's almost like a Marxist dichotomy between the owners of assets and the renters of assets. Because in a zero rate environment, every asset went up. And those that obviously didn't own assets became obviously disadvantaged from that. And now we have this sort of like this sort of protracted, a cumulative effect of this distortion, which has now led us in 2024 to a situation now where people are feeling that they want to change regardless of what that change is.

14:50Now I talk about why this environment is so rich. I think one of the things that's happened now has been with the distrust that exists within the public, people have turned to the internet, They turned to different sources of news, such as Twitter, X, yourselves. And I believe that information now is in a completely different forum than where it was before. And I think with interest rates at 5%, what we've done is we've knocked out two things. We've knocked out that carry trade. So you can't just make money from anything you do at 0 % interest rates. And secondly, you've knocked out zombie companies.

15:28So unproductive companies do not work. So I think the paradigm we face now is we've got so much going on, so many exogenous events in the market. And I think at the same time, we're asking more from the companies that we invest in. You've got to be able to beat not just your cost of capital, but probably something more than that to generate return, which means that only good companies are surviving, which is probably why I'm so excited by it. Well, Daniel, exactly what we were just talking about, macroeconomic distortions caused by unconventional monetary policy, zero interest rates and then some.

16:05How do you think about it in terms of this distortion premise? How do you think about it? What would you add to that point? Well, I agree with almost everything that he says, and I completely concur with the diagnosis. What's the biggest problem that we are living right now? Is that we have not seen the cleanup of the zombie companies, and we have not seen the cleanup of the excess in government spending that was massively increased taking advantage because of the pandemic. But it's interesting to see how usually what happens in a process of monetary contraction and rate hikes is that the excesses of the past, be it zombie companies, excessively indebted and badly managed businesses, and the governments that have not done their homeworks and have massively increased their deficit, those in the contraction tend to suffer.

17:10But this is not what has happened this time. What has happened this time has actually been the opposite. And that's why I'm worried. So I agree that there is a fantastic opportunity in those companies that are in technology, in the disruptive side of technology, in innovation, that have managed their balance sheet properly and kept their margins. But my concern about this process is that the level of excess increased dramatically in a very short period of time, between March and September 2020, we saw the largest monetary base increase in history, in the recent history of the economy. But not only that, is that government spending, deficit spending has not been reduced.

18:01I find it amazing that people look at the GDP figures today and do not see that a two-and-change trillion deficit is an abomination in this kind of an economy. So basically, my concern in this current environment is that on the one hand, we have not seen that cleanup of those large businesses and quoted companies that went way too high on debt and took too much risk. And we have not seen a sobering of the monetary laughing gas effect of government spending. So that is the problem, because if we now start a process of rate cuts and liquidity, net liquidity, by the way, is rising and money supply has also recovered quite significantly since November.

19:02So we may not have seen a process of cleanup enough in order to really set the economy to a more productive and stronger level of growth afterwards. Sometimes disguising or hiding a recession is a bad thing. Recessions usually are a symptom or the consequence of an excess. So when we disguise a recession with high deficit, huge debt, and at the same time by the entire burden, as I said before, of rate hikes and monetary contraction falls on the very small businesses and families, then instead of cleaning up the problem, what we do basically and what has happened and we are seeing in the United States GDP is that the problem is actually accelerating, not slowing down.

20:02So let me ask you that to this point about GDP. We got something of a bit of a Goldilocks print this morning. Obviously, these are real inflation-adjusted figures. So it's adjusted for inflation. And of course, it's presented a seasonally-adjusted annualized rate. So why don't we see more impact from the debt and deficit overhang plus inflation? Like, why hasn't that been more of a component to getting a number that looks pretty good? Well, because we have heard the narrative that monetary policy has been restricted, and monetary policy has been hugely accommodative. Money supply may have declined a little bit, But what we have seen is a monster increase in the access to the window of liquidity of the Fed by banks.

20:54Therefore, access to credit has not only not fallen, it's basically flat in an environment that should be of monetary contraction. So think about this. Think about what is going on. This is like basically, this is like an economy. Think about an athlete that is running out of steam, that is really, really, really tired and suddenly gets a huge boost of steroids. The athlete is not getting any better, but can still show a certain level of performance. This is what we are seeing right now. If you look at the GDP, excluding the accumulation of public debt, this is the worst print in basically since the 30s.

21:41The worst print since the 30s. So obviously what happens is that you're bloating GDP in a various number of ways. Number one, government spending. But government spending does not only affect that part of the calculation. It also affects consumption because there's a lot of public sector workers that have been added to the labor force, and those are also spending more. Real consumption is relatively strong, but if you look at it, what we're seeing basically is the effect of the reduction in savings, and therefore people are consuming from their credit cards. Investment is quite poor. And then you have, and this is the key, this is another key component, the external sector.

22:33You have exports minus imports. Hey, you have a massive boost for the US economy coming from lower imports because oil prices have fallen, because we have seen most of commodities declining last year, etc. So you have a number of things that are not improving the situation of the average citizen, of families, of small businesses, and that are basically disguised by the fact that the element of contraction of supply of credit has not happened. In fact, we have seen basically the opposite. So that's why it happened. The other element is what we discussed prior, which is that the GDP deflator has come down radically, and that obviously boosts real GDP.

23:25But ask families if their month-on-month, year-on-year expenditures have declined as massively as the GDP deflator. That does not mean that it's badly calculated. It means that in periods in which there is a huge boost of inflation, there is a period, even when there is a gradual disinflation, in which the elements of higher prices on the non-replaceable goods that we mentioned before, the sticky inflation on shelter, on used cars, etc., etc., all those things maintain a certain level of robustness in the consumption figure that is actually not real, because it doesn't mean that citizens are purchasing more things with their salaries, but purchasing the same at higher prices.

24:24We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. So the good news is it's measured correctly. The bad news is it doesn't mean what you think it means. Exactly. It means that the economy is slowing down much faster than it looks. And what it means basically, and I had this call yesterday from a friend in Arizona, and this person was saying, I see everything very, very challenging. I don't see this as a booming economy. And I said, well, you're probably right. You're probably right.

25:06Because what you are seeing is your consumption in real terms, real to your salary, not real to a basket deflator, i.e. what he is seeing is what am I purchasing with$1 relative to what the average is calculated by the Bureau of Statistics. And I'm not saying that it's badly calculated, by the way. I have to say, we all have to say that the CPI measure is a good way of analyzing year-on-year trends, not reduction of purchasing power of the currency. That is the key. Such a good point. It's useful for one particular thing, for economists who are understanding the directionality of the trend, but not useful for judging the level of pain you feel in an economy.

26:02I'm going to get to questions in just one second, because we have a really interesting and fun one up next. But let me ask you this. Since we've recently just passed Davos, it's interesting. One of the cool things about Davos this year is they invited Kevin Roberts, the head of the Heritage Foundation out there. You know, people have been criticizing them, saying, hey, listen, you don't have any conservative viewpoints out about what's happening. This tends to skew left of center. They brought Kevin Roberts out, and he just lowered the boom on them and framed out. By the way, we don't do politics here at Real Vision Daily Briefing.

26:29But if you want to get a sense of what the conservative opinion is about the Davos consensus, I think it's really important if you're an investor in these markets, you've got to understand all sides of this. Kevin Roberts delivers the goods. Tell me what you thought about what happened at Davos this year, what you think of Davos more generally, and how it plays into all of these issues that we're talking about right now. Yeah, I've been to Davos five times in my life and I stopped going when there was no discussion on anything. You know, it was basically just a mantra repeated as if you were, you know, basically in some kind of a sect gathering.

27:10It made no sense to witness presentation after presentation after presentation of people saying exactly the same things over and over. So I think that what was refreshing about Davos this year is precisely what you just said, is that we need to hear different opinions and different viewpoints. And we need to see that there is not one way of dealing with everything, particularly when it is painfully obvious that the way of dealing with things in the economy since the 2008 crisis has been a phenomenal failure, both in terms of the reduction of poverty, the reduction of inequality, and all those things.

27:56There's been a massive increase in debt, massive increase in government size, huge increase in taxes. And the elements that those so-called top-down views should have brought have not happened. So, OK, fair enough. Let's hear different viewpoints. And I think that that's why it's so important to have people like Kevin. It's so important to have people like Milley also saying, look, let me give you the example of Argentina, because people think that Argentina is an example that, oh, you know, is something that doesn't matter. No, Argentina actually has been implementing those policies that have been the consensus of Davos for 60 years.

28:40So I think that that's been a very important, refreshing factor is to bring back debate, bring back realistic debate, not mantras. Bring back the analysis of what is happening in the economy, not saying, oh, well, there was this two trillion stimulus plan. It didn't work. Well, it's because we didn't spend enough, obviously. We need a little bit more granularity and a little bit less mantra and a little bit less new religion of statism that obviously is not working for the average citizen, is not working for the average business. And the reason why I don't like that is very simple, is that we are destroying the foundations of progress.

29:31The foundations of progress are saving the very important factor of creative destruction and prudent investment, not spending and debt, and certainly not constant bailout of the zombies to raise taxes on the small productive businesses. Yeah. So well said. And that's exactly what we're doing right now, talking about these issues in ways that you might not hear somewhere else. And we're committed to that, obviously, at Real Vision. If you don't hear at least one thing, no matter what side you're on, that makes you uncomfortable, we're probably not doing our jobs. Listen, this is a great question from Bonito.

30:15And it's a fun one. Daniel, should we be looking at the global economies as a collective Beetlejuice market. Follow me, he says. A once bright star still functioning, but running out of gas, rapidly transitioning from growing to shrinking and back. The most likely result being it goes supernova moving forward because its chemistry has irreversibly affected its function. Boy, that is such a great description of hysteresis. And to pick up on your metaphor from earlier about the athlete who is taking steroids, yeah, maybe you can run faster for a couple of quarters, but maybe you destroy your knees in the process.