Demand Destruction? Two Reasons to Be Skeptical

Destruction of demand ≠ Disinflation

Global central banks have made an “all-out” effort to push for policy tightening to curb demand. But softer economic data in the United States and the Eurozone have exacerbated recession fears. As growth prospects diminish, many predict that the destruction of demand will lead to lower inflation. That is, tighter monetary policy and associated higher financing costs will reduce demand and offset supply shortages resulting from geopolitical instability and supply chain disruptions. This view depends on the belief that inflation outcomes are largely driven by central bank policies.

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However, the “muted” inflation of recent years, particularly during the crude oil slump of 2014-2016, has demonstrated the insensitivity of inflation to demand-side policies. Even the European Central Bank’s (ECB) quantitative easing (QE) in 2015 failed to stoke demand in a way that reduced oversupply. The U.S. Federal Reserve’s dovish policy stance in the decade before the pandemic pushed the federal funds rate in Atlanta’s Wu-Xia shadow below zero several times, but the preferred price measure of the Fed, personal consumption expenditures (PCE), was less responsive to these policy changes. that at the end of the Cold War or China’s entry into the WTO, among other catalysts.

Personal consumption expenses vs. Shadow federal funds rate

Chart showing personal consumption expenditures versus the shadow federal funds rate
Sources: Federal Reserve Bank of Atlanta, US Department of Commerce, Kekselias, Inc.

Similarly, recent quantitative tightening and rate hikes have not generated enough demand destruction to offset geopolitical commodity shortages. Rather than following central bank policy over the past two decades, inflation moved largely with commodity prices, or supply and demand factors.

Eurozone, US and UK inflation vs. index of raw materials

Chart showing Eurozone, US and UK inflation against the commodity index
Sources: Eurostat, UK Office for National Statistics, US Federal Reserve, Bloomberg, LP, Kekselias, Inc.

This casts doubt on the “rates-determine-activity-determines-inflation” framework and suggests that domestic monetary policy cannot raise or curb inflation on its own. Other factors must come into play.

Worksheet for Inflation, Money and Debt Puzzle: Application of the Fiscal Theory of the Price Level

1. Fiscal expenditure = Greater demand

Given the long and variable trickle-down effect of QE, pandemic-era policies sought to counter shortfall demand by expanding balance sheets and through fiscal stimulus, or by printing money and sending checks directly to households. This dramatically reduced the time lag between central bank easing and realized inflation. The deployment of “helicopter money” quickly revived demand.

As pandemic disruptions eased, the expected fiscal tightening never materialized. Instead, fiscal-monetary cooperation became the norm and cash payments a regular political tool. After its Eat Out to Help Out programme, for example, the UK government announced a £15 billion package to send £1,200 to millions of households. As UK energy prices soared, Liz Truss, the front-runner to become the next prime minister, proposed an emergency fiscal spending package to ease the public’s financial stress.

Across the Atlantic, many US states have announced stimulus payments to ease the pain of high inflation, and President Joseph Biden has introduced a student loan relief program. The lesson is clear: central banks are no longer the only game in town when it comes to economic stimulus.

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2. Geopolitical events = Supply interruptions

As multinationals regionalise, move to the coast and re-shore supply chains and prioritize resilience and redundancy over cost optimisation, energy shortages in the Eurozone have created new interruptions German chemical production will fall in 2022, which could export inflation abroad.

As geopolitical instability contributes to domestic economic challenges and more fiscal stimulus is deployed, inflation may be much less sensitive to traditional monetary drivers. Under these circumstances, a rigid framework that equates tight monetary policy and high prices with demand destruction and disinflation will no longer be workable.

For investors gauging portfolio risks, these conditions may offset disinflationary pressures from slowing growth.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Pavel Muravev

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Victor Xing

Victor Xing is founder and portfolio manager of Kekselias, Inc., and a former fixed income trading analyst at Capital Group Companies with a focus on monetary policy, inflation-linked bonds and interest rate markets.

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