Looking ahead, we probably face either (mild) inflation or debt deflation.*  Both leading to the same place.  Losses on assets.

* [Debt Deflation] = deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending.

What we are watching right now is “the assets” twisting and squirming to try and find a way for someone else to take the pain.  In more simple terms.  Rich people (assets) trying to somehow shift the pain to poor people (labor market).  Like we chose to do in 2008.  Homeowners suffered most of the pain (paving the way for Trump’s takeover and the effective destruction of the “traditional Republican” party, but I digress).

Don’t think it is going to work this time around.  Our current state is…

• …labor market looks fine.  If you are in the bottom quartile, it looks awesome (see the “Wage Level” tab here, 4th quartile is “poor people.” 1st quartile is “rich people.”  It explains a lot of the angst out there)
• …a LOT of assets are already carrying nasty mark-to-market losses.  When rates go up, stuff priced in a lower rate past goes down…

Near-term future.  The Fed either…

• …raises rates too high for too long.  CRACK!.  Another crisis and debt deflation.  2008 scenario.
• …raises a bit to save face, then starts cutting.  HSSSSSSS….
  • Inflation stays positive for a while (2% to 4% range?).  Assets lose more value.
  • Labor stays solid and wages keep creeping up for the bottom 1/4 (they have gotten HUGE gains in the last 2 years).  Prices don’t keep up.  Profits go down.

Is there a middle scenario?  No mega-crisis, but assets don’t take a hit?  Maybe?  “The  assets” are definitely searching for that easy exit.

• Maybe if we keep raising rates, maybe the labor market will finally break?!?  The PR is “to slay inflation and protect the little man.”  The un-spoken aim is as much to arrest continued wage gains and bargaining power.  The problem?  A labor market break would have to happen in the next few months.  That doesn’t look likely.  Especially as 4.5 points of rate increases haven’t done much so far (except wreck the banking system).
• If not, is there some other clever way we can socialize the losses and privatize the remaining profits?  Like today’s plea by regional banks to insure 100% of deposits for 2 years.  Note they are not also volunteering to submit to the more strict regulatory regime they wiggled out of a few years ago…  A government guarantee to gamble for 2 years => “privatize the gains.”  Why some Bank CEO’s are OK with a crisis.

Maybe “the assets” find a partial way out?  I don’t see a way to socialize the losses (pushing the pain into the real economy) absent a major crisis like 2008.  Maybe that is why some people seem OK risking another 2008?  2010-2020 was a pretty good decade for some…

But I’m not sure the Fed will play along this time around.  The trail of blame here leads a little too obviously to the Fed’s doorstep.  That (highly political) institution is already squirming to avoid taking the rap.  So some near-term losses probably get socialized.  The right thing to do to keep the banking system running.  But the Fed isn’t likely to sacrifice itself to cut losses outside of its immediate reach.  The best they can do is offer palliative care (ie. rate cuts).

Long-term future?  Either…

• …a virtuous circle in the real economy.  Higher wages flow through to more demand.  Tight labor markets = higher productivity (robot waiters here we come).**  Investment.  Things really start humming.  This is great for everyone EXCEPT the people suffering losses from 2%-4% inflation chewing up the 2008-2022 assets priced for a low-rate regime.
• …the air goes out of it.  Like in post-2008, the virtuous circle never gets going because too much money leaks out in each turn of the cycle.  Bled out of the real economy supply/demand cycle (really the wages/spending cycle).  Leaking into “assets” piled on top of an increasingly stagnant real economy.

What is deeply annoying (to me) is that I was pretty much here in my thinking about 2 years ago.  But I have managed the last 2 years pretty badly.  I couldn’t/didn’t see through the logic of my own damn argument.  Sigh….

**  Productivity gains are the sole driver of economy-wide prosperity.  The standard MBA myth is “far-sighted, profit seeking executives drive productivity gains.”  Economic history suggests rising wages are a more powerful driver economy-wide productivity gains.  Why?  People are lazy.  Managers are people.  Without the goad of higher wages, they don’t look for productivity gains.  But, when their backs are to a wall, they (like most people) get creative about finding a way out.  The inverse of  “Necessity is the mother of invention…” is “your average Joe doesn’t do much unless circumstances force them to…“

We risk another 2008-style crisis.   Is that really preferable to 3%-4% inflation for a year or two longer than we’d like?  Even that is a false choice – ignoring all the other tools we have to fight inflation (that don’t involve crippling the world’s financial system).

So why do so many people want the Fed to keep on yanking that lever – risk be damned?!?  I keep seeing public figures calling for the Fed to stay the course.  It is plain as day that we risk tipping the financial system over into a 2008 style financial crisis if we press too hard for too long. Is that a risk worth taking?

Am I confidently predicting a crisis?  No.  Why?  Financial crises aren’t predictable!  Who expected really expected to spend last weekend brushing up on the mechanics of a classic George Bailey “Its a Wonderful Life” bank run?

I am confidently predicting that the Fed pointlessly and exponentially increases the risk of a financial crisis the longer they keep the yield curve inverted (short-term rates higher than long-term rates).  It doesn’t matter how much they hike next week.  What matters is how long they keep rates at the current (or higher) level.  The longer we stay where we are, the higher the risk of a crisis.

The Silicon Valley Bank fiasco was one warning.  Credit Suisse’s blow-up a few days later was  another warning.  Blackstone closing the exits to its BREIT Real Estate fund a few months ago was another.

What I have not seen is a convincing argument for “We should risk a 2008-style mega crisis – keeping the yield curve inverted – in order to prevent a greater threat.”  “Inflation!!!” is the cited threat?  But is that really such a big deal?

Inflation is also NOT AN OBVIOUS CRISIS!  Look at these links to various Federal Reserve measures of inflation expectations.  Nothing here says “we should risk a bank crisis to avoid the horrible fate foretold here” IMHO

• https://www.newyorkfed.org/microeconomics/sce#/inflexp-3
• https://fred.stlouisfed.org/series/T5YIFR
• https://www.clevelandfed.org/indicators-and-data/inflation-expectations

From a newsletter I subscribe to.

“New Deal democrat argued that “Properly measured, consumer prices have been in deflation since last June “. He highlighted the lagging nature of Owners’ Equivalent Rent (OER), the major component of shelter CPI, as house prices tend to lead OER by 12 months or more. After making all the adjustments, NDD concluded:  If we substitute the FHFA house price index for OER, headline CPI would have been down -1.4% as of December (since that is when the reported FHFA data ends).” 

Current inflation is also driven mostly by real economy supply demand dynamics.  The inflation solution must also come from supply/demand.  With the price mechanism (“inflation”) doing that balancing with time and patience.  The level of short-term interest rates is, in that equation, not a particularly decisive factor.  The non-impact of 4.5 points of rate increases would seem to be evidence enough by now?

What a weekend to be locked out of your own blog account! A bit of a grab bag of thoughts here – sorry for some repetition….

Silicon Valley Bank has taken us from from “higher [rates] for longer” to “not much higher for not much longer.”  Why?

1. The Fed’s original and first priority (since 1907) is to safeguard the banking system.  Inflation (since 1977) comes second.  Employment is a distant third.  The 2% inflation target just barely turned 20 (2012).
2. The first canary just died in the banking system…  Note that Commercial Real Estate is 24% of on-book bank loans and also showing serious stress from high rates.  The labor market is showing NO signs of stress. 
3. The banking system (and commercial Real Estate) will blow up before the labor market does.  The labor market probably wouldn’t soften quickly even if the Fed hiked to 7%.  Even 6% might spell disaster for the banks and a building re-finance.

If they keep on hiking and hold for longer, Powell goes down in history as “the guy who blew up the finance and real estate industry in a quixotic, ill-judged attempt to bring down inflation driven by supply/demand factors out of the Fed’s control”  Arthur Burns #2…  Not Paul Volker. Powell does not want that to be on his gravestone.  

Even if Powell wanted to grit his teeth, he will be fighting a rising tide of anger and fear from a lot of very influential people.  Look at the howl of protests and entreaties from “libertarian” Silicon Valley after SVB went under.  Libertarians do tend to assume the little people will pay the Price of Liberty (NB – there are very few low-income libertarians).

1. Fed tightening cycles are breath-holding contests.
2. The labor market is “supposed” to gasp for breath first.  But it is doing great.  See Feb jobs report.
3. SVB is the first gasp for breath.  There are a lot more “mark to fantasy” assets sitting out there that can’t stay that way for much longer.  Rate bets (like at SVB) and precarious Real Estate assets facing re-financing risk.  Higher rates endanger both.
4. If the Fed is going to damage the economy until it slows, that damage is going to hit people who are used to getting taken care of (see “Silicon Valley Bank Depositors”).  The Fed would permanently impair a lot of wealth before that ever trickles down to the labor market.
   
5. Paul Volker did not get his Wall Street sainthood by “impairing a lot of wealth.”

In sum – the labor market looks too healthy and the financial system too shaky to do “higher for longer.”  So we hike a bit to save face.  Then find a way to justify ~3% inflation.  3% being, BTW, totally fine. 

So the collapse of Silicon Valley Bank puts an end to this tightening cycle.

Moreover, the fed will have to cut rates sooner vs later to get short-term 1-2-year rates (where the Fed has more influence) down below 10+ year long-term rates (where the free market sets prices more then the Fed does).

Will the Fed have slain inflation?  No.  We have no counter-factual, but it is pretty obvious the whole tightening exercise didn’t do much to change the course of the real economy.  The cause of the inflation was in the real economy – supply demand shocks – and the cure will be in the real economy too.  As the line goes “the cure for high prices is… high prices.”

Anyone with real faith in free markets would have told you that 18-24 months ago.  There is a stack of academic research that has long explored the limitations of the Fed’s powers.  But Wall Street types believe more in rules of thumb than in fancy academics – especially if those academics are even a teeny weeny bit to the left.  No matter that MMT has laid out a very robust framework for understanding the current inflation.  The rule of thumb was… “The Fed is all powerful.  They will crush the economy.  Unemployment will soar.  The great Oracle Larry Summers has told me so….!”  We’ve seen that on front pages for 18+ months now.  Even as the contrary evidence has steadily piled up.  Until SVB went BOOM!

So the Fed fired its big bazooka.  4.5 percentage points of rate hikes later, the real economy has gone lumbering indifferently along.  But the banking system just had a near-systemic crisis.

Never forget that the Fed was created/empowered to protect the banking system after the panic of 1907.  That mandate was strengthened after the Great Depression. 90% of what the Fed does ever day is herd, manage, and protect the banking system.  The banking system is also most Fed staffers’ revolving door employer when the retire.

That “control inflation” mandate?  It didn’t get formalized until 1977.  The “set in stone” 2% inflation target?  A creature of Ben Bernanke in 2012.  The Fed cares about the banks first, inflation second, and full employment by lip service only…

The Silicon Valley Bank crisis was unique.  But dismissing the risk signal on those grounds is like arguing this particular dead canary was a little odd, so we don’t need to get the hell out of this coal mine before the toxic gases build up and blow.  he canary is still dead and others will soon follow.  The Fed knows this.  The Fed will act accordingly.

The Fed still probably raises rates in the next meeting to save face.  But this tightening cycle is done.  They can’t keep raising for long.  Nor can they keep rates at the current level.

Why? An inverted yield curve is kryptonite for banks and all sort of other financial markets players.  A week ago, the 2 year Treasury rate was at ~5% and the 10 year rate was at 4%.   Simplifying drastically, that meant were paying deposit rates tied to that 5%, but earning loan/asset tied to that 4%.  Losing 1% a year is a path to insolvency.  The reality isn’t that simple, but an inverted curve still leads to bankruptcy or… bank runs.

This week, the 2 year had tanked almost a full point to 4.3% and the 10 year has only gone down to 3.7% from 4%.  Why?  Because the market sees the Fed can’t tighten much more for much longer.  Banks can hold their breath for a while, but they can’t hold their breath indefinitely.  They can’t outlast the labor market.

The labor market just keeps chugging along.  It isn’t going to crack soon enough for the Fed to save face.  Not before another of its bank canaries die.

Have we slain inflation? Nope. Fed was never that powerful to start with. But do we naturally fall to something like 3%? Yeah probably. And 3% is (gasp) not really that different from the (arbitrary) 2% fed target.

I am not an energy expert by any means.  Nor am I a Ukraine expert.  So why not look at them both?  🙂  At least I can ask some relevant questions even if I can’t fully answer them.

I believe the consensus view on the Energy sector incorporates the consensus view on Ukraine – “there will be a stalemate.” We don’t have conditions for a stalemate in Ukraine (see below).  That invalidates an big chunk of the energy market consensus.

I genuinely don’t know what “a flood of Russian oil and gas” does to the energy market dynamic.  Or what is priced in.  I do think you need a solid scenario to answer that question before you commit capital to the energy sector. 

If you are looking at the energy sector, your investment thesis MUST at least consider these very plausible, potentially cascading scenarios.

1. Russian retreat to (more or less) pre-invasion lines.  Ukraine breaks through (again) and routs the Russian Army locally (again).  Decisive loss (again) of Russian military hardware and trained personnel.
2. Ukraine’s breakthrough turns into a rout.  Russian equipment losses are massive.  Russian morale losses are even more catastrophic.  The Russian army melts back over the border leaving much of its equipment behind.  Crimea is threatened as the Kerch bridge comes under fire…
3. Putin’s government teeters on the brink.  Russia’s 2024 (too-obviously-rigged) national elections go badly awry.  Putin finds himself bleeding legitimacy – avoiding any windows above the 1st story.

Why does that matter to energy markets?  Russia produces a lot of oil and gas.  If they are in a hole, they will likely (choose one option only)

1. Prudently maintain production at levels that sustain the long-term profitability of the global energy sector….
2. Sell everything they can to anyone who will buy it at whatever price they can get.   Try to buy off the populace; fund a factional power grab; and/or a personal exile plan B.

#2 seems a lot more likely than #1.

What about those sanctions?  I’d expect the principled, steel-backbone politicians of Europe will find some way to buy lots of cheap Russian oil and gas once we get this whole “neighbor-invading” unpleasantness behind us.  Especially as Russia actually has…

1. …destroyed itself as a credible military threat.
2. …shown that “we’ll turn off your gas!” ultimatum is not quite the threat many  imagined it to be.  No-one in Europe froze to death this winter.  But Europe does need to re-fill for next winter.

Stalemate is a comfortable but wrong  assumption. 

The people predicting stalemate today are the same people who kept predicting Russia would  “win” long after Russia had clearly lost.  They were (obviously) wrong then.  They are still (equally obviously) wrong now.  But their collective echo chamber is big enough for them to feel comfortably wrong together.

The oil patch has a notorious political leaning (and thus a blind spot).  Its denizens tend see the world through a more (ahem) “pro-authoritarian” political lens.  The US oil industry is not known as a bastion of liberalism.  Nor are the sub-set of investors who specialize in energy.  Nor are many oil-rich US states or oil-rich countries (Norway aside).  What feels comfortable inside that echo chamber doesn’t always synch well with reality.

A stalemate in Ukraine requires BOTH sides to be either exhausted or reined in.

1. Russia is exhausted.  It has been for 6+ months now.  A stalemate is the best outcome they can hope for.
2. Ukraine is NOT exhausted.  They are winding up for a big offensive.  Fresh tanks. Fresh troops.  Fresh long-range missiles.
3. No-one is talking much about “reining in” anyone.  All the noises out of Ukraine’s backers are in the opposite direction.  With the (large) exception of a weirdly Pro-Russia, Pro-Authoritarian element in the US.  Some of whom likely live in or invest in Big Oil country…  Also various German SPD politicians with compromising photos in their FSB files… but I digress.

Ukraine has beaten consensus expectations pretty well so far.  Russia has screwed up pretty much every chance they have had.  So the high-probability bet today is not “stalemate.”

If we get to late November 2023 without a big Ukrainian breakthrough, we might have a stalemate.  That is what Russia should be playing for (instead of bleeding away tanks and troops in Bakmhut and Vuhedar). But Russia is not doing the smart thing…

This excellent Axios piece (pasted in below) gives us our Zen koan for the day.

Investors hang on every last word out of the Fed.
The real economy doesn’t give a sh*t
Which is… “reality?”

As a bonus, one of my actual favorite Koans – A Cup of Tea.  On good days I am pouring the tea.  On bad days I’m the guy with the cup… 🙂

Nan-in, a Japanese master during the Meiji era (1868-1912), received a university professor who came to inquire about Zen.

Nan-in served tea. He poured his visitor’s cup full, and then kept on pouring.

The professor watched the overflow until he no longer could restrain himself. “It is overfull. No more will go in!”

“Like this cup,” Nan-in said, “you are full of your own opinions and speculations. How can I show you Zen unless you first empty your cup?”

AXIOS:  Why rate hikes haven’t affected the economy more

Two days after Russia invaded Ukraine, I wrote “Putin is already Losing in Ukraine.”  Even back then, it was already pretty obvious.  Whatever emerged from the war, it would not be a Russian “victory.”  Putin has lost more and more with every day since.

I’ve never asked the question on the other side of that coin – Have the Ukrainians Already (Mostly)  Won?”  The answer is… yes?  Winning more every day.  Not a full-scale “victory” (yet).  But they have a decent shot at it.

A conversation around stock markets (which have recently been pretty upbeat) made me ask that question.  Maybe markets are pricing in a Ukrainian victory?  Economically, that probably re-starts Russian energy production and exports.  Lower energy costs are a good thing economically (and for headline inflation).  “Ending a hot war in Europe” would also be a good thing for markets.  Enough said.

But it already looks more like a win for Ukraine.  One or two more successful offensives and they have a decisive victory by Spring-Fall of this year.  Even if they don’t win a decisive victory, they will have largely won.

Think about what “victory” really means for Ukraine:

1. A de-fanged Russian military incapable of mounting serious offensive action.
2. Multi-layered, modern air defenses effectively denying the airspace to Russian planes and missiles.
3. NATO-standard equipment with adequate ammunition and training.
4. NATO-quality aircraft with trained crews.
5. Economic Integration with the European community.
6. Implicit defensive support/security guarantees from NATO.
7. Recapture of territory occupied in 2022.
8. Recapture of the Donbas – or the important parts of it.
9. Recapture of Crimea.

Ukraine has ticked off a lot of that checklist already.  Much of the rest could come in 2023.  That sums up to victory…

• …already or soon-to-be there on 1 to 3 (self-defense/security).  #4 (fighter jets) is likely soon.
• …well on their way to 5 and 6 (integration with the West) if Ukraine doesn’t backslide on corruption and rule of law.
• …one or two more successful offensive away from some part of  7 and 8 (taking back territory).
• 9 (Crimea) is still looking like a stretch for now, but not forever…

The next 6-12 months also favor Ukraine…

Russia is getting weaker.  It is frittering away its last dregs of offensive capability now.  They will no longer be a meaningful offensive threat to Ukraine by the end of 2023.  They might not run out of (poorly trained) men, but they will run out of advanced weapons, missiles, tanks, trucks, and artillery shells.  Most damaging, they are running out of trained officers/specialists to lead and direct that rabble.  Armies stand and fight.  Mobs generally don’t.  Russia can dig in.  Try to hold out.  But Russia won’t be taking more ground (barring a miracle).

Ukraine is getting stronger.  By year end, it will be re-armed with superior Western hardware.  They are getting longer-range missiles which will wreak further havoc on the Russian supply system.  They are also getting top-drawer air defense systems.  Top-drawer fighter aircraft look to be coming soon.  If Ukraine controls its skies, it fully controls its territory.  Russian aircraft already don’t fly over Ukraine.  If Ukraine’s aircraft can fly, Russian troops will be sitting ducks.  At that point, Russia REALLY ceases to be an offensive threat.  They will struggle to supply defensive positions, with no ability to supply meaningful offensive gains.

For a complete victory, Ukraine still needs luck on its side.  Another breakthrough like Kyiv, Kharkiv, Izyum, and Kherson.  The Russians have “collapsed” locally in those 4 breakthroughs,  but we have not (yet) seen the general military collapse I’ve been looking for…  Yet those are 4 more breakthrough than the Russians have had over the past 6-8 months.  The Ukrainians have been winning.  The Russians have been losing.

The least likely win above is #9 – Crimea.   Note that Crimeans themselves don’t feel particularly “Ukrainian.”  But Ukraine does have a long-game, non-military path to re-taking Crimea.  The Crimeans themselves might eventually choose to be rich in a prosperous, EU-adjacent Ukraine vs poor in corrupt, China-dependent, petro-state Russia.

Crimea remains – legally – part of Ukraine.  A local popular uprising would be enough for international recognition.  That local revolt doesn’t happen unless/until the Russian central government is seriously weakened and/or distracted.  But the richer and more “European” Ukraine gets, the more likely it is to re-absorb Crimea.

Many call the present situation a stalemate.  Based on the false expectations that wars are fast-paced, action-packed, decisive affairs.  A mental error compounded from a mixture of recency effects (US in Iraq), historical telescoping (WW2 history is a series of decisive battles, but WW2’s reality was MONTHS of “no major news from the front”) and Hollywood thinking (fast cuts over the boring stuff).

Reality on the ground is not a stalemate.  It is just the messy business of grinding it out.  The parts of history that don’t often make it into the history books.

Putin is Already Losing in Ukraine

As headline inflation numbers come down, the Fed is going to find it harder to justify high short-term interest rates.  Especially if most economic sectors are holding up well in the face of that moderating inflation.  Double-especially if the most rate-sensitive sectors of the economy – near and dear to the wealthy – are really starting to suffer.   Especially Real Estate.

 “Hold the course” only sounds like the smart, disciplined course of action IF  you assume someone else – the Labor market – takes the hit.   How many Senators are going to stay the course if their (or their donors’) Real Estate holdings are being sacrificed “for the greater good?”

Think yourself out to December 2023.  Economic growth is solid.  Jobs are plentiful.  Wages are going up for the bottom 1/3 of workers (see chart below).  Supply chain pressures have faded.  Oil and energy are cheaper as the Ukraine war is winding down.  The 2024 US election season is heating up.  Headline inflation is mechanically trending down towards 3%-4%.

Note the above isn’t too far from where we are today.  No miracles required.

We likely also see darker clouds gathering in the economic sky of 2024.

• …Real Estate is starting to buckle under the pressure of high real interest rates.
• …banks are struggling with the pain of a sharply inverted yield curve (short-term rates higher than long-term rates).

Might the Fed find a “data driven” excuse to cut rates?  Right now, the Fed is emphasizing non-headline sub-measures of inflation (like “core services”).  These measures justify higher rates for longer.  But if they change their emphasis, they can declare victory.  Heading off an incipient revolt on Capitol Hill and/or from the campaign trail.

The Fed won’t (and doesn’t have to) formally abandon its 2% inflation target.  They will just tacitly accept 3%+ inflation while paying lip service 2% inflation target.  The Fed has plenty of recent practice with lying about aspirational target-missing.  They danced artfully around below-target sub-2% inflation for YEARS during the 2010’s.

Note also that the 2% target is not based on any “hard” science or analysis.  There is a decent (economic) argument that 3% would be a better target.  More important, the counter-argument (against 3% and for 2%) is grounded more in politics than counter-economics.  No serious economist really believes 3% inflation would be much worse or even much different from 2%.

Neat chart below I might blog about later:  Low-wage people have made out fairly well since 2020.   High wage people?  Not so much.

Summary:  It will get super awkward if the labor market holds up too well while the CRE market starts to go into a too-visible tailspin.  The Fed will have to cut rates.  The Fed won’t want to look like it is riding to save the fat cats.  But it will have to act before any tailspin gets out of control.

There is consternation about why markets keep predicting relatively early and rapid Fed rate cuts.  The analysis usually centers on when/how the labor market cracks.  But what if the market is predicting the Fed will cut rates to save the Commercial Real Estate market (and the banks that depend on it)?  Just some musings.  I am no Real Estate expert.

Having established in my last post that (gasp) inflation has a political angle, we can talk about the political elephants in the room.

The politics of inflation boils down to Labor vs. Property.  “Property” decomposes to Real Estate + attached financial supports – Banks and other financing entities.

It is often said the Fed raises rates until something breaks.  Seen in this light, a Fed rate raising campaign is really a “who can hold their breath the longest?” contest between Labor and Property.  As financing costs go up, which market cracks first?  The Labor market or the Property market?

For the past 30 years, Labor has lost those contests (or that is the dominant narrative).  This is why the New York Times keeps soberly predicting that we “must” see higher unemployment to bring inflation down.  The Labor market “must” crack first.

Then the benevolent Fed will step in to save the proles hard working American people after (clears throat) some “necessary hardship.”  Here comes the cavalry!

But what happens if the Property market cracks first?  Labor comes into this hiking campaign enjoying record high savings and a record-tight job market.  So Labor can hold its breath an unusually long time.   Moreover, higher rates only affect the labor market indirectly.  But higher rates directly pressure the Property market.

Any property’s value is driven directly by how much it costs to finance it.  If financing costs go up, property values go down.

When you read “Real Estate,” the mind goes immediately to Residential Real Estate.  But a lot of homeowners are sitting on sub-3% fixed rate mortgages.  They don’t really care if lending rates are 6% (unless they have to move).  They can hold their breath for quite some time.

The sector that can’t hold its breath much longer might be Commercial Real Estate (CRE).  The smaller (Commercial Rents) elephant huddling behind the larger (Home Prices) elephant in that “Property” corner of the room. Commercial properties have shorter term financing.  A lot of it is variable rate.  They have rainy day equity cushions, but they can’t hold their breath forever.  And that equity itself is best thought of as… “wealth.”

We have already seen some cracks.  Blackstone closed the exit door of its $69 billion mega-REIT fund (which still carries highly suspect property valuations).  We’ve also seen big, solvent Real Estate developers groups walking away from properties – handing the keys over to lenders for financially un-viable buildings in New York and LA.  Making a cold-blooded decision that rents won’t support their financing/profit expectations.  Especially with low (I’ve seen 50%?) post-COVID workplace occupancy rates.  Long COVID is real in Real Estate.

If Commercial Real Estate breaks, their lenders also get hit.  Never forget that 95% of the Fed’s day-to-day focus is supervising and shepherding the banks.  It will protect its flock.  CRE is a big chunk of business for most US banks.  The keys to non-viable assets end up in their mailbox.  At the same time, high Fed rates mean Banks also face a profit-destroying inverted yield curve.  The math of borrowing from depositors at, say, 4%-5% while lending at 3%-4% is money-losing.

So maybe the Fed “has” to cut rates to save Commercial Real Estate and Banks?  Some weak caribou can go under.  But the whole herd “must” be protected.  That isn’t a political statement.  It would be an economic disaster if  we had a CRE-driven bank crisis.

The Fed should act to avert one and it most definitely will.  Why?

1. Senators:  Rich people tend to run (and win) Congressional Seats – especially Senate seats.  Rich people also tend to have Senator’s  cell phone numbers.  The “rich families in town” usually own a lot of local Real Estate.  Especially in Red States and “States without Tier 1 cities.”  Even Rich people who make their money elsewhere usually end up investing in CRE.  Commercial Real Estate is the bedrock of wealth in America.
2. The banks.  Like it or not, the financial system will always get bailed out.  Because it is a disaster if it seizes up.

But politics dictate that we must NEVER speak of CRE and the Fed in polite company.  The only acceptable elephant to talk about is the Labor market.  Why?

1. “The Fed just cut rates to bail out a bunch of fat cats and their lenders” is not a headline that plays well in Peoria.
2. The dominant narrative just assumes Labor must suffer the “necessary hardship” of a rate-raising cycle.  Thus assuming the passive-income-people who own (and lend on) buildings can hold their breat long enough to win the  contest.
3. [sputtering] To even utter the words Labor and Property together in a single sentence is…  is…. why my dear sir!…  that is socialism!!!!!

We will see.

Something has definitely shifted in Ukraine.  The West has clearly decided Ukraine can and should win militarily.  We’ve seen all sorts of taboos lifted in the last few weeks.  Although maybe it is just that Ukraine is now running out of tank shells too.  More important, Putin seems dead set on an offensive.

It turns out Putin kept back 150,000 of those 300,000 poor would he mobilized a few months ago.  Now, after the sort of exacting, targeted, hyper-efficient husbandry of precious human resources for which the Russian military is world renowned, these hyper-warriors are about to be unleashed upon Ukraine… Or perhaps a semi-trained rabble driving 20 year old tanks – some even with working main guns…

So how does this change the dynamic?  It is possible the Russians could surge forward and capture hundreds of square meters of land.  maybe a few small provincial towns.  But it is a near-certainty any offensive would grind to a halt quickly.

Why?  Among other things, they don’t have enough trucks to supply a long penetration.  That is why the Kyiv offensive fell apart.  Nor could they bring up their artillery to support it because HIMARS would strike from the sides.  So, barring a miracle, it bogs down with perhaps a few propaganda successes.

That might be Putin’s aim.  Find some way to declare victory and play (again) for a “frozen conflict.”  I am guessing the motivations are more animal than that.  He’s demanding an offensive like Hitler in the bunker (excellent movie BTW).  So his lackeys are going to give him one.  With the same foresight they brought to the original invasion plan.

The problem?  After he gains the few hundred meters,  Putin will no longer have those 150,000 troops – rabble they may be.  Nor will he have their tanks.  Or the innumerable shells fired to support the push.   Or the few trained soldiers thrown in to stiffen the offensive going.

So Ukraine absorbs the initial push, falls back, and then stabilizes or seals off the line.  What happens next?  The Ukrainians attack.  Wherever they want to.  With fresh troops.  Knowing the Russians have just wasted their reserves on a futile push.

That was not my original scenario, but the noises about an Ukrainian offensive are noticeable quieter.  And there is a certain logic to the above.  Instead of destroying the Russians, let the Russians destroy themselves.

A few related thoughts.

1. Ukraine, if they can manage it, is actually better off letting the Russians penetrate.  Then, cut them off.  Cut the bulge off from re-supply (artillery and HIMARS).  Then wait for the trapped troops to give up.
2. Ukraine can, as at the start of the war, give away land and save their men/machines.  The deeper the Russians come, the more that will end up destroyed.  As with Kyiv.
3. The drama of a Russian attack followed by another plucky Ukrainian defense will solidify Western support.  They will get those F16 fighter jets they want.

Why, politically, do we insist our only economic tool must be a bludgeon?  Why ignore a whole array of more precise, more effective alternative instruments?  I’m talking about simple effectiveness here, not my personal politics.  But politics are exactly why we are left clubbing ourselves with a bludgeon while the toolbox stays shut…

Olivier Blanchard – moderately right-winged pillar of the mainstream Economics establishment –  recently set off an Econ twitter explosion.  How?  He observed that inflation has (gasp) a political dimension (“Distributional conflict” below  = politics).

Obvious, right?  Judging from the reaction… no.  A lot of people do not want to talk about the elephant in the room.

1/8. A point which is often lost in discussions of inflation and central bank policy. Inflation is fundamentally the outcome of the distributional conflict, between firms, workers, and taxpayers. It stops only when the various players are forced to accept the outcome.

— Olivier Blanchard (@ojblanchard1) December 30, 2022

The most vehement objections came from those with the nominally “apolitical” agenda – the technocratic, Fed-centric, Monetary-mechanics.  They want economic policy “kept away from those useless, corrupt politicians.”  Let the experts in the ivory tower of the Fed handle it.  From this flows the “its all the Fed and out of our hands”  narrative of Team Monetary.

Why is this a problem?  Because the Fed can only bludgeon the economy with an incredibly limited, often-ineffective toolkit.

Look at 2022.  The housing and auto sector have come to a screeching halt.  Asset markets have tanked.  The rest of the Real Economy has sailed along largely indifferent.  Eventually the bludgeoning will have some long-lagged impact;  as bludgeoning does.  The Fed itself doesn’t pretend or aspire to much more precision than that.

The Fed’s limitations are pretty obvious if you see inflation’s sources and causes in the Real Economy (supply chains and labor markets and all that supply/demand stuff).

Outside of the housing and auto finance markets, the Fed has remarkably little agency in the real economy.  Basically they raise rates and wait for the famous long-lagged effects to pop up somewhere.  But the Fed Funds rate only raises some rates in some places with a whole lot of weird counter-balancing effects mixed in.

Even large-scale corporate capital investment decisions are remarkably unaffected by Fed-driven changes in interest rates.  Companies invest because they need or want to.  The cost of capital is a factor, but (unsurprisingly) far below “is this a good idea?” on their decision list.

What if we had a scalpel?  A tool that could act with more speed, certainty, and precision?  What if we used – gasp – the Government’s taxation and spending tools to, like, directly affect the economy?

The 2022 scenario below is a counter-factual, but the mirror image of the 2020 stimulus.   The 2020 scenario is very very real – a “factual.”

• The 2022 alternative scenario:  Inflation explodes.  Some sort of “automatic stabilizer” kicks in and raises taxes – preferably consumption taxes.  Inflation skids to a halt in the face of lower spending.  As a super-beneficial side effect, inflation expectations never really gets going because “everyone” will know that tax hike will snuff it out…
• The 2020 Actual Real World Scenario (in future):  The economy weakens.  Some sort of “automatic stabilizer” kicks in and sends out checks – preferably to the people most likely to spend the money immediately.  The economy perks up, savings accounts aren’t ravaged, and we have a swift and speedy recovery to pre-slump trend.  The average American still experiences ups and downs, but the downside damage isn’t quite so systemically damaging.

The 2020 stimulus had an unexpectedly massive economic impact.  Its effectiveness and impact surprised nearly everyone – even the super lefty Economics crowd.  The US recovered from 2020 at light speed compared to the post 2008 recovery.

We bounced back so hard, we kindled inflation.  So why not use the same tool to bring inflation down (hard)?  

It is about here that you’ll shake your head and say;  OK in theory, but it is politically impossible…. A true statement, but a political statement.

The scalpel stays in the drawer.  The bludgeon is all we get.  Why? Because of politics.  Not because of sensible economics.  Or technocratic wisdom.  Just greedy, self-dealing politics.  That “distributional conflict” of which Mr. Blanchard dared speak…

So whose politics?  Who would use a bludgeon when they had a scalpel in the drawer?  Who’s narrative leaves no space for political (ie. non-Fed) action?  Who is so deeply wedded to that anti-government narrative that they will gladly impoverish the nation to sustain it?  Why build this technocratic smokescreen to conceal what political agenda?

Hmmmm…