Strong Views Lightly Held

I keep running into a lazy consensus around Ukraine – a long, grinding war prosecuted by implacable, iron-fisted Putin pressing crushing energy sanctions until…? The end game is usually hand-waving about “negotiations” that largely assumes Ukrainian capitulation.  If those ill-examined assumptions proves wrong, how much will it upend markets?  Because the evidence suggests that consensus scenario is wrong.

So what happens if Russia’s energy and consumer goods flows re-start?  That is not in most 2023 forecast expectations I’ve seen.

• Russia’s energy flows flood back into global markets.  European and global gas prices plummet.  Oil prices likely drop too.  Those price changes will positively impact everything that depends on energy (real-economy inflationary) and negatively impact mathematically measured inflation (nominally deflationary).**
• A re-start of Russian consumer imports from the West.  Russia’s pre-war economy was the same size as Spain, so this won’t move the needle much.  But a lot of Europeans – no longer paying an oil/gas war tax – will shift spending more on other stuff.  So the global effect will be solidly positive (thus inflationary).

The “hot” war will likely last months.  Definitely not years.  Only an armchair general could expect humans and machines to keep up this tempo.  The rate of equipment loss/depletion is too high.  Although human morale – depleted by time and the equipment running down – probably cracks before the hardware does.  As the last weeks show, the Russians can’t hold their lines with the men/equipment on hand.  So the Russians probably lose heart before the Ukrainians do.  Neither can keep up this pace indefinitely.

Per my prior post, the end game is (hopefully) a frozen conflict that stays cold(ish) until past Putin’s sell-by date.  In that transition from hot war to frozen conflict, Putin is most likely to move towards re-opening the gas taps.

Putin has to be desperate to re-open the gas taps.  Why?  Putin needs the money!  Public opinion still matters in Russia (as it also matters in China and even – gasp – North Korea).  How does Putin distract Russia’s attention away the strategic and military disaster of Ukraine?  Engineer a consumer boom.  Data are hard to come by, but Russia’s non-oil/gas consumer/producer economy is losing altitude fast.  Putin can’t risk an economic tailspin in 2023.  Putin needs money to spread around.  He especially needs to re-start imports of stuff like iPhones.  The last thing he needs is a humiliating defeat and a tanking economy.

The West won’t push back on gas or oil.  Everyone wants to get back to business.  A struggling Europe will jump at economic normalization.  The US will go along; Lifting consumer sanctions;  Keeping Russia’s defense industries restricted (especially chip supply).

Obvious, accessible facts point to the scenario above.  It is not guaranteed, but its a lot more likely than a long grinding war/embargo.  That market consensus seems to rest on  some unusually lazy assumptions?!?

1. Russia is still the Cold War bogeyman that haunted the childhoods of anyone over 40-50?  Russia is an obviously mis-managed economic basket case outside of its (foreign technology dependent) oil, gas, and commodities sectors.
2. Russia is still a military super-power?  How does this belief hold up against the abject reality of the past 8 months?  I have no idea.  But this shibboleth keeps shambling through conversation after conversation.  Often accompanied by a hand-waving well they have nukes.  With no follow-on thinking about where/how Putin could actually drop a nuke that would help his position tactically or strategically.  Do you really think China would or could just let that go by?  Putin is smart enough to know nukes are a fast path to personal disaster for him.
3. Putin is some sort of James Bond villain – and iron willed master strategist in absolute control of unthinking minions?  The real Putin is the mafia boss of an unruly mafia state.  How much absolute power is wielded by anyone in the Godfather movies?  Putin’s reality is a lot closer to that swirl of negotiation, maneuvering, double-cross, and occasional outbreak of fratricidal violence.  Goldfinger or Blofeld might keep sending waves of minions to their death.  The Godfather would be nervously looking to end this misadventure and get some walking money in capo’s pockets before it brings down the family.

I expected a short war before the Russians’ headlong retreat from Kharkiv.  I expect that scenario to replace the lazy consensus over the next few months.  I’m not certain how much that will impact markets.  It might be already priced in – explaining some current market behavior/pricing conundrums more than it changes anything.   It will, however, force a lot of people to re-think their outlook.

** Energy prices are best seen as a tax on economic activity.  So an energy price increase is akin to a tax increase.  A decrease is like a tax cut.  Energy’s impact on inflation is thus counter-intuitive.

• Lower energy prices imply “deflation” in YoY prices, but they give an  inflationary boost to the real economy.
• Higher energy prices increase measured inflation, but they are a deflationary drag on the real economy.

The above never gets mentioned in the business press.  But it is an intuitively obvious dynamic accepted by mainstream economics.  More on that later.

Ukraine will end up with a “frozen conflict” one way or the other.  The only question is how frozen for how long?   Framed that way, the Ukraine’s diplomatic/political end game is obvious.  A conflict frozen long enough to outlast Putin’s life span – political and/or literal (he is 69 years old).  5 years is too short.  10-15 years is likely enough. 

This sucks for everyone – especially Ukraine and ordinary Russians.  But everyone paying crazy gas prices would like to see a good-faith, negotiated solution to the Ukraine war.  Putin needs a face-saving exit most of all.  But Putin himself has taken that option off the table.  We all know he won’t keep his word.  Any agreement with Putin might as well be signed on toilet paper.

So who gets to decide the end game?  Ukraine!  I’m stunned how many commentators refuse to see that simple truth – especially the “it is the US’s fault for not barring Ukraine from NATO!!!” “realist” crowd.  Ukraine is not some US puppet state.  It is their war.  The rest of us are bystanders.  Some countries have more influence than others (see below).  But we must start with Ukraine’s interests.

What are Ukraine’s likely goals?

1. Degrade/destroy the Russian military.  Leaving Putin impotent until past his sell-by date in power and/or on this earth. Putin is 69 years old.  So preferably for the next 10-15 years.  At least for the next 5-10 years
2. Re-capture as much territory as possible before winter sets in and/or the Ukrainian Army exhausts itself.  Achieve defensible lines.  Setting up a strategically advantaged pressure point to threaten/bleed Russia as a bonus – Crimea being a good candidate.
3. Don’t tip things over into nuclear war.

#1 – Degrade the Russian Military:  With this second Russian military collapse (around Karkhiv/Izyum) Ukraine has likely won a 5-10 year window of Russian military impotence.  A near-certain 3rd Russian collapse around Kherson likely advances Ukraine to the 10-15 year window.  Another collapse around Melitipol/Mariupol would be icing on the cake – incursions into Crimea and the Donbas being bonus points (and carrying rising nuclear risk).

Russia’s military hardware losses will take years to replace – especially under sustained sanctions for things like semiconductors.  Remember we now know every chip that goes into the designs Russia has fired into Ukraine.  It would take more years to fix the obvious organizational and intellectual flaws of the rigid Russian command and fighting approach.  Those are likely un-fixable under the dead hand of a damaged autocrat like Putin.  Even with a free hand, it would take a generational change along the lines of the post-Vietnam US military reconstruction.

#2 – Territorial gains: TBD. Ukraine did just re-take thousands of square kilometers in the last week.  With Kherson likely and Melitipol/Mariupol + Crimea + Donbas still in balance.  Even if they just re-take Kherson, Ukraine will be in decent shape.  Note those gains came after a spate of summertime “informed” articles declaring the conflict a stalemate.  Things tend to happen in a non-linear way in both war and peace, but especially in war.

The USA, Europe, Russia, and Putin’s Interests.

What are the USA’s interests?  Ours lies mostly in #1 (destroy Putin’s army).  But we’ll will go along with #2 (territory) as long as it doesn’t threaten #3 (kaboom).

What is the European interest?  Who cares? It doesn’t matter!  Outside of the UK, the Europeans aren’t giving enough military support to Ukraine to get a seat at the table.  Poland and Slovakia – the transit points for arms shipments – have leverage.  But they hate/fear Russia as much Ukraine.  The rest of Europe – especially the Germans – are just along for the ride.  Their military cupboards are too bare to act as an inducement and they can’t withdraw aid they aren’t capable of giving.  A lesson learned for the future, but its too late for them to get in the game now.

What is the Russian interest?  Get rid of Putin and get out of the clutches of the Chinese before its too late.  Better a prosperous junior member/partner of the EU than an impoverished oil and gas milk cow for the Chinese.  Enough said.

What is Putin’s interest?  Who cares?  It doesn’t matter!  Ukraine will decide how, where, and when the war ends.  Putin lost control of the end game about 4-5 days after the invasion.  He lost control of the war – and thus “lost the war” – before the summer.  Outside of pre-emptive surrender, Putin has even less say on the matter than the Germans do (which is saying a lot).

Putin’s best option now is a face-saving not-so-obvious surrender.  Barring a battlefield miracle, that is the best deal he can get.

However, Putin’s prior bad faith takes a good-faith negotiated settlement off the table.  No-one will believe him.  Whatever paper he signs, the world will assume a bad-faith frozen conflict.  The Ukrainians know that better than anyone.  So they will keep punching until their knuckles give out.  More on that in my next post.

Unfilled jobs – the “vacancy rate” – has gotten a lot of attention in the inflation debate. But that debate ignores an obvious discontinuity in the underlying data series. The data have definitely changed drastically around COVID. Some of that may reflect real economic change, but some of it may simply reflect a technological shift to online job listings. If so, forward-looking analysis based on older, pre-online data is likely skewed-to-the-point-of-useless before the conclusion (positive or negative) can even be considered.

There is a vigorous economics debate around the relationship between inflation and unemployment (Phillips Curve) and job vacancies (Beveridge Curve). Larry Summers and Fed Governor Waller got into a spat over it. Different papers (see below) have predicted either doom/gloom or “nothing much at all” from the same data set.

But the debate assumes the data series itself is still reliably reflecting the same trends in the same way. It is obvious the data series changed drastically in the COVID era (see chart below). So what drove that drastic change?

1. A lot of jobs have gone unfilled (what the data are supposed to measure). Anecdote supports that.

2. A lot of job listings have gone online (and likely skewed the data series). Anecdote supports that too.

The shift to online has likely driven a permanent, stair-step increase in the vacancy rate. How badly has it skewed the data vs prior history? I have noooo idea. But the reported vacancy rate started creeping up in 2016-2017 and then exploded after COVID. That coincides with smartphone adoption and the rise of regular Joe job sites like Indeed (LinkedIn for the bottom 75%).

The marginal cost of posing a “vacancy” online is near-zero. Businesses aren’t paying to run classified ads in the paper anymore. Even before COVID, that upwards trend from 2016 on reflected solid anecdotal evidence of companies posting “just in case” vacancies for that needle-in-haystack candidate without much expectation of success.

Wanted: Left Handed machine tool operator. Fluent in Japanese. Sight-reading of music and proficiency in the Tuba strongly desired. Must be willing to relocate to Iceland.

At the same time, a lot of high-turnover job vacancies – retail sales, food service, etc – moved online. These vacancies were always out there, but filling by word of mouth or a “Help Wanted” poster in the window. I have no idea how well the JOLTS survey was capturing that data before 2016, but I’d guess a lot weren’t showing up in the actual data series. The data series is better for counting them now, but likely non-comparable to the days when classified ads ruled the land.

So we have likely seen a permanent up-shift in the data series. Some percent of recent vacancies are probably not “new” vacancies. Just “better capture of vacancy data.” This is great from a data collection perspective. But it undermines any statistical analysis that assume the current data are consistent with prior period data.

I do not exactly know how the JOLTS vacancies data is calculated, so I am just guessing at the skew. I do think the post 2016 shift suggests some impact from the shift online. The post-COVID explosion in the data series is harder to guess at but we know a lot of activity was forced online. Meaning it may be technology-driven measurement shift as much as an economy-driven shift. Meaning we maybe can’t rely on any of these papers. Which is particularly scary given that serious people like Larry Summers and Fed Governor Waller seem to put a lot of weight on the vacancy analysis without considering the underlying data.

LINK TO VACANCIES DATA:  https://fred.stlouisfed.org/series/JTSJOL

Some Recent “Vacancy” papers. None of them mention the obvious data skew in the chart above.

Federal Reserve Bank of San Francisco “Finding a Soft Landing along the Beveridge Curve,” https://www.frbsf.org/economic-research/publications/economic-letter/2022/august/finding-soft-landing-along-beveridge-curve/

September Brookings paper: “Understanding US inflation during the COVID era,” https://www.brookings.edu/bpea-articles/understanding-u-s-inflation-during-the-covid-era/. This paper argues the case that the unemployment rate is a flawed metric to follow as long as the number of job opportunities exceeds the number of job seekers.

Why am I so focused on Ukraine?  Partly because it is fascinating.  But more because it is so important to a lot of really important trends. If the cut-off Russian forces don’t hold around Kherson, the shock waves of that collapse will reverberate a long way.

1. The war is driving a lot.  Economics (Oil/gas/wheat and inflation) and politics (China/US conflict, Europe, US Domestic, etc…).
2. A lazy consensus – a long grinding war that Russia eventually wins –  doesn’t square with reality on the ground.

If Ukraine runs counter to consensus, a lot of people will have to re-think (and re-price) their expectations for oil prices, gas prices, economic growth, Russia’s geopolitical position in the world, China’s likely policy path, etc etc. 

That is why Ukraine matters.

If you don’t have a view, you are risking a blindside hit to your world view.  Professionally, that would be a dumb risk for me to take.

Yesterday, I thought another Russian collapse around Kherson was increasingly likely.  On this news, the odds just went up.  This is simple stuff to build.  The Russians are getting really desperate if they are buying it in from North Korea.

WASHINGTON — Russia is buying millions of artillery shells and rockets from North Korea, according to newly declassified American intelligence, a sign that global sanctions have severely restricted its supply chains and forced Moscow to turn to pariah states for military supplies. (NYTimes)

It is possible the buy is less about an immediate shortage and more about Russia trying to use Chinese Yuan they otherwise can’t spend.  But that is also significant/interesting economically.  More on that later.

A friend asked me to update my Ukraine thoughts yesterday.  It turned out I had a lot to think through, so here goes with my apologies. 

A lot of people believe that time is on Putin’s side.  That argument is framed in terms of years.  The broad sweep of geopolitics and grand strategy so beloved of armchair generals (and political scientists) everywhere.

Time is NOT on Putin’s side if you think in weeks and months.  If the Russian’s can’t hold their ground in Kherson for the next 3 months, your grand sweep of geopolitics gets swept into the dustbin of history (sorry – couldn’t resist the mixed metaphor).   Historians know better than to ignore the little details.  

The Russian’s prospects in Kherson are dismal and getting worse.  So things in Ukraine are going as good or better than I had hoped.  Why?

1. The Ukrainians did some really creative, smart things.  Specifically, they disabled the bridges supplying the Russian army around Kherson west of the Dnipro river – wide with steep banks.  The Russians have been reduced to supplying themselves via a jury-rigged ferry and (I presume) helicopter lift.  More generally, the wildly successful Ukrainian campaign to destroy Russian ammunition dumps and command posts.  The super-accurate, long range US HIMARS missiles have been even more effective than hoped.  See pictures below.
2. The Russians did one spectacularly dumb thing.  They poured more troops in the Kherson pocket.  Even after the first HIMARS strikes on the bridges showed the vulnerability.  If/when that pocket collapses, Russia will lose most of the men and all the equipment.  A delusional Hitler trapped and lost 600,000 German Soldiers in Stalingrad – betting wrongly he could keep it supplied.  It was a tremendous victory for Russia.  Kherson will likely be Putin’s Stalingrad- thankfully on a smaller scale.

Outside of what Russia can fly in, the Russian war effort has narrowed to the whatever and whoever is already in that pocket West of the Dnipro (zoom in on the map here).  Stuff and men not already across the river are no longer relevant.  Equally important (and fantastically stupid), that stuff and men likely can’t get back over the river.

So will the Kherson pocket collapse?  The probability of collapse only increases as the weeks go by.  Why time is not on Putin’s side.  Ukraine launched its counter offensive last week.

The Ukrainians just need to force the Russian tempo without grinding down their own troops.   If they are careful about not over-pressing attacks, they likely precipitate a Russian collapse before the Ukrainian army runs out of steam itself.  The longer #2 and #3 go on, the more weak spots Ukraine will find for #1 (breakthrough).

1. Probe for weak spots and (maybe) score a decisive breakthrough.  Steady pressure calibrated to minimize Ukrainian casualties.  Giving the Russians no rest, but avoiding a slugging match.
2. Stir the ants.  Follow them back to the nests,  Bomb the nests.  Activity forces the pace of re-supply.  Ukraine can watches for where the supply trucks go.  All targets for the HIMARS list.  Every ammo dump and command post that goes BOOM strains the morale and supply situation further.
3. Grind down the supplies, equipment and morale of the Russian military.  With the bridges cut, every Russian shell fired is that much harder to replace.  Every destroyed Russian gun shrinks their fire support.  As the weeks go by, the vehicles will start breaking down (a tank’s running time between overhauls is measured in days/weeks not years).  Other gear will break or get hit.  Most important, all of the above will wear out the Russian soldiers themselves.

Every week that goes by, the Russians will get weaker.  Their supplies of morale probably runs out before the shells do.  Every Russian soldiers West of the Dhipro knows he is trapped in hostile country with blown bridges behind him.  Think yourself into that personal situation for a moment…

Moreover, I don’t see how Putin extracts himself from this trap.  He can’t keep the bridges in repair.  So…

1. If Putin tries to hang on.  How will he keep a steady enough flow of fuel, spare parts, men, and replacement vehicles?  How will he replace the lost guns?  His stranded troops will get just get more bedraggled as winter comes on.
2. If Putin tries to belatedly pull back.  The tanks and other heavy equipment are trapped.  He can’t pull the troops back without abandoning huge amounts of gear = bad PR.  Moreover, any fighting retreat is just a step away from becoming a rout.  Would some Russian unit really sacrifice itself to hold the perimeter while the lucky ones get out?  For how long?

So my guess is the Kherson pocket falls in the next few weeks/months.  Its final images an abandoned mass of tanks and trucks at the Western approaches to those bridges.  Russian soldiers trudging across on foot or (more likely) trudging West towards POW camps.  Those photos will be very very hard to censor or explain back in Mother Russia.

Maybe Putin can paper over another defeat?  I don’t think so.  Kyiv was embarrassing.  Kherson will be humiliating.  Practically, he will have lost a equipment and men he can’t easily replace.

The above is fairly obvious from the situation on the ground.  I’m just guessing at what actual Ukrainian generals have pretty obviously put into motion.  Hopefully I’ve avoided straying over the line into “armchair generalship.”

But now lets cross that line, settle into that armchair, and guess what they might do next.  I don’t expect to be right here.  I am expecting to look foolish.  But its worth noting the possibilities.

• Ukraine can likely choke off supplies to the occupied areas around Melitipol – creating another under-supplied pocket.  Look at the map.  Russia’s supplies come out of Crimea over two rail and road routes.  The Western link is now within HIMARS range.  The smaller Eastern link crosses a bridge that can likely be destroyed.  The alternate rail and supply routes coming East from Donetsk are also likely within HIMARS range.  Same goes for the ports along the coast.
• If the Melitipol pocket falls, Crimea itself becomes a pocket.  If Ukraine can hit the bridge over the Kerch strait (connecting Crimea to Russia), Russia will have to supply it by sea.  Ukraine has taken delivery of a lot of anti-ship missiles.  Ukraine will also re-take control of Crimea’s main water supply (note the canal that runs to Crimea from the dam at Nova Khakhova).  That starts to look a lot like a siege.
• Meanwhile, the HIMARS will keep landing anywhere an ammo dump or command post can be found.

So as we slide into year’s end, Putin will likely have lost an big red blob of territory around Kherson.  He will be struggling to supply and hold the last big red blob around Melitipol.  Crimea will be under threat.  He will have lost men and hardware he can’t easily replace.  His economy will be struggling further as inventories and spare parts run short.  All this will be impossible to hide from your average Russian.

Does the above end the war?  I have no idea.  Putin’s next move is hard to guess.  Especially because he’s exhibited such spectacularly bad judgement since Feb 24th.  But he will be move from a position of weakness – on the ropes and reeling.

So to go back to my friend’s question, Ukraine has been progressing more or less as I’d expected.  As I noted in a prior post Putin has trapped himself as the organ grinder’s monkey.  Ukraine is now grinding the organ faster.  Betting the monkey will stumble again.  We can’t be certain that will happen, but the bet gets more likely as the weeks go by.

Putin cannot force a decision.  He can’t stop the war from grinding on.  Grinding his army to pieces along the way.  Zelensky just told the NATO summit the war likely ends Christmas 2022 – the front half of winter on the steppes.  My guess is that is the intersection of two lines

1. How long it will take to break Russian morale and fighting strength – precipitating another Kyiv-style rout someplace somewhere.
2. How long Ukrainian morale can hold out (hopefully long enough to force the result above).

Zelensky’s bet is that Russia’s army will break someplace, somewhere.  Keep grinding the organ and wait for the monkey to stumble. Forcing Russia to the negotiating table in a position of weakness.

How accurate are the HIMARS?  The black circles below are show the impact sites of a recent strike.  Another video I’ve seen shows a neat, evenly spaced row of craters hitting just one traffic lane of the bridge upstream.  The bridges are still standing.  Ukraine can repair the structures in some future peacetime.  But the roadways are un-usable Swiss cheese.

Ammo Dumps:  HIMARS fiendish accuracy means the most dangerous posting in the Russian Army today is probably working in a command post or ammo dump – which have been exploding spectacularly for weeks now.  The actual front lines are probably statistically safer.  The videos are worth searching for.  The explosions are huge – mushroom clouds looming over entire cities.  The campaign has had a real impact on Russian artillery fire (based on hard data from Nasa’s FIRMS wildfire-spotting satellite).

A lot of commentary assumes Labor costs is the only variable in the “inflation” equation. We “must” have unemployment to control labor costs!!!!  This is an article of faith for your typical Wall Street Journal reader.

But price is set by 3 variables, not just labor costs.

Price = materials costs** + labor costs + profit margin

Wages are very sticky.  Since you can’t usually cut wages, you MUST cut workers.  Correct – assuming you are solving for constant profits.

However, the most “variable” variable above is actually profits.   Corporate profits have been sky high for 2 years.  I wish I had seen the corporate profits chart in this tweet last year.  If there was a bubble anywhere, it was here.

Reverting from 13% margins to the pre-COVID 10% margins implies a ~25% drop in profits.  That just gets us back to prior trend.

Stable earnings have bolstered the market recently. From here on, however, it will likely be the margin story that defines this cycle. Margins may be hard-pressed to remain as high as they have been since recovery from the pandemic. pic.twitter.com/Lz7772KixK

— Jurrien Timmer (@TimmerFidelity) August 10, 2022

While “everyone” looks for a big increase in unemployment, an equally plausible 2023 scenario is…

• Fairly stable employment with sticky wages (labor costs stay high).
• Materials costs are always hard to predict**, but lets say supply shocks fade and that creates room for price cuts and discounting.
• “The cure for high prices is high prices.”  Price destroys demand – free market 101″.  At some magical point, we get off a lot of vertical demand curves.  Think about airline seats – if you have 2 empty seats left, the marginal price the day before the flight is $1,000.  If you have 10 empty seats left, it is $500. if you have 20 empty seats, it is $200. Small shifts in demand drive big swings in price.

End results for companies depends…

• If they are the lucky few with strong pricing power (most companies don’t have much) => No problem we raised prices and can hold them.
• Everyone else = paying higher wages supplying into a softer market with less demand.  The hit will flows to profits.

A profits recession will still suck, but it wouldn’t be the employment recession you read about in the WSJ.  In reality, I’d probably expect a bit of both.  But profits are the more variable variable.

The obvious investment conclusion is “own companies with pricing power.”  Preferably those seeing strong demand.

** Materials costs are high now, but very hard to predict.  I will note two rules of thumb:

1. The cure for high prices is… high prices.
2. “I’ve seen gluts not followed by shortages, but I’ve never seen a shortage not followed by a glut.” 

The Fed isn’t know for telling simple stories in plain English, but Fed Governors Mary Daly and Esther George are doing just that.  Their narratives contradict the dominant narrative of the business media/pundit complex.  Maybe they are trying to tell us something?

The media/pundit/sentiment complex is all about Armageddon – drama gets clicks.  Daly (considered a dove) and George (considered a hawk) both see a low-drama path to the economy settling down without a major crisis or deep recession.  The wisdom of the crowds in commodity and bond markets are voting with the Fed governors so far.

Not also that Fed Governors and the financial markets are out on the field.  The pundits are just commentating from the stands.

Before we get to Daly’s forecast (below), lets start with a chart and the sentence in bold.  She’s setting her stage this way for a reason.

While adjustments in financial markets after FOMC communications are not unusual, the speed and magnitude of the movements during the past six months have been unprecedented, as the figure shows. 

The fact that financial conditions and real activity are adjusting to expected monetary policy tightening, even when actual rates have not fully risen, means that long and variable lags may not be as long, or variable, as typically assumed.

Figure 1
Financial conditions around federal funds rate increases

Source: Goldman Sachs US Financial Conditions Index and FRBSF staff calculations.

Ms Daly goes on to share her own forecast (my emphasis below).  It is surprisingly specific and contrary to what you’ll read in the WSJ or FT.  Many want us to believe the behind-the-curve Fed is desperately clutching at straws.  I don’t see that here.  Time may prove her wrong, but she makes a fair. reasonable argument based on what we know today.

The question is: how much economic slowing are we likely to see? Here, history gives us some useful reference points.

One is the Great Inflation of the 1960s and ’70s and the subsequent Volcker disinflation, which, by the mid-1980s, had brought inflation down from its double-digit peak. But it came at a very high cost, pushing the economy into what was then the most severe recession since the Great Depression.

But this is not the only example or precedent of how the economy reacts to policy tightening. In the mid-1990s policymakers faced a rapidly declining unemployment rate and worried that a 1970s-style high inflation environment was coming. So they raised interest rates by 3 percentage points in roughly a year. This rapid policy tightening put the brakes on falling unemployment, but the overall effects on growth were mostly benign. Most notably, the economy and the labor market maintained a relatively strong expansion through the end of the decade, and inflation remained in check (see Blinder 2022 for additional discussion of past tightening).

For a number of reasons, I expect our economic transition now to look more like the mid-1990s than like the 1970’s Great Inflation and subsequent painful disinflation. That’s because many of the factors that helped fuel the Great Inflation are not as prominent today.

…conditions in the economy are quite different now than they were in the Great Inflation. There is a sizeable amount of excess demand in both product and labor markets, supported by COVID-related fiscal and monetary policy. This translates into large, accumulated back orders for goods and historically high job vacancies in the labor market. Adjusting rates to slow the economy will most likely reduce these backlogs and high job vacancies before digging into current production and employment.

In economics terms, this would mean that we are on the steep portion of a fixed supply curve or Beveridge curve (see Waller 2022). And moving along those curves by reducing aggregate demand to return normal conditions would bring inflation down with a more limited effect on overall economic activity (Powell 2022).

In its extreme form, this implies that policy adjustments to lower inflation will be cost free. While I think that scenario is highly unlikely, I do expect the costs of adjustment to be moderate, with some slowing of GDP growth below its longer-run trend and an increase in the unemployment rate from the very low levels we see today.

There is another surprise here;  Another Fed Governor offering a direct, plain-English narrative forecast.  This is weird.  Especially because the stories diverge markedly from what market pundits and business media are saying.  That gap is worth minding.

I harbor deep suspicions about the media/pundit narrative.  All the bold-face magazine covers – regime change!, massive inflation!, run-for-the-hills!  This stuff gets clicks, makes reputations, and drives trading flows.  That is exactly why I mistrust it.

The Daly and George narratives are less exciting, but more reasonable.  We’ve had a massive shock.  Hopefully we work it out.  In a year the Ukraine War is over and supply chains have has sorted this out.  This year’s drama is mostly forgotten.

We’ll only know who is “right” with perfect hindsight.  I’m trying to stay open minded.  But I’m inclined to believe the commodity/bond markets and the Fed, not Larry Summers and a bunch of big-name investors talking their books.

As an aside, her speech also contains a very reasonable explainer for why the Fed didn’t act more quickly to raise rates.  She is correct here.  The Fed’s critics are only “right” with perfect hindsight – the second-to-last refuge of a scoundrel.

To manage these risks [deflation vs inflation in 2021] we needed to do more than just assess their likelihood. It was also important to stack the potential outcomes against the tools we had to deal with them. Unfortunately, with the proximity of the zero lower bound our tools are not symmetrically effective. When inflation is too high, we have ample room to raise the federal funds rate to pull it back down. But when inflation falls too low, and the zero lower bound binds, we have to rely on less robust tools, such as asset purchases (Cúrdia, Chen, and Ferrero 2012).

This meant there could be significant potential costs to overreacting based on emerging—but still limited—evidence of price pressures. Especially when any premature tightening would be hard to reverse and its consequences could hamper growth and productivity in the longer run.

https://www.frbsf.org/economic-research/publications/economic-letter/2022/june/policy-nimbleness-through-forward-guidance-speech/

Take a moment to read the short, surprisingly clear speech by Fed Governor Esther George July 12th.  It contains a warning to her fellow Fed Governors.  She thinks the current Fed consensus risks a major policy error by overly hasty action.  Confusing temporary (pandemic and Ukraine) shocks with long-term shocks.  It is also a tidy analysis of our present economic situation.

She has been around a long time and is known as a “hawk.”  She was also the only Fed Governor to vote against the 75bp interest rate increase last meeting.  This is not typical hawk-speak… 

I find it remarkable that just four months after beginning to raise rates, there is growing discussion of recession risk, and some forecasts are predicting interest rate cuts as soon as next year. Such projections suggest to me that a rapid pace of rate increases brings about the risk of tightening policy more quickly than the economy and markets can adjust…it is unclear just how high rates will need to move in order to bring inflation down. These dynamics suggest it will be particularly important to observe how the economy is adapting to changes in monetary policy.

The bond and commodities markets see the same risk.  Commodity prices are tanking.  The bond market expects the Fed to be cutting rates in 2023 (meaning too-fast raises in ’22 followed by an unseemly scramble to undo the damage in ’23).  The 10 year yield is pointing to slowing growth and rate cuts (going DOWN even while expectations for near-term rate cuts are going up).  Market-based inflation expectations have been coming down for weeks now.   So has the Cleveland Fed’s inflation expectations index.

With the evidence above, you could usually bet the Fed will follow the markets (while pretending to lead).  Multiple markets are clearly signalling the tightening campaign is (or should be) getting close to its conclusion.

The risk is the Fed (or Powell) refuses to take the hint.  Powell has been widely reported as desperate to protect his reputation/legacy.  He wants to be remembered as a Paul Volker (“slayer of the inflation dragon!”)  not an Arthur Burns (“wimp of the 70’s stagflation”).

So are we going to have a recession to protect the vanity of one man?  Ms. George seems to be asking that question to nudge her fellow governors away from enabling Powell’s agenda.

The good news?  Powell probably can be convinced to declare victory if inflation readings start to come down because prior, temporary shocks are, well, temporary (we can’t say “transitory” anymore).  Especially if the market is telling him the alternative is an “unseemly scramble.” If Powell is that much of a egoist/politician, he’ll be tempted by the easy win.

More sympathetically, the Fed and Powell need to talk tough now to get the result they want.  But some of that tough talk is, hopefully, just bluster.

Markets are usually more right than pundits, but they still might also be wrong about declining inflation.  They were wrong 6 months ago when the Fed started talking about raising rates (the 10 year also went down in November/December too).  Although the markets are usually more right than the Fed or the talking heads.  Lots of risks and uncertainty, as always….

The speech is still worth a read in full.  She does a great job of summing up “where we are and how we got here.”  In particular, she clarifies just how weird and out-of-whack the whole situation is.  Prior analogues are pretty useless because we’ve never seen a situation like this before.  When someone starts telling you about the 70’s/80’s or (much worse) 2001 and 2008, you already know they are wrong.  Navigating on a bad map using a broken compass is certain to get you lost.  Navigating from common sense gives you a fighting chance.

“If only we had something more precise!“ Says surgeon holding a rusty kitchen knife over a tray full of scalpels…  

How “should” we slow demand in an overheating economy?  Congress should be (temporarily) raising taxes.  The Fed’s rate policies should be back page news today and always.  Yes, that sounds absurd.  Because we have all succumbed to political learned helplessness.  But it is still blindingly obvious.

How many times have you read some variation on? “Fed rate changes are a blunt weapon, but (insert shrug here) its the only way to slow demand.” This is poppycock.

The tax code gives us infinite ways to slow demand immediately with precision.  With the side benefit of reducing the deficit in the bargain.  Yet the tax code toolbox just sits there un-opened.

It didn’t used to be this way.  In the 1940’s, tax increases were the “expected” inflation response.  This is the Fed Chair writing in 1943.

The public, which has come to understand the need for increased taxes as a means of inflation control, would find it more difficult to see how an expansion of the Social Security program at this time would serve the same purpose.

Of course, we know there is zero chance that we would ever use the surgical tools of the tax system.  We will, instead, sign the whole economy up for brutal economic chemotherapy.  Because that learned helplessness serves a political agenda…

BTW the alternate title to this post:  “They” Say They Care About The Deficit. They are Lying...

The consensus forecast on the Ukraine war seems be for grinding, low-level conflict.  That seems unlikely.  It is probably mostly or totally over by Winter. That is a better outlook than forecasters have assumed.  It might be the outlook markets are pricing in via, for example, plunging commodity prices.

Putin has already lost the Ukraine war  Ukraine, by continuing to exist, has won a minimum victory by simply not losing.  By keeping the war hot enough for 6-7 months, they can likely win – either big or small.

Ukraine doesn’t want a grinding war.  So they will use the next 6-7 months to break the Russian military machine.  Ukraine wins either by sparking a Russian rout or by grinding the Russian war machine down to a dull nub.  Either way, the “hot” war is probably over when winter takes hold and/or before mud season.

Every month of fighting increases the probability the Russian line collapses in some neglected sector.  The Russians will be that much more stretched, tired, and bogged down in static positions the Ukrainians can hit with precision artillery/missiles.  Ukraine will keep forcing Russia to play whack-a-mole – hoping they miss a whack.

Over time, high-quality troops become low-quality troops.  Russia today has a mix of low-quality troops holding most of the line backed by reserves of high-quality troops.  The high-quality troops press attacks and act as a sort of “fire brigade” to handle local emergencies.  Ukraine is pressing local attacks to exhaust those fire brigades.

Eventually, a mole doesn’t get whacked.  The fire brigade fails to arrive in time or sufficient force.  The Russian lines break.  If a local breakthrough gets traction, it will spark a rout – another Kyiv-style panicked retreat or a mass surrender.  A second Russian collapse re-captures big chunks of  Ukraine’s lost territory and likely brings Russia to the negotiating table.  That would be an unequivocal win for Ukraine.

What if Ukraine doesn’t rout the Russians? Every month of combat now pushes out the date that Russia can resume the war.  If Ukraine (and the US) grind the Russian war machine down far enough, that date slips past the sell-by date for Putin’s regime (and/or lifespan). 

Even if Putin hangs on, Ukraine buys years to rebuild its military/economy and integrate with Europe.  By the time Putin is ready to invade again, he’s likely confronting a very different Ukraine and a much lower chance of success.

In the calculus above, we need to be watching Kherson and Melitipol.  The Donbas battles get all the press coverage, but the war won’t be won or lost there.

I wrote up some more detailed commentary on these two scenarios, but the above gets the point across.  So including it as a sort of appendix.

Hobble the Russian War Machine Until After Putin’s Sell-By Date:

If Ukraine just keeps fighting the Russian military to a (relative) standstill, they buy themselves 5-10 years.  That is enough time to re-arm with NATO gear, rebuild and integrate with Europe, and potentially even join the EU (which has a mutual defense pact).  If there ever is a next round, Ukraine will be in a much better position to defend itself.  Especially in contrast to a Russia stagnating under the weight of sanctions.

I ran across a convincing article arguing that, after another 6-7 months of war, Russia would need 7-10 years to replace their Tank/APC losses and re-build precision missile stocks.  I’m in no position to judge how “right” that 7-10 year production estimate is, but the war has shown that Russia’s entire military needs a total structural and personnel overhaul – different organization, tactics, and skills.  That structural rebuild alone probably needs 10 years even if the equipment stocks are there.

Putin may not have even 5 years.  Especially if he loses badly enough in this ill-considered war.  He probably doesn’t have much more than 10 years given his age and the likely trajectory of post-war Russia.  Leaving aside the rumors Putin is seriously ill.

So prolonging the war now postpones any possible resumption of hostilities in the future.  Potentially past Putin’s time in power or on this earth.

Another Kyiv – Rout The Russians

How does Ukraine precipitate a rout?  Doing what they are doing right now.  Probing and poking for weak spots.  Blowing up supply dumps with the HIMARS rockets (as they are doing right now).  Blasting individual positions with accurate artillery fire (the NATO 155mm guns are MUCH more accurate than the Soviet-era stuff). In this regard, the recent arms shipments may have legitimately tipped the balance.

The front line Russian troops are left to sit and wait – feeling cut off, under-supplied, and dreading a sudden, deadly 155mm knock on the door.  If they don’t sit still, they must move and move and move again.  Mobility is also exhausting and leaves you vulnerable to ground attack and (again) artillery.  If Ukraine punches through a weak spot and threatens to cut them off, those front-line Russians will break and run.  That is how Ukraine sparked the rout around Kyiv.  They will try to do it again around Kerson, Melitipol, and/or Izyum.

Putin can’t afford another headlong flight like we saw around Kyiv  Much less a mass surrender.  The large loss of equipment would set them back further (per the above).  The loss of face/morale would be devastating.  Politically, another rout leaves Putin a dead man walking.  It would likely leave the Russian military a shattered force like the Soviet Army after Afghanistan or the US Army after Vietnam.