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February
13
2023

Unidentified Flying Inflation
Michael Every

A Chinese balloon was shot down over the US early last week. An unidentified flying object was shot down on Friday over Alaska; another over Canada on Saturday; Montana airspace was briefly closed on Sunday for related reasons; and yet another unidentified flying object was shot down during the Super Bowl. You want “we are not alone” speculation, you got it: CNN reports the US fighter pilots who shot down one of the objects could not identify any propulsion, and that it was just staying in the air at around 40,000 feet. So, a balloon(?): which can actually be effective war weapons according to some experts. You want Sputnik Cold War national security paranoia, you got it too. The alleged origin of these and other balloons, China, is about to shoot down a flying object over itsterritorial waters. (Which may be a good defense, except that it undermines Beijing’s complaint about the US shooting down one the first balloon in the same way.)

If you think this backdrop doesn’t matter for unidentified flying inflation, which we are going to look at this week via US CPI on Tuesday, then your head is up in the clouds.

On Friday we heard the new BOJ Governor is going to be Ueda-San, sending everyone Googling. At first it was decided he was a hawk and JGB yields and JPY were up; then that he is a dove, and markets swung the other way. Ueda will have to deal with Japan’s traditional problems, plus QQE and YCC, plus high headline inflation, plus rising wages, plus a massive increase in the defence budget, plus a potential Japanese trade deficit. Bloomberg today says that “Regardless of whoever sits in the BOJ hot seat, the biggest worry of global bond investors-- a wave of Japanese cash heading home-- has already begun in earnest and looks unlikely to stop.” 

Russia announced it will cut oil output by 500,000 barrels a day in retaliation for G7 sanctions, pushing Brent up around 2.5%. That’s supply destruction that helps to ensure countries like Japan and Europe run trade and fiscal deficits, with downwards pressure on FX or upwards pressure on bond yields, both making higher defense spending harder to sustain.

Additionally, the US revised its 2022 CPI data higher. December is now 0.1% m-o-m not -0.1% as first reported, November 0.2% instead of 0.1%, and October 0.5% not 0.4%. What that means for Tuesday is anybody’s guess: the market consensus is 0.5% m-o-m, although there are credible calls saying things could be much lower and much higher.

Nonetheless, current risks are of a close encounter with inflation of the third kind: not the cyclical, transitory, supply-driven kind we can ignore; nor the cyclical, demand-driven kind we easily fought with monetary or fiscal policy; but rather the nasty structural mixture of supply and demand driven inflation that comes with unstable geopolitics, the weaponization of commodities and supply chains, and a shift back to national security, industrial policy, and protectionism. Which is where UFOs and Top Gun antics come in.

The fact that the market's "2023 is not 2022 / immaculate disinflation” call could collapse in just six weeks would hardly be a surprise: year ahead calls are usually rubbish, and ones that reverse staggeringly wrong 2022 calls without revising the underlying understanding of why things happened that way, far more so.

Some of us have been Richard Dreyfuss making models of structural geopolitical inflation out of mashed potatoes, to similar responses from the market to that of his wife and kids; or investigating mysteries like Mulder and Scully. But most didn't want to believe.

Do we really have unidentified flying inflation? No: it's just that comfortable economic theories or market mental models no longer working today is as hard for some to admit as the existence of little green or grey men. That’s despite Russia’s actions, the West’s responses, balloons being shot down all over, and NordStream 2 being blown up. All of this is inflationary, and structural, on both the supply and the demand side.

• The Chairman of the US House Armed Services Committee is pledging to remove all Chinese goods from US defence supply chains, with a major dislocating impact along them. The Economist covers ‘The history and limits of America’s favourite new economic weapon: America has ramped up controls on technology trade with China’.

• The UK Telegraph reports ‘Europe rushes to launch Covid-style plan to ramp up shell production for Ukraine’, noting the ECB “could be used to raise funds to place orders large enough to convince defence firms to increase production.” (As long flagged here as a risk by the way.) It notes, “European governments have backed plans to use the EU’s multibillion-euro fast-tracked coronavirus vaccine scheme as a blueprint to produce the ammunition so desperately needed by Ukraine. A number of the bloc’s leaders told the Ukrainian president they “no longer have much in our warehouses to give” after he handed them weaponry wish-lists of weapons during a visit to Brussels earlier this week… Ukraine is firing an estimated 6,000 artillery rounds every day, according to Western intelligence figures, whereas Russia fires 20,000 a day – the same amount manufactured by European defence producers each month.”

• Yet this is also about far more than munitions. Foreign Policy magazine underlines the critique that President Biden’s geostrategy lacks an economic vision that brings allies along, making it more reliant on a US military with inadequate funding despite a $848bn defence budget. Indeed, Bloomberg commentator Noah Smith underlines @ElbridgeColby in saying ‘Europe has to stand against Russia: the US is going to get distracted, and Russia isn't going to stop.’ That would change lots of things a very great deal.

• Secret British cross-party talks to try to rebuild ties to the EU, particularly in regards to defense, Russia, and China, are surely no coincidence; not as another UK insider says its armed forces are in such a parlous state that ‘If the UK went into battle today, I doubt we’d survive’.

Consider this all geopolitical reality bellowing out the Close Encounters’ five tones: and expect more big picture tunes to follow.

Meanwhile, we can see identified risks of flying inflation. The UK Chartered Institute of Personnel Development (CPID) says 55% of recruiters plan to lift base or variable pay this year as they struggle to hire and retain staff in a tight labor market; more than half of respondents reported having problems filling vacancies, and nearly one in three expected similar issues in the next six months. Wages are seen rising 5%, the most in at least 11 years, albeit far below CPI. At the same time, the CPID say planned pay settlements in the public sector will fall to 2% from 3% in Q4 – which will do wonders for the efficiency of the state as it faces up to existential geopolitical challenges. And in the US, Iowa is floating allowing children over 14 to work in mines and manufacturing as part of an apprenticeship. I had flagged a shift to blue collar work over the ‘go to college and do media studies’ route: I hadn’t expected we would see child labor.

In Australia, the press bewails ‘Why the Reserve Bank is pushing us towards a recession that we don't need to have’; as “Chatter in the fixed income market is at DEFCON 1” on rumours RBA Governor Lowe may have said Aussie rates need to rise to 4.50%-4.75% to keep up with the US. The question is asked, ‘Is there a better way to kill inflation than raising interest rates?’, suggesting an alternative based on wage policies advocated by Keynes in ‘How to Pay for the War’ (1940). That has been referenced here a few times here in recent years – but not at all in ‘2023 is not 2022’ year-ahead calls.

Unidentified flying inflation? The truth may be out there on Tuesday.

Michael Every is the Head of Financial Markets Research Asia-Pacific. Based in Hong Kong, he analyses the major developments in the Asia-Pacific region and contributes to the bank’s various economic research publications for internal and external customers and to the media.

Michael has nearly two decades of experience working as an Economist and Strategist. Before Rabobank, he was a Director at Silk Road Associates, a strategy consultancy based in Bangkok. Prior to this, he was Senior Economist and Fixed Income Strategist at the Royal Bank of Canada based in both London and Sydney. Michael was formerly also an Economist for Dun & Bradstreet in London, covering ASEAN. 

Michael holds a Masters degree in Economics (with distinction) from University College London and speaks Thai.

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