Based on how the news is reporting, one would think the U.S – China trade deal is going to solve all of our global growth problems. Once an agreement is struck, global trade should flourish, stock prices should reach new all-time highs, productivity should rise and perhaps, more importantly, inflation should rise. It seems investors these days do not understand what inflation is or how global trade affects inflation. Regardless, any trade deal between the U.S. and China, or any other nation, will be disinflationary and not inflationary.
According to the Federal Reserve and other central bankers, inflation is best measured by an increase in consumer prices. Inflation is the expansion of a fiat currency and a corresponding increase in consumer prices is merely a reaction to the Fed maintaining an easy monetary policy for too long. The Fed chooses to use consumer prices as a gauge of inflation so they can continue expanding the currency supply since consumer prices and wages are among the last to feel the effects of currency-printing operations.
While investors continue to believe that an increase in global trade will lead to inflation, they could not be further from the truth. Consumers engage in trade to acquire goods and services that are unavailable in their local area or are cheaper than goods or services available in their local area. The reason American consumers like foreign-made goods, particularly Chinese made goods, is due to their lower price when compared to a similarly made U.S. good.
Due to all the regulations and taxes facing American corporations, it is by far cheaper to produce a good in a country with lower wages and fewer regulations. China checks both of those boxes. From a price perspective, a trade deal would lead to the removal of tariffs, which are a tax on consumers, that would lead to lower consumer prices. Based on the Fed’s definition of inflation, lower consumer prices are disinflationary.
The counter-argument is that lower consumer prices will free up monies that can be spent on more goods and services, which would then cause inflation. This is a valid argument, except the amount of currency in circulation has been decelerating for the past two years. With the money supply running at about two-thirds its normal rate on an annualized basis and one-third its normal rate on a quarterly basis, there is not enough currency being created by the financial system to lead to an increase in consumer demand.
The other headwind to demand is debt. With a record level of corporate and consumer debt, there is not enough new currency being created to pay against the debt and to drive consumption at the same time. When left to choose between the two, paying debt is the priority since default leads to forfeiture of an asset.
From the consumers perspective, the end to the trade war should lead to lower prices. Lower consumer prices will eventually find their way into the Consumer Price Index (CPI), which the Fed monitors as one of its preferred gauges of inflation. As the rate of inflation slows, the Fed will be forced to hold off on any further monetary tightening.
However, history does show that countries who engage in trade are generally more prosperous. Global trade does create more U.S. dollars, as the dollar is the world’s reserve currency. As the world’s reserve currency, most trade is done in U.S. dollars. Therefore, an increase in global trade should lead to an increase in U.S. dollars. An increase in a fiat currency, such as the U.S. dollar, is inflationary.
In order to facilitate world trade, there needs to be enough dollars available to finance global trade. Trade begins when a foreign manufacturer obtains dollars, likely through borrowing, to buy raw materials to produce a good. The finished good is shipped to America where dollars are borrowed to pay for the finished goods.
Those dollars return to the foreign corporation, who exchanges their dollars for local currency at a foreign bank. Once a foreign bank has too many dollars, it exchanges them with their central bank who in turn uses their excess supply of dollars to buy U.S. Treasury bonds. The purchase of U.S. Treasury bonds allows the U.S. government to continue to pump currency into the U.S. economy by running a perpetual budget deficit.
Ultimately, the American consumer will borrow currency, even if temporarily by using a credit card, to purchase the finished good. Throughout the entire supply chain to the end consumer, currency is being borrowed. Since borrowing is the mechanism in which currency is created, the global currency supply expands as more borrowing occurs. As the global currency supply expands, so does inflation.
This is where World Dollar Liquidity comes into play. World Dollar Liquidity is the ease of obtaining financing in the global financial markets or the number of dollars available to finance global trade. World Dollar Liquidity is defined as the sum of the Monetary Base plus the amount of foreign-owned U.S. Treasury bonds. Based on the most recent data of the largest foreign-owned holders of U.S. Treasury debt, the amount of foreign-held Treasuries increased at a mere +1.8% on an annualized basis. Meanwhile, the Fed continues to contract the Monetary Base as part of their monetary tightening cycle.
The Monetary Base is a combination of the total amount of currency in circulation, plus the total amount of currency in bank reserves and bank excess reserves. When the Fed unwinds their balance sheet or sells their cache of U.S. Treasury and Mortgage-Backed Securities back to the public as part of their monetary tightening cycle, it causes bank excess reserves to fall, along with the Monetary Base.
The total amount of currency in circulation is growing very slowly and is likely soon to contract. The broad M2 Money Supply is growing at an annualized rate of just over 4%, which does not sound bad until you realize that historically when the annualized growth rate of the money supply falls under 3.7%, our economy has seen nothing but recessions and depressions. The quarterly growth rate of the M2 paints a different picture as it is growing at a rate of 0.5%, which translates to an annualized rate of 2%.
Should the money supply continue to decelerate or even worse contract, the Monetary Base will continue contracting along with World Dollar Liquidity. As it stands now, this will be the first recession where the currency supply contracted at the onset of the recession. During the Great Depression, the money supply did contract, but not until later during the recession. A contracting money supply will be a big problem for global central bankers.
Asset prices are sensitive to the currency supply and when the currency supply falls, asset prices eventually fall with it. It is interesting to think that the salvation of the last financial crisis, which was zero-interest rates and Quantitative Easing, will be the catalyst for the next recession as central bankers try to overcome the rapid destruction of money caused by low interest rates.
Looking back, the Trump Administration placed over $250 billion worth of tariffs on Chinese goods ranging from industrial to consumer items with duties ranging from 10-25%. With consumers already expecting prices to rise due to inflation, most consumers cannot pinpoint how these tariffs are impacting their daily lives. Regardless, the tariffs themselves are inflationary, while the removal of them will lower prices, and reduce the effects of price-inflation accordingly.
Should there be a new trade deal with China, it will not spur global growth or inflation as many investors are expecting. If anything, a trade deal with China will redirect trade from other countries, as World Dollar Liquidity, along with global trade, is contracting. The removal of tariffs will be disinflationary, which will lead to lower stock prices, lower Treasury yields, and a dovish Fed. Even if there is a trade deal struck, Congress must still ratify the agreement and so far, they have yet to approve of the new United States – Mexico – Canada trade agreement.
A Look at How Hedge Funds are Positioned (04/08/19 – 15 min)
The Fed Remains On Hold (04/10/19 – 15 min)
Weekly Economic Update (04/12/19 – 31 min)