Fractured globalization and disinflation dynamics

Yet another frantic month in global financial markets as May came to an end. On global geopolitics, it has become evident that the Russia-Ukraine war will have prolonged adverse impacts. Having failed to achieve a swift military victory that would have toppled the Ukrainian government and paved the way for a pro-Moscow regime in Kyiv, President Putin now apparently intends to annex the occupied southern and eastern areas of the country directly into the Russian Federation in the coming months. While the illegal annexation of Crimea in 2014 provoked renewed denunciations along with threats of tougher sanctions and diplomatic isolation, the present aggression is effectively severing the economic and financial ties between Russia and the world’s most advanced economies.1 Consequently, the disruption in several commodity markets affected by the conflict and the resulting negative effects on international value chains will persist, possibly for years.

As the world enters an era of fractured globalization, markets have also to respond to tightening financial conditions in developed nations, notably the U.S. After several years of exertions, the mechanics of monetary policyinduced disinflation should be straightforward. Surprisingly, that doesn’t seem to be the case. When central banks raise shortterm interest rates to tame CPIs, they are typically manipulating three levers to achieve the desired result. First, they are anchoring expectations, which is critical to stabilizing the pricing mechanisms of the economy, as it provides hard evidence that authorities are committed to the stabilization of the general price level. Second, by increasing the intertemporal discount factor, they are reducing the net present value of assets without a compensating effect on liabilities (which generally tend to grow), thus creating a negative wealth effect that cools off aggregate demand. Third, by increasing the cost of credit, they are deliberately dampening consumer and investment spending, which also leads to a reduction in the domestic absorption of goods and services. Apparently, the conventional wisdom was factoring in the first outcome but not the other two, which is perplexing, for there is no precedent of combating high inflation without driving down income and output growth.

As for the calibration of monetary policy, there is a key relationship that is commonly ignored by the common wisdom: the more debt households and firms have taken, the larger are the recessionary effects resulting from the negative wealth phenomenon, the drop in investment spending and other related events that take place when financial conditions tighten. Consequently, the flipside of heavy indebtedness is that central banks do not need to go overshooting to achieve their inflation targets: small increases in policy rates rapidly summon powerful disinflationary forces. Therefore, it is no statistical coincidence that short-term interest rates in over-leveraged economies are much lower than in those that are less addicted to credit (Chart I). Simply put, the former countries can no longer bear a high cost of capital.

Looking at the world’s largest economy and the epicenter of market anxiety, America’s total credit to the non-financial sector is not slight by any standard. At 281% of GDP according to its latest statistical reading, it is more than twice the average of Latin America’s largest countries2, for instance, having increased by no less than 91 percentage points over the past two decades. But then the disinflation process is taking place at a fast pace, even though monetary tightening has barely started. Indeed, the Federal Reserve has raised the Fed funds rate by a scant 75 bps and only announced the end of its quantitative easing program. Yet, the five-year break-even inflation - i.e., what market participants expect annual CPI change to be in the next five years, on average - has already fallen 64 bps over the past couple of months (Chart II). Granted, it has happened along with a sharp downturn in stock markets, housing indicators and consumer sentiment, but this swift adjustment is exactly what is expected in a situation of heavy indebtedness.

All else constant, break-even inflation in the U.S. should converge shortly to the Fed’s comfort zone (around 2% p.a.). Admittedly, headline CPI numbers will trend down much more slowly, but such inertia results from price stickiness in some areas of the economy, a well-documented phenomenon, together with methodological issues related to the estimation of cost-of-living indices. Against this backdrop, an instructive process of differentiation across global markets is likely to continue. A deeper downturn in America, even if it adds to China’s economic growth troubles, does not necessarily signify the end of the upturn in commodity prices. For one, the world demand for some primary products such as food is not closely related to business cycles. For the other, supplyside disruptions in several geographies more than compensate for the slackening demand.

Still on the differentiation narratives, asset prices in countries that are dependable exporters of commodities, have comparatively low indebtedness, smaller fiscal imbalances and higher domestic interest rates should outclass those of more vulnerable regions. The performance of stock markets, as gauged by MCSI metrics, which already factor in the impact of a stronger U.S. dollar, has supported this inference, although the ranking year-to-date may look weird (Chart III).

In fact, Latin America being relatively uncorrelated with the world economy, advanced nations, and emerging markets is more a norm than an exception. Indeed, the region consists of fundamental stories that are quite specific, hence the seemingly unrelated trends. Taking the case of the largest country, Brazil, the most intriguing developments of late are at odds with the downbeat global outlook: a combination of record trade surpluses, a fast reduction of public indebtedness (Chart IV) and the world’s largest privatization in 2022, namely the sale of the state-run power utility Eletrobras, which will occur in early June.?

1 See “The three decouplings” by Brenner, I. in Eurasia Group Update dated 23-May-22.

2 138% of GDP; average of Argentina, Brazil, Chile, Colombia, and Mexico, according to the Bank for International Settlements (BIS) - credit to the non-financial sector database.

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