For a good while now, experts, including many of those appearing on this channel, have been warning about the “lag effect” of the aggressive interest rate hikes and quantitative tightening program conducted by the Federal Reserve and other major world central banks over the past year.
These experts have cautioned the speed & severity of these cooling measures would cause a sharp economic slowdown that could easily result in recession, deflation & a material correction in the financial markets.
But here mid-year in 2023, the economy is chugging along at 2%+ GDP growth, inflation remains at 3% and the S&P is up 18% YTD and the NASDAQ up a whopping 35%.
So where is the slowdown? Were those predicting one wrong?
They weren’t wrong, says Dr. Lacy Hunt. Perhaps just a little early. But a credit crunch is now at hand that will indeed start freezing up the gears of the US economy.
To learn why, we have the great fortune to sit down with Dr. Hunt himself. Dr. Lacy Hunt is a former Senior Economist to the Federal Reserve Bank of Dallas, as well as several of the world’s largest global banks. He now serves as Executive Vice President and Chief Economist of Hoisington Investment Management Company.
Lacy Hunt 0:00
Inflations precede recessions, and serious inflations precede serious recessions. In other words, once you allow the inflation to get out of control, then basically you’re setting up the the situation that will lead to instability on the downside.
Adam Taggart 0:22
Welcome to Wealthion. I’m Wealthion founder Adam Taggart for a good while now experts including many of those appearing on this channel have been warning about the lag effect of the aggressive interest rate hikes and quantitative tightening program conducted by the Federal Reserve and other major world central banks over the past year. These experts have cautioned that the speed and severity of these cooling measures would cause a sharp economic slowdown that could easily result in recession, deflation, and a material correction in the financial markets. But here in mid year and 2023, the economy’s chugging along at a 2% plus GDP growth. inflation remains at 3%. And the s&p is up 18%, year to date and the Nasdaq up a whopping 35%. So where’s the slowdown? Were those predicting one wrong? They weren’t wrong, says Dr. Lacy Hunt, perhaps just a little early. But a credit crunch is now at hand that will indeed start freezing up the gears of the US economy. To learn why we’ve got the great fortune to sit down with Dr. Hunt himself. Dr. Lacy Hunt is a former senior economist to the Federal Reserve Bank of Dallas, as well as several of the world’s largest global banks. He now serves as executive vice president and chief economist of Hoisington investment management company. Lacy, thanks so much for joining us today.
Lacy Hunt 1:49
Adam Taggart 1:51
Lacey, it’s always a pleasure to talk to you. It’s always a graduate level course in macro economics. I’m so excited to jump into it with you very quickly. Before I do, I just want to give one quick disclaimer that this interview is for educational purposes only and folks watching Lacey’s not advertising, Hoisington management, nor Z soliciting business for Hoisington. Here, he’s just talking to us as a private individual and a very accomplished economist. With that out of the way, Lacy. Let’s start if we can with a high level question, I like to ask all my guests at the beginning of these discussions, what’s your current assessment of the global economy and financial markets?
Lacy Hunt 2:31
Well, it is true, as you said, we had to something growth right in the second quarter after some more growth in the first quarter. However, I don’t I don’t think that number is really very representative for a lot of the sectors. For example, the Chicago Fed has a national activity index, which is weighted is had as 80 some odd different components in it. And it’s declined for four consecutive months. Only 30 or so the indicators rose in the month of June. There are sectors that are gaining support and sectors that are gaining. But there are a lot of areas of the economy that are weak. The one of the things in economics is called a circular flow, which has been proven time and time again, which fit with what we spend equals what we earn. In other words, gross domestic income must equal gross domestic product. And, but they have different income streams. So consequently, over the short run, there’s usually a significant statistical discrepancy. Well, the gross domestic income has declined in three of the last four quarters. It’s dropped in three of the last four quarters, even if we exclude the losses of the Federal Reserve. So yes, the economy has continued to move forward, but the the areas that are moving forward are becoming narrower and narrower. Let me just talk about something that was very apropos to the second floor. The as we know, or as we believe, according to the consensus, that the GDP growth rate was 2%. And there were various components moving up and down. However, I believe the controlling factor, the one that was that one that really permitted the second quarter to look good on surface was what happened in automotive automobile assemblies, according to the Federal Reserve, in their industrial production release surge they just a hair under a 50% annualized rate. Now, the reason for this, in my view is that this was the last major sector to restore operations from the pandemic, they had various significant supply chain issues. And, but in the second quarter, they had a 50% gain in output, and about a 10% gain in sales. And as a consequence, there was a very big surge in automobile inventories. And the inventory levels are now approaching 60 days, which is very close to what the the companies like to aim for. Okay, so here, here’s the situation, at a minimum, directly and indirectly, automotive production and sales, the whole gross automotive output is is at least 4% of GDP. It might be 5%. But let’s assume that it’s the lower number 4% 4% times 50% means that this one industry gave us a contribution of 2% to GDP directly,
Adam Taggart 6:20
which was most of the number for q2. That is correct.
Lacy Hunt 6:24
In other words, it’s it was the controlling factor. And even with this monumental benefit, the manufacturing sector has declined at about a 1.3% annual rate since reaching a peak lesson. And automotive output, which is your high multiplier, high productivity sector is a half a percent lower now than it was a year ago. Another element in the picture is that the United States, even with the problems that I’ve mentioned, which are not generally acceptable ideas, the rest of the world is doing quite poorly. I think it’s fair to say Europe is in recession, China is struggling badly. They, Japan is doing poorly. And I think that I would summarize it by saying that the economy is far weaker than is generally recognized.
Adam Taggart 7:25
Okay, economy’s far weaker than generally recognized. And it sounds like if we look on the surface of some of this headline data, and maybe we can tell ourselves that things look okay, but you’re basically saying, one, you got to look at the full data set. And two, you got to dig beneath the surface, because a lot of what’s driving some of these headline numbers are maybe sort of short term one offs, right? We’re not, we don’t expect you think we’re going to get a similar boost to GDP in q3 from the automotive sector.
Lacy Hunt 7:55
As a matter of fact, if you look at the automobile assemblies, according to the plans of the automobile companies, and the plans always vary in their monthly variations. And there’s a strike in the industry, that’s possible, we know. But according to the plans, automotive output is supposed to be flat for the rest of the year. So you go from a 50% rate of contribution, 2% of GDP, and the second quarter to zero. In other words, it’s not going to replay itself in the second half. It’s behind us. Okay, so the very great economist, ran the Bureau of Labor Statistics for a long time, George Moore, believe that one of the things keys to short term forecasting was to look at gross automotive output growth GDP, and look at what was happening to the non automotive and then assume that the major swing over the short run came from the automotive sector. Automotive is not as big as it used to be, but it’s still an important sector. And I believe that what happened in the in the second quarter, was really a reflection of a gigantic move in a major industry. Not saying it was not a negative. I mean, it was not a positive it was a positive, but it’s a non repeatable one off positive. Okay,
Adam Taggart 9:18
so I want to spend most of this conversation going through the key takeaways from the recent q2 letter that you sent out to your your clients, their Hoisington very quickly, though,
Lacy Hunt 9:31
just occasional documents.
Adam Taggart 9:35
Very much so. Yeah. So before I do that, I just want to get your high level response to this question, which is your your letter basically warns of upcoming credit crunch, and I’m gonna let you really walk through the argument for that. We had an economist on his channel not that long ago, Ed Yardeni, and he sort of talked about this concept of a rolling recession where instead of the entire economy sort of slowing down at once, and when growth contracting, that it was almost like a relay race where the recession baton was being held to different industry sectors, and by the time one sector kind of bottomed and started recovering, it would hand the baton to another sector. And so you never had sort of a full depression of the economy, you just sort of had this flatline level of growth, where you’re not going too much above it or too much below it, because different parts of the economy are entering recessions at different times. So he was sort of saying, like, I don’t really expect us to see a full contraction. I think you have a different point of view. But the reason why I’m asking you just to sort of comment that on a high level, is to this question of people who are saying, hey, all these people have been warning about lag effects and coming recession and all that stuff. But but we’re not seeing it out there. Right. So what would your high level response to that be before my entire credit
Lacy Hunt 11:00
bombs would be is that what has happened is the economy and aggregate has continued to move forward. But the number of sectors that are expanding is narrowly and that the main driving force behind this narrowing in economic activity, the decline in GDI. The drop in the important manufacturing sector are precursors of what are to come. And keep in mind that additional monetary restraint is still being pumped into the system. The Fed has not only done a lot of work, but it is continuing to do work. In terms of the fact that the interest rate levels are high, their scheduled market is looking for another increase in July. And the the more even more critically than that, we have reached high levels of real policy rates. And we’re seeing a marked contraction in both bank credit and money supply in real terms, which which will continue to be a drag against the economy as gold as we go forward.
Adam Taggart 12:20
Okay, so let’s tackle each one of those going forward, because you go into them each in your letter. The causal factors for this credit crunch, I think, are several, and you just mentioned a number of them. But But doesn’t that sort of all start with money supply and velocity of money?
Lacy Hunt 12:41
It will, yeah, this is the most critical it starts with the Fed raising the policy rate and shrinking permanent reserves in the banking system, they that’s where it starts and manage is first transmitted to money. So money is the first bridge visible indicator indication that that things are going to change. And one of the things I wrote a book 47 years ago called dynamics of forecasting, financial cycles, and one of those in large scale econometric model of the financial markets. And one of the findings that I had in the book and which is still borne out by the data that’s in our latest letter, and which you want to discuss now is that money supply leads a bank credit, money is leading bank credit lags. And in the current situation, we’ve had such a severe contraction in money growth, that is now leading to a contraction of bank credit, in real terms, very large decline in real terms. And, and, and actually, in nominal terms, bank credit has now declined every month since February. And it looks like we’re in July here, we’re just experiencing the second consecutive monthly decline in bank loans. So deposits are coming down. This is force the change in the bank behavior. It’s not to the bank’s interest to reduce their balance sheet. When they reduce their bank balance when they when they reduce their balance sheet. It means that they’re cutting their earnings potential. And that’s not something that they want to do. And so the Federal Reserve by changing money supply growth, then they change behavior. And we’re seeing that right now. Now, there are other elements that are coming into the picture. Because because the income side of the economy is not doing well. We’re beginning to see an increasing delinquency rate. We’re beginning to see an increase in in corporate bankruptcies, and this is a reflection In the fact that even though the stock market is extremely exuberant, and an aggregate macro sense, I’m not talking individual companies looking from the big picture downward, corporate profits are declining. And I’ll just give you one very tangible expression of left. The Treasury’s tax collections are very sensitive to what happens to household income and corporate income. And so we’ve we’ve gone through two important tax dates. And in the spring, we went through the April 15 tax collection, and then the Jim 15 tax collection. And according to the Congressional Budget Office, there was a very substantial shortfall in the Treasury’s tax revenues. And it hit both the corporate and the household side, which is an indication that the GDI numbers are in fact correct. And that they are correctly indicating a weakness inside of the economy. And so we have you really don’t have to dig that deeply. Adam, you can find confirmation of the problems that that are in the economy at a time when the Federal Reserve is still pushing downward on the economy, future economic growth. Okay,
Adam Taggart 16:26
so, so many, so many questions to follow up with on that. Let me just start with the decline in taxable receipts, which you’re right, it shows that that GDP is going down because there’s less income tax. We haven’t really talked much about the debt side of the equation yet. But the we’re going to be spending, I think, over a trillion dollars this year on interest payments on the national debt. Right? It’s approaching
Lacy Hunt 16:59
that and it will be even more next year. The fact of the matter is there’s two elements that work that the treasuries average maturity of the debt is five years. And so in other words means that half the debt is under five years. And a lot of debt was put on not only by the Treasury, but by the private sector, at the very low interest rate levels. So if you’ve put that on, and it was a three year note in 2020, that debt is maturing this year, there’s about $10 trillion worth of public and private debt maturing this year, similar amount that will occur next year. When when when interest rates rise, and interest expense goes up. What happens is that the income stream from prior projects that were debt finance has to be challenged, channeled into interest repayment. Well, interest repayment is extremely non productive. It keeps you in business. But it doesn’t. It doesn’t build new facilities, it doesn’t hire new workers. doesn’t bring any marginally new dollars. Yeah, no, it’s basically a deadweight loss. Now, the corporation, the net interest expense this year has not risen a great deal, because when the interest rates are low, the corporations very correctly borrowed very heavily. But as we go forward in time, and the debt that was taken on in 2020 2122, is going to roll well, and it will contribute to higher interest expense at a time when these monetary lags are working their way through the economy.
Adam Taggart 18:52
Okay, so I just want to underscore for viewers here, we’re talking basically about incomes going down, right national income going down, while at the same time, national interest expense is going up substantially. So we’re having this increasing gap that’s going forward right now, and you just talked about monetary lags, but I just want to get the question out in the table. Lacey for the the big question of is the lag effect actually really going to matter here? I hear you saying yes. Just wait.
Lacy Hunt 19:24
Well, it’s it’s it’s monetary as well as is what’s happening with regard to fiscal policy. They both operate with lags and they and fiscal policy doesn’t operate in a way that many people generally expect them to. Let’s deal with monetary policy. The I believe that the financial cycle leads the business cycle. And I like I think there’s actually three interconnecting sine waves. There’s the financial cycle the business The cycle and the price labor cycle. Now, these lags vary all over the place. And we calculate them. But, and I will give you some numbers. But we have to understand that the lags vary because they’re different initial conditions. You don’t have the same conditions domestically in a tightening cycle as the same conditions internationally, for each tightening cycle. Another critical differences is the demographics. Sometimes demographics are very strong, sometimes they’re very weak. Another element in the picture is the starting point of how high inflation reaches before the Federal Reserve responds, in this particular case, the Federal Reserve did not respond quickly. They let the inflation run, they let it get hot, I mean, permeate into the system, and begin to affect the wage decision. So the lags are varying all over the place. And it’s important to try to distinguish but how the initial conditions influence Now having said that, and giving given all of these complications, I would say that from the peak of the financial cycle, to the start of the GDP cycle, you’re dealing with a lag of about five to nine quarters. Now, by my calculation, the financial cycle peaked in the fourth quarter of 2021. So the second quarter was the sixth quarter. The quarter that we’re now in is the seventh, the fourth quarter will be the eighth, the first quarter of next year will be the ninth. In other words, we’re still well within what would have been the normative lags. Another element here is the way in which fiscal policy operates. Now, people presume that that larger deficits mean greater fiscal large s. And there are elements of the federal budget that that potentially could help the economy, for example, between the inflation Reduction Act and the chips act, that adds a trillion a trillion dollars to federal spending over the next 10 years. And that’s believed to be helpful. But I don’t believe that it will be helpful. A couple of reasons for that, number one, there’s a great deal of academic research that shows when when we engage in deficit financing, the economy gets a lift for about six quarters. In other words, the multiplier is positive. But then after six quarters, the multiplier begins to retreat. And by the end of the three years, the multiplier is negative. In other words, essentially, what happens is that the resources are transferred from the private sector to the government sector. So let me give you some really hard numbers here. We have the devil said, for the first time months of the fiscal year, from October through September through June, and the deficit is $1.4 trillion, which is the same as it was for the 12 months and the fiscal year 2022. Okay. All right. In the first nine months of the current fiscal year, all of this $1.4 trillion deficit has been funded by the domestic private non bank sector, the Fed was selling the banks her the agent of the Fed was selling and the foreign factor was new. In addition, because the Fed and the banks were selling, the domestic non bank sector actually purchased not all, not only all of the new deficit, but they bought an additional trillion dollars of Treasury securities, which means that the private domestic non bank sector retroactively funded 1 trillion of the $6 trillion of debt that was issued in 2020 and 2021. And when that transfer occurs, you’re moving resources from the positive high multiplier private sector into the negative multiplier government sector. And so, the increase in the budget deficit is another negative, it is not a positive, it is draining resources from the private sector. And it will continue to do so, under the current scheme.
Adam Taggart 25:02
Okay, so let me just make sure I fully follow. So the Federal Reserve has been putting its foot on the brakes, if you will, economically with its policies. I think a lot of people think okay, yeah, but the fiscal side is still putting on the gas. Right. We’ve got money coming into the system. I would not agree with that. I don’t think you would, right. Yeah, that’s what I’m trying to ask,
Lacy Hunt 25:27
is outwardly stimulative. It’s outwardly stimuli. But, but when you allow for the fact that the resources are coming out of the private sector, it means that you are actually transferring into the negative multiplier of government sector. All right, and
Adam Taggart 25:46
just to help people understand that this comes down to productivity and how this this capital gets used. You know, Laci has said that on the government side, right now, it’s actually a negative multiplier, meaning that that if capital flows into the government sector, it’s actually sort of anti productive, if you will. And so right now we’re seeing this, this transfer of billion, trillion for whatever you said, you know, basically, coming from the fit for the for the first nine months of this fiscal year, yeah, has gone from the private sector into the government sector, and presumably Lacey just because it can earn money pretty safely on that capital, right? It’s just saying, hey, I can get paid, you know, five plus percent at really low rates, or whatever. And so that money could be spent productively in the private sector, but it’s getting kind of hoovered up by these high interest rates or high yields on safe treasuries. And therefore, going from a public, sorry, a positive multiplier environment into a negative multiplier environment
Lacy Hunt 26:50
will set Adam Wilson, I might say that, when it’s a little bit hard to know exactly where the deficit for the current fiscal year will be. Even though we have less than two months, a little only a little bit more than two months to go. But the folks that Piper Sandler who have done a great job over the years have a preliminary estimate coming from their policy group, that indicates that we’re going to run a deficit of 600 to $800 billion in the final quarter of the current fiscal year, in other words, means that we’re going to be somewhere between 1.6 and 1.9 trillion deficit for the current fiscal year, all of which will be funded by the private non bank sector, the Federal Reserve is, is basically liquidating about $96 billion a month of government and MBS paper. And the banks are also liquidating. And so, by definition, it means that this your domestic, private non bank sector has has got to give up the resources to fund the government sector.
Adam Taggart 28:05
Okay. All right. So basically, what I hear you saying is, is we really, we really have a Federal Reserve that’s trying to cool the economy, and the deficit spending that’s going on that many people have thought, Oh, well, that’s kind of counteracting that. You’re saying no, it’s actually not it’s, in many ways, probably making it worse. You had a comment here, I want to get back briefly to back to our money supply and velocity because there’s a there’s a chart you have in your, your letter that I want to I want to share with folks here, and I want to help them understand it. And it’s where you show real Odile, which stands for other deposit liabilities, which I believe you think is sort of a superior measure of money supply.
Lacy Hunt 28:52
I firmly believe that because it does not include currency, which is fading and importance. You can’t use currency for large scale transactions. And more and more businesses don’t want to take currency for a variety of different reasons. And it does not include money market mutual funds, money market mutual funds are not banks, they cannot create deposits. They all they can do is attract the existing pool of deposits, which then they immediately shift out in the buying all other types of assets. And so I believe it’s a superior measure. And it has another advantage, you can follow it weekly off the Federal Reserve reliefs. H one. H Yeah, H A, a Federal Reserve release h eight.
Adam Taggart 29:40
Okay. And I assume as goes the growth or shrinking of OD ELLs sort of goes the expansion or contraction of the general economy. So can you tell tell us what’s happening with other deposit liabilities right now? Comment on its velocity Well, and then I’m going to tie it all together with a big question after we sort of define this for folks. Okay.
Lacy Hunt 30:05
All right. So the Federal Reserve actually throttled back on quantitative tightening during the the debt ceiling drama. And the they didn’t hit their reduction of, of treasury notes, bonds and MBS paper, I think because they, they didn’t want to rattle the market. While there was this issue. However, in July, the Federal Reserve has resumed the full fledged quantitative tightening. And for the week of July the 12, which is the latest week the other day, though, other deposit liabilities dropped by over $100 billion, which is a new all time low. So we had a transitory slowdown. In OTL, it still dropped in nominal terms slightly more substantially in real terms, but the rate of decline ease because the Fed pulled back, not not a policy move, but because of the debt ceiling issues. They’ve resumed it. And now audio has dropped to almost 15 point 2 trillion, which is a new low. And when we look at it in real terms, odbl has declined by a record amount over the latest 12 months, a near record amount over the latest 24 months. And it’s also now declined for the last 36 months in real terms, which is an indication to me that the huge money mountain which was created in 2020, and 2021 has been reversed. And that compares with a long term trend rate of growth of 3%. So the the money growth, the audio is pointing in the direction of additional monetary restraint coming under the system.
Adam Taggart 32:08
Alright, so basically, as you’ve been talking here, I’ve had your chart of OD real LDL and OTL velocity, and we can see that RealAudio has now been in contractionary mode for the recent two years or so. It’s three years now, three years, okay. And that velocity has just plummeted. I mean, it just took a nosedive here, right. And the trajectory continues to be to the downside, as you’re
Lacy Hunt 32:34
saying there’s been a there’s been the three year moving average has come down. If you look at the quarterly data, there’s been some upturn. But I believe that velocity will turn down for two reasons one of which we already discussed, a substantial amount of the income stream from the debt is going to be traveled channeled into interest expense non productive, the multiplier will turn negative. In addition, another influence on velocity is the bank loan to deposit ratio. And it has been rising, the banks have been selling government securities to try to hold their loan base in the face of declining deposit is a well known cyclical phenomenon. But when the when the Federal Reserve eventually shifts to a monetary Yi’s, the banks will buy government securities, but loans will continue falling, the loan to deposit ratio will come down. And the factors together will push velocity back toward the lows.
Adam Taggart 33:36
Okay. But I take from all of that is just you expect to see a continuation of the trend of money supply as defined by OTL. shrinking and velocity continuing to slow, all of which is contractionary for the economy. But you just made a comment. And this this is really where I was sort of building up to all this, which is you said the money mountain created in 2020 2021, which supported spending and inflation has been eliminated. So on this program to help people sort of understand the record amounts of stimulus that were put out during the pandemic in the impact that it’s had on boosting asset prices and keeping the economy more robust than it otherwise would have been. We’ve used this analogy of a pig going through a Python, right, you’ve had this massive stimulus pig getting shoved through the Python of the economy. And there’s been much debate over how much of that pig is left in the Python. If I look at that comment you wrote here in your letter, it sounds like you think the pig may be fully through the Python at this point. Is that true? It is.
Lacy Hunt 34:42
But unfortunately, I said earlier, there’s three sine waves that are work here. There’s the financial cycle, the GDP cycle, and then the price labor cycle. And so there’s this five to nine month lag between The between the financial cycle and the business the GDP cycle. But then there’s another one to two quarter lag within the price labor cycle. And in other words, the the federal the Federal Reserve actually, actually inflation has been responding more rapidly than it normally does. But in order to get the inflation right back to the 2% target, that requires additional time. And so let’s say that the Federal Reserve doesn’t raise the federal federal funds rate again, it just allows the current system in place, what that means is there will be forthcoming monetary restraint, still entering the system. But it’s still it’s still having to work through these lags. And so the return to price stability is still further away. And that’s one of the difficulties for the Federal Reserve, when you when, when you when you allow money, mountains, or you have high money growth, you boom, the bones. But because of the lags involved, and you cannot see the progress occurring, what you tend to do in monetary policy is slumped this months. And so the the very complacent, widely held consensus is in here, in my view is overly optimistic.
Adam Taggart 36:31
So you were a senior economist for the Federal Reserve of Dallas, so you have a sense for how the institution works, and how the the people there run it. Presumably, you know, with the 1000, PhDs or whatever that are, you know, available to the FOMC. You know, they should sort of understand what you just mentioned there, right. But they, it seems the data they’re looking at, like, let’s look at the employment numbers. Right. You know, unemployment is still relatively low, as measured by the government. And do you believe that the Fed may be looking at a number that will move eventually in response to all these lag effects that we’ve talked about, but it hasn’t moved yet? Because like you said, it’s sort of the end of the whip there. And, and basically saying, hey, look, unemployment is still really low, so we can continue tightening more, and therefore they may be over slumping the slump, right, because they’re looking at data that is so lagging and hasn’t really moved yet.
Lacy Hunt 37:37
I think that is I think that is exactly the problem. And that’s why Nobel laureate Milton Friedman contended that a better policy was to keep money supply growth in a relatively narrow range, don’t let it get extremely high or extremely low. And John Taylor did it with the federal funds rate. In other words, what these two great scholars were saying is that discretionary monetary policy basically fails us in the final analysis, to my way of thinking, the financial cycle leads the GDP cycle, and the G, which is a coincident indicator, and the GDP cycle leads the price labor cycle. Let me let me just give you one one example here that I think is very worrisome. We have experienced now a record 10 Quarter decline in productivity. Productivity, to me is a major economic income. From the standpoint of the well being of our people, it’s more important than any other indicator that I can think of it, it’s tied to the rate of growth and real per capita GDP, which is lagging quite considerably what it is historically done. And so, when you when you have a situation right now is that productivity is dropping very sharply. One of the consequences of that is that human labor costs are rising faster than compensation. Because because the unit labor, common compensation, productivity is its productivity is output per worker hour. So when you get a decline in productivity, that means that unit labor costs are rising faster than in compensation, which means that comp in the current situation, compensation unit labor costs are outpacing price increases, which cuts into corporate profit margins. Well, a declining corporate profit margin is not acceptable. Neither is a decline in real earnings of your household sick. And so what has to be done to right the situation is that firms are going to have to rationalize their workforce to bring product Nobody into alignment. In other words to get
Adam Taggart 40:03
to translate, rationalize their workforce, you mean lay people off,
Lacy Hunt 40:07
they are. And if they don’t do that, and productivity will continue to decline, their margins will continue to implode. And it’s it’s part of the process of restoring price stability. And and so once the firm’s can no longer take the margin erosion, and you say, because of the stock price strength, there’s an assumption that corporate profits must be doing well, but they are not. They’re declining, in the aggregate sense. And they will continue to decline as long as you have this situation, as long as you have declining productivity. You cannot have a rising standard of living. And so what the Fed is doing now is it’s trying to restore the price stability, so that we can have a resumption of growth that lifts all boats when, when you get into these inflationary environments. It doesn’t work for the vast majority of our people. There are only very few of us that really benefit from inflation. Inflation robs everyone, but it robs the modest and moderate income households the most. Let me just put a little more contemporary spin on it. Right now, for a variety of reasons, we’re getting a little bit of a support in commodity prices, they had been coming down. But the oil sector is rebounding, to some extent, production has fallen off. There have been all kinds of distortions that were created by the pandemic, we have poor crop conditions in the United States and elsewhere. And so the commodity price indexes are starting to turn back up. Now, a lot of people are saying, well, that’s inflationary? Well, it’s inflationary in the sense that the price of basic necessities fuel and food will start going up. However, in the current situation, this is not like 20 and 21 and 22, when money supply growth was very rapid. And so what it means is that consumers will have to pay the higher prices for the food and fuel that are currently rising. Because they’re not they don’t they’re inelastic goods, they don’t have substitutes, right. But in this environment, that will mean that the consumers will then have to shift more of their resources from discretionary goods into non discretionary goods, which will ultimately weaken the economy. Otherwise, you’ll you won’t have the high multiplier sectors advancing. And so when you you get a spurt in commodity prices, such as we’re experiencing right now, that actually is more ultimately, a recessionary development than an inflationary although it is technically both. So
Adam Taggart 43:11
when might say a stagflation airy development, but yes,
Lacy Hunt 43:13
it is, but but at the same time, the monetary restraints still moving through the system, and the fiscal multipliers which were initially positive, which are now turning negative.
Adam Taggart 43:26
Okay. Yeah, I think that that’s, that’s a key thing I want people to take from this conversation here, which is that those fiscal interventions, you know, resumption of the fiscal, you know, taps if you will turn them back, turning them on to stimulate the stimulative effect of that is largely gone and now becoming an anti stimulative effect, which I think a lot of people are not thinking of it that way.
Lacy Hunt 43:58
Well, even even if you don’t buy my analysis of the multipliers, which is well supported, and I gave quite a bit of documentation in the letter, the the fact of the matter is a shortfall in revenue which add to the deficit doesn’t boost the economy, and the interest expense doesn’t boost the economy.
Adam Taggart 44:19
Absolutely. So you you basically painted a picture for why companies you think are going to have to start laying off workers because we’re just we’ve been having this this chronic slide and productivity here. I’m gonna put words in your mouth feel free to change them but but do you see layoffs as inevitable? You know, as the necessary medicine needed to try to get productivity realigned.
Lacy Hunt 44:47
This is the way I would say. inflation’s precede recessions, and serious inflation’s precede serious recessions. In other words, once you allow the inflation To get out of control, then basically you’re setting up the, the situation that will lead to instability on the downside,
Adam Taggart 45:08
okay. And I’m guessing you would say 9% CPI, as we saw last year, that’s serious inflation,
Lacy Hunt 45:14
you cannot let inflation run on. The it doesn’t, it hurts too many people and causes too many imbalances. And the problem is the same that Europe has is saying that, by the way, China, the Chinese economy is so weak that they are actually now a deflationary element in the world. And while the Chinese just announced, the new stimulative measures, keep in mind that these stimulative measures are hinging on the efficacy of taking on more debt, right. And they’re shifting more of the Chinese economy from the private sector into the government sector. Well, but the private sector has the high multiplier, the government sector has a negative multiplier. So in actuality, even though the markets have a Nash have reacted positively to the so called Chinese stimulus, the net effect is that it will make China weaker, not stronger.
Adam Taggart 46:21
Alright, that’s another one I want to underscore then because, again, that’s been one of the factors that people have been touting as why we may have a soft landing or a renewal landing is is hey, you know, China’s reopening backup here, and that’s going to, you know, boost the global economy. And we, we probably did see some initial boosts, you know, from their, their reopening efforts at the end of last year. But it does seem to be when you look at the data, much more disappointing than than hopes were pinned on this. And, you know, China did kind of help pull the world out of the global financial crisis, a lot of
Lacy Hunt 46:57
major factors that pulled us out of the global financial crisis, China was a very lightly indebted economy. Exactly. And that’s where I’m going to increase in debt. And by the way, the emerging markets follow China, they were very lightly indebted. Now we have a situation where China is more over indebted in the United States, we don’t even know to the degree to which it’s over indebted. And the emerging markets are more indebted. And so the initial conditions for the global economy, I believe, are actually worse now than they were in 2008 2009. Of course, the demographics we know are much worse.
Adam Taggart 47:37
All right, so they cannot ride to the rescue this time. And so even though the market is cheering, the recent news that China is going to start stimulating its economy here, you’re basically saying nothing. And that’s a sign of trouble. It’s not a sign of the
Lacy Hunt 47:53
dead. It’s not their solution. The problem is that they’re overly indebted. And it’s the only thing that’s different is that is that China feels that the the private sector is underperforming, and they’re now expanding the command and control economy. Well, expanding the command and control economy moves China further in the direction of negative multiplier activities, not positive multiplayer activities.
Adam Taggart 48:22
Okay, so talking about government stimulus for a second, you say in your letter that even if they get the Odile V, the velocity of Odile, they’re going to stop its plunge and, you know, keep it stable going forward. You’re saying that’s still going to severely limit the Feds capabilities to spur economic growth? What if the Fed just pivots? Right? And it just says, Hey, you know what? Maybe it gets inflation down to 2%. Or maybe it gets worried about the economy. And it says, okay, you know, we’re going back to QE, and we’re going to start buying stuff again, asset purchases. How could that change the story here? I know from previous conversations with you, you’ve said that the more we go through this cycle, it’s increasingly like the Fed is pushing on a string, its efforts get less and less bang for the buck. But But could they? You know, if we start falling into a credit crunch, could they undo it with stimulated
Lacy Hunt 49:31
they will certainly appeal the federal funds rate back. But this is this is going to be different. This will be a cyclical event. Not not not like the pandemic where outside force forces everything down substantially. And so what the Fed I believe, will cut the federal funds rate in discrete intervals. They’ll respond 25 basis points, they’ll wait a while and they’ll cut pay If they wait a little bit more than make that 50, or said, who knows, but it will be a process. The, the thing that was unique about 20 and 2021, in the face of the pandemic, is that the Federal Reserve stepped out of its lender of last resort role, and became, to a certain degree, a spender of last resort. Now, we’ve seen that that can be very inflation, inflation is too much money chasing too few goods, that you cannot have a situation where the Fed prints money. So I don’t think that we would, I think the Federal Reserve has probably learned that that that they have to stay within the confines of the Federal Reserve Act, and take advantage of what they learned when they did not adhere to the, to the laws that’s
Adam Taggart 51:02
written. Okay. And does that does that mean that you don’t think we’re gonna see QE anytime soon.
Lacy Hunt 51:10
I assume maybe that eventually they will go back to it, but it won’t be any more effective. And keep in mind that it’s, it’s, it’s whether they’re doing it in a lender of last resort role or spender of last resort. If they’re directly paying the treasury bills, even though they camouflage it, that’s going to be inflationary. But But quantitative easing, in the sense that they did, and Bernanke, which was all within the lender of last resort, role, formation, that was not inflationary. It, to put it kind of a phrase, in 2021, the Fed crossed the Rubicon. And they were printing money. Not entirely, but but they were to a significant extent, if they stay within the confines of the, of what they are the authority that they’ve been actually given and operate accordingly, then, it will be a long, difficult process to restore the economy once the recession says,
Adam Taggart 52:19
okay, and I’m just gonna ask this again, because again, you understand the Federal Reserve way better than most people alive, they crossed the Rubicon can be fooled to
Lacy Hunt 52:27
have been fooled by what they did in 2020, and 21.
Adam Taggart 52:32
All right, but I trust your judgment and insight more than almost anybody else’s here. So they, they they crossed a line during the pandemic, it sounds like you’re saying, you don’t think they’re going to intentionally crossed that line again, anytime soon, because they saw the inflation Genie that they let out of the bottle. And they really don’t want to do that, again,
Lacy Hunt 52:53
the federal funds rate is going to come down, but it will come down at discrete intervals, sometimes faster, sometimes slower. They will get to the point where they will stop quantitative tightening, that’ll be another move that will occur. And it’s possible that that they, you know, restore the Treasury security purchases, but I don’t believe that it will be like, like in the 2021 experience.
Adam Taggart 53:23
Okay, got it. So again, that I’m digging into this, because there’s people that that understandably say, hey, when we get into, you know, if these lag effects are going to be real, and they start really slowing the economy down, but the Fed just gonna go back to what it was doing a couple years ago. What I hear you saying is, don’t count on exactly that playbook. You hear
Lacy Hunt 53:43
that? And I hear it too, and I’ve been in debates with, but keep in mind is that that had a crushing impact. On our modest and moderate income analysis we get this is the expansion since the end of the pandemic was 11 quarters in that 11 quarter period, your real average weekly earners income for all full time, hourly and salaried workers, which is about 120 million people that decline by a record 3% and an expansion Never before happened. Was there some initial benefit? Yes. But the vast majority of our people were devastated by the inflationary surge that arose from the Federal Reserve’s actions. Okay.
Adam Taggart 54:31
Let’s see if it’s okay, we’re gonna go a little bit long here, just because this has been this is a great discussion. I’ve got some questions I really want to get in here. And I know one or two you wanted me to ask you. One we touched on a little bit, but I’d like to flesh it out a little bit more. So anyway, she just talked about how the aftermath of what the policy decisions in 2020 and 2021 have disproportionately hurt the modest and moderate households, right And they continue to just be hanging on by their fingernails here. They’re the ones who are going to get disproportionately hurt by this right sizing of workforces right to try to address the productivity issue. Right. So layoffs are going to hurt those those households more directly. You talked about how commodity prices are having a little bit of an upsurge here. Oil prices have moved higher recently to you talked about how that is a precursor in many ways to lower consumer spending, which then hits the economy, and then, you know, forces profit margins down and companies have to then lay off here. So I asked if you thought layoffs were inevitable. Do you see a recession as inevitable from here? And is this just more sort of disproportionate trauma for those moderate and modest households here? Looking out, you know, it’s hard to have a sanguine outlook for for the bottom 90%.
Lacy Hunt 56:05
Okay, let me just give you a couple of statistics. From 1870 Until the late 90s, the beginning of this century, it real per capita terms, GDP grew by about 2.2% per annum.
And in the 20 years since then, we’ve grown at 1.3%. Round. Okay, sorry, what was the first number again? 2.2% per annum? So
Adam Taggart 56:41
2.2 versus 1.3.
Lacy Hunt 56:44
That was that was making 70 to 2000?
Adam Taggart 56:48
Yeah, so we’ve basically seen a halving of real GDP growth per capita, since the start of
Lacy Hunt 56:54
it, we’ve won three versus two, we’re down, you know, not quite a half 40% or something. So basically, I believe that the most critical element in this is the fact that we’ve increased government size. And there’s a very strong deleterious impact that comes from debt. And so when when, so here, we were growing at 2.2. And now we’re growing at 1.3. So what happens in that situation, and we’ve had much greater involvement, much greater involvement of the government sector. If you go back to 1971, when Nixon closed the gold window, and that was a very critical day, in my opinion, when we were when we when when the dollar was on the gold exchange standard, and there was a gold outflow, it created a public outdoor, and there was a bit of a control mechanism from the outflow of gold, to a restoration of fiscal sanity. But when Nixon closed the gold window, then we there was no constraint from the dollar. And so government activity was able to increase. And so the since 1971, through the present, the government share the government size has increased from about 25% of GDP, to about 34% of GDP. Now, there were a couple of very bright economists, Swedish econometrician, Hendrickson and Berg, writing in the Peer Reviewed Journal of Economic Studies, had estimated a paper written in 2011, that for each one percentage point, increase in government size, that we would lose point 05 2.1% of real per capita growth per year. And this, this was a this outstanding work has actually been been validated by the time period since their work was published, we have lost nine tenths of 1% per year, we’re at the very upper end of their range. In other words, we increase the government share through either direct deficit or by cooperation with the Federal Reserve. You get a bigger government share, you get a bit smaller private share, the per capita growth rate comes down. And it’s been historically shown time and time again, when the per capita growth rate comes down. You exacerbate the income and wealth divides,
Adam Taggart 59:55
which we’ve obviously seen, right over the past couple of decades. This seems to be great. validation of your comments that the government government is indeed a negative multiplier.
Lacy Hunt 1:00:04
Think it is. That’s what it’s all it’s also consistent with, with the excellent work in 2012 of Carmen Vincent Reinhart writing with Ken Rogoff. They found that if growth government debt moved above 90% of GDP for more than five years, that you would lose a third of your growth rate against trend. Well, that’s the same data that we’re talking about from, from Bergen, Hendrickson, were washed out more than a slightly more than a third as a result of the debt or government size, which are intricately interconnected. And so we may think that the government is the solution to the problem, more government intervention, but more government intervention is actually creates more of its own problems. I mean, I think what’s happening in China is is a clear cut case of the fact that reverting to more command and control more and more government debt is counterproductive. We saw the the Japanese who lost more than three decades, but that type of policy, Europe, the data, those studies apply to what’s happening in China, Japan, Europe, United States, you go on this path, you’re gonna get this result.
Adam Taggart 1:01:30
All right, and like to you talk about those two studies, in some depth in your letter and a question for you since I’ve been mentioning it so much. Is it alright with you, if I make this letter available for download?
Lacy Hunt 1:01:43
Yes, we make it we make it available as a public service. Okay, great. So folks, if you want to download this for free, it’s an educational document.
Adam Taggart 1:01:53
Okay. Thank you. So then, folks, if you want to download this for free following this conversation,
Lacy Hunt 1:01:57
to make it available, we have done that over the years. It’s also published on our website as well. So, okay, great. You’re not hiding it. Alright, great. So when you read the current one, everything’s there, or it’s in alright. So folks,
Adam Taggart 1:02:14
what we’ll do go to wealthion.com/lacey. We’ll have a downloadable version of this and a direct link to Lacey’s website as well. So you can read it however you want to go explore Hoisington if you can.
Lacy Hunt 1:02:26
Adam Taggart 1:02:30
All right. Well, look Lacey. Um, one other thing that you’ve mentioned a couple of times, but we haven’t really, I think maybe given it its full shrift here is the fact that bank credit lending is tightening here, right. So this is this is a separate contractionary powerful contractionary force that is layered on top of what the Federal Reserve is doing here. So how substantial is this? And what does history tell us to expect when this happens? Well, it is very interesting. In fact, our interview with Lacey will continue over in part two, which will be released on this channel tomorrow, as soon as we’re finished editing it. To be notified when it comes out. Subscribe to this channel, if you haven’t already, by clicking on the subscribe button below, as well as that little bell icon right next to it, and be sure to hit the like button to while you’re down there. Now, much of the discussion in this video is centered around Lacey’s recent q2 letter to Hoisington. Investors. He has generously made that letter available to the general public, so be sure to go get yourself a copy for free right now over at wealthion.com/lacey. And finally, if the challenges that Lacey is detailed in this interview, have you feeling a little vulnerable about the prospects for your wealth, then consider scheduling a free no strings attached portfolio review by a financial advisor who can help manage your wealth, keeping in mind the trends, risks and opportunities Lacey’s mentioned here. Just go to wealthion.com and we’ll help set one up for you. Okay, I’ll see you next over in part two of our interview with Lacey Hunt.