Hello and welcome to our video #MacroMemo this week. We'll talk about that banking stress in the U.S. and the extent to which it might be starting to ebb, at least slightly. We'll talk about the economy and some resilience we continue to observe in the data there. We'll, of course, check in on inflation, which has been getting a little bit better in 2023 and might make a decent sized improvement as the March data comes out.

And we'll also talk again, in an inflation context, about who wins and who loses when there is a temporary bout of higher inflation, which is what we've been experiencing. And we'll lastly spend a moment on political polarization in the context of these recent Trump indictments and what all of that might mean in an economic context.

Okay. Let's begin with banking stress.

This has been the feature subject over the last month or so in global macro affairs. Two mid-sized U.S. banks, you may recall, failed in early March. Credit Suisse, the big Swiss bank, was acquired by UBS. And so there was some chaos in the banking sector for a period of time. We are still seeing deposit outflows, particularly from smaller American banks.

We are still seeing heavy usage of Fed liquidity lines, meaning that banks are still keen to ensure they have enough liquidity to meet their customers’ needs. There is still some risk in general and there are still some weaker players, so let's not suggest everything is perfectly, neatly resolved. But I would say the intensity of the concern is declining and we can see that via credit spreads and other things.

It's at a minimum fair to say no other banks have failed in the last month and some of the liquidity lines and some of the special liquidity being offered by the U.S. Federal Reserve is starting to shrink in terms of usage. So starting to see some ebbing of concern there. We are still fully expecting lending standards to tighten, so that is going to hit the economy.

We're budgeting for that, it's part of our recession forecast. We are still assuming the U.S. commercial real estate sector weakens, it's particularly linked into smaller and mid-sized U.S. banks. We should expect less lending from small U.S. banks in particular. So there are some longer-lasting effects from what’s recently happened and still some risk and uncertainty in terms of what is happening next.

But in the grand scheme, it's gotten a little bit better in recent weeks. And we still think that the government solutions that were put forward a month ago are pretty credible and in theory sufficient to prevent the kind of bank runs that were happening in early March.

Okay, on from there just to the economy more generally:

The story for several quarters now has been one of surprisingly resilient economic activity and that's still more or less the case. So we still saw some pretty decent economic data over the last several weeks. The U.S. payrolls numbers were good again. The Canadian employment numbers were likewise good. Global purchasing managers’ indices have been going a little bit higher as opposed to lower, but their level isn't all that impressive.

The G10 Data Change Index remains a little better than it was over the second half of last year, though not great.

And so that really is the story. It's economic data that isn't getting much worse, that might be getting a little bit better, that isn't all that wonderful in an absolute sense. But it's just not a recession at this point in time.

And actually, as we look at economic surprise indices, they are moderately positive right now -- and it's not because the data is great, it's because people expected bad outcomes and the outcomes weren't as bad as expected.

And so the economy's holding together for the moment. I will continue to warn that clouds are looming. We can see the lagged effect of higher interest rates coming and perhaps even the effects starting to mount.

We can see bank lending conditions tightening. So we still look for worse economic conditions ahead. It would still be quite unusual to avoid a recession, given all that's happened in the inverted yield curves and everything else. But for the moment, the economic data is hanging on.

Let's shift from that to inflation. So inflation has been the big problem of the last few years and it got significantly better in the second half of 2022.

It got a little bit better in early 2023, but not by a lot, and that disappointed people. As we look at the March data, which is starting to roll in, we think there actually is room for a more substantial improvement. And that's in part because we can see that real-time inflation indicators are down nicely that month. That's in part because some of the nowcasts, including the Cleveland Fed's nowcast, are also looking pretty good.

So we think we could get some nicer numbers out of there, but more work is needed.

And as we as we break the inflation print down, particularly the U.S. one, into its various subcomponents, you can say goods inflation has been cooperating. It has been coming down quite nicely, full stop. The shelter component has not been. It's the biggest inflation driver right now.

We know home prices are falling. We know that dwelling costs in general are going down. But there's classically a lag before that shows up in the CPI. That should start to turn around the middle of this year.

And then you're left with core services, ex shelter as the last category. And that has peaked, although I wouldn't say it's come down.

What we really need there is a weaker labour market and a weaker economy and we just haven't gotten that yet. That's the best predictor of where core services, ex shelter goes.

And so one thing we've done recently is we've been looking at the tightness of economies. Just how overheated are they? And you might be surprised to learn there's a really wide range of estimates or guesses as to that question.

We looked at five different ways of gauging how tight the U.S. economy is, as a bellwether economy. Three are external and two are models that we built. And you get the full range of possible outcomes.

One of them says the U.S. economy still has some slack in it. It could run fast for a little while longer without overheating inflation any further. The other four say the economy is overheated or in excess demand to varying degrees.

But even those disagree. Some say it's quite a mild case and some say it's substantial overheating and so I guess the conclusion is that there isn't a single conclusion. When we average the five measures we reach a reasonable guess, which is just the economy is in a position of moderate excess demand. Therefore, you'd think inflation would be running a little hotter than it should be.

And we probably do need to cool the economy off somewhat. But there is a wide range of estimates and maybe the economy isn't as radically overheated as one would conventionally imagine based on a lot of the news reports out there, which is an interesting thought.

One other quick view on inflation, which is just now pivoting from the U.S. to internationally.

One thing we've looked at is where the consensus forecast for inflation has gone. When we look across a wide range of countries, we could say roughly a year ago, more or less 100% of the consensus inflation forecasts for different countries were rising. So forecasts were being upgraded, higher inflation was proving more problematic than expected. I can't say it's the opposite today.

It's not fully the opposite today. But whereas we had nearly 100% of the consensus forecast rising for inflation a year ago, it's around 50% rising today and around 50%, of course, going in the opposite direction. So it's a more balanced picture.

It's certainly no longer the case that inflation is proving surprisingly problematic each and every day.

Another inflation thought: so this is really just a critique of who wins and who loses from an unexpected temporary bout of higher inflation? That's what we've had recently. It hadn't been expected a few years ago but we believe it is ultimately a temporary phenomenon. But you do get, of course, a significant number of losers. I think that's well appreciated.

The average household does worse. We see wage growth not keeping pace with the cost of living, as an example. Some companies do worse, in particular if they have low pricing power. I would say more do okay, or maybe even better. More on that in a moment. Fixed rate lenders do worse. That would be a bank lending at a fixed rate, but it also be someone who bought a bond at a fixed rate.

That's a fixed rate loan as well. And so, of course, those both loans were made on the presumption that inflation would be lower. But it wasn't lower, So the real return is therefore less than would have been expected. So that's a group that loses.

People who hold physical cash, of course, are always losing when there's inflation. But they lose even more when the inflation is high.

Stock market investors, I guess, do better than most asset classes in the sense that there's a natural hedge in revenue and in earnings. But stock market valuations usually get hurt to some extent because a higher discount rate is applied and essentially future earnings just don't get valued as highly.

Taxable investments or taxable investors of every description do a little worse.

The effective real tax rate goes up because taxes are levied on your nominal investment returns. And when inflation is a bigger chunk of that, you're basically paying more tax for no more real return. So there's a loss there.

And then finally, and really in application almost everywhere, the economy itself is usually a bit weaker. High inflation is corrosive and central banks don't like it and they're tightening monetary policy and that does some damage as well.

And so all sorts of losers. I think maybe what is less intuitive is that there are some winners from high inflation. So some companies, companies that have high pricing power, companies that have a higher labour share of their expenses (because wages don't move as quickly up as other things), companies that are in capital intensive businesses where they bought machines 10 years ago and are still using them.

And those machines were pretty cheap at the time, and yet these companies can still charge a higher price on their product today.

So some companies do better. In fact, the average company did manage a higher profit margin over this inflation spike. So a significant fraction did better.

Fiscal finances do better when it's a temporary, unexpected inflation leap. So government revenue soars, as we've seen in recent budget numbers.

There's more money to spend. The spending obligations don't initially soar because it takes longer for union wages to be renegotiated and for program commitments to change and so on. So governments do suddenly have more money to deal with.

They're also, by the way, pulling in some of that extra revenue from that higher effective investment tax rate I mentioned.

And debt-to-GDP ratio is looking a little better because nominal GDP, which is not the denominator, goes up faster, the debt doesn't. And so suddenly the debt ratio looks a little bit smaller. So governments love it in the short run. I would say not in the long run.

Fixed rate borrowers do well, of course. If you locked in that mortgage or if you borrowed money as a company at a fixed rate before the inflation spike, you're paying a much lower real rate on that borrowing than you expected.

And so that's a net win.

So there are winners or losers. There are more losers than winners, but it's just not an absolute story.

Okay. Let's finish with just a revisitation of a theme we've touched on a few times in recent years. And so political polarization, declining trust, and I guess all of that in the context of this recent Trump indictment.

And so the indictment in the Southern Manhattan court over hush payments made during an election campaign. The debate is what happens here, who wins and who loses. And it's a whole lot less clear than you might think.

For instance, former President Trump has enjoyed a boost in popularity from his anti-establishment base, given the credentials he gets from being charged . . .

and claiming it's political in nature. But he could lose the centrist voters who are ultimately needed to push someone over the finish line, say, in the 2024 presidential election. And there's also the chance he's convicted, which would then have some cascading consequences. The Republican Party's fate is no longer quite as tied to Trump as in the past, but it's still significantly influenced by his prospects for good or for ill.

Finally, you could imagine this might be a win for the Democratic Party if if Trump is convicted. But you could imagine it's a loss if he's found not guilty. But really, it's more complicated than that.

Even if Trump were convicted, it would just open up the Republican nomination in 2024 for someone who might be a more viable presidential candidate and still present a greater threat to the Democrat candidate.

Similarly, a lot of prosecutors and a lot of pundits believe that there's been an overstepping in pursuing felony charges against Trump, when normally it might have been a lesser charge. And some wonder whether it made sense to pursue hush payments when there are still serious allegations against his role in that January six, 2021, attack on the Capitol building.

So the conclusion is that it’s far from clear how the political calculus changes out of this. It’s not clear that the Democrats win or that the Republicans lose. What is clear is that there’s been some further increase in political polarization, some further decrease in societal trust, and that risks damaging the economy, if I can take it back to the economy as an economist.

So we’re continuing to look for signs of that. Some of the places we’re looking include:

• Is it harder for commercial to occur? Are those becoming less smooth because Americans are becoming less trusting of each other? I wouldn’t say that’s obvious.
• Are we seeing higher risk premiums in U.S. assets reflecting the uncertainty and chaos there? I wouldn’t say we’re seeing that either.

At this point of time, it’s a risk these things spill over into the economy. It’s been a risk for a number of decades, but we haven’t seen it yet, we’re just continuing to watch.

On that note, I’ll stop and thank you for your time. I hope you found some of this interesting and I wish you well with your investments.