DANIEL LACALLE is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”
Daniel Lacalle
‘Soft Landing’ Is Almost Impossible Expectations of a controlled explosion are overly optimistic
48 I N S I G H T May 27–June 2, 2022
We can see that markets have lost more than $7 trillion in capitalization in the year so far with a very modest move from the Fed. icant damage to the economy, are simply too optimistic. However, the biggest problem is that the Fed wants to curb inflation while at the same time, the federal government is unwilling to reduce spending. Ultimately, inflation is reduced by cutting the amount of broad money in the economy, and if government spending remains the same, the efforts to reduce inflation will only come from obliterating the private sector through a higher cost of debt and a collapse in consumption. You know that the economy is in trouble when the fiscal deficit is only reduced to $360 billion in the first seven months of fiscal year 2022, despite record receipts and the tailwind of a strong recovery in gross domestic product (GDP). Now, with GDP growth likely to be flat in the first six months but mandatory and discretional spending still virtually intact, government consumption of
monetary reserves is likely to keep core inflation elevated even if oil and gas prices moderate. The idea of a gradual cooling down of the economy is also negated by the reality of emerging markets and European banks. The relative strength of the U.S. dollar is already creating enormous financial holes in the assets of a financial system that has built the largest carry trade against the dollar in decades. It’s almost impossible to calculate the nominal and real losses in pension funds and the negative result of financial institutions in the most aggressively priced assets, from socially responsible investment and technology to infrastructure and private equity. We can see that markets have lost more than $7 trillion in capitalization so far in 2022 with a very modest move from the Fed. The impact of these losses isn’t evident yet in financial institutions, but the write-downs are likely to be significant into the second half of 2022, leading to a credit crunch exacerbated by rate hikes. Central banks always underestimate how quickly the core capital of a financial institution can dissolve into inexistence. Even the financial system itself is unable to really understand the complexity of the cross-asset impact of a widespread slump in extremely generous valuations throughout all kinds of assets. That’s why stress tests always fail. And financial institutions all over the world have abandoned the healthy process of provisioning, expecting a lengthy and solid recovery. There’s no possible painless normalization path. After a massive monetary binge, there’s no soft hangover. The only thing the Fed should have learned is that the enormous stimulus plans of 2020 created the worst outcome: stubbornly high core inflation with weakening economic growth.
JIM WATSON/AFP VIA GETTY IMAGES
f t er mor e t h a n a decade of chained stimulus packages and extremely low rates, with trillions of dollars of monetary stimulus fueling elevated asset valuations and incentivizing an enormous leveraged bet on risk, the idea of a controlled explosion or a “soft landing” is impossible. In an interview with Marketplace, Federal Reserve Chairman Jerome Powell said that “a soft landing is really just getting back to 2 percent inflation while keeping the labor market strong. And it’s quite challenging to accomplish that right now.” He went on to say that “nonetheless, we think there are pathways ... for us to get there.” The first problem with believing in a soft landing is the evidence of weak economic data. While the headline unemployment rate appears robust, both the labor participation and employment rates show a different picture, as they’ve been stagnant for almost a year. Both the labor force participation rate, at 62.2 percent, and the employment-population ratio, at 60 percent, each remain 1.2 percentage points below their February 2020 values, as the April jobs report shows. Real wages are down, as inflation completely eats away the nominal wage increase. The University of Michigan consumer confidence index in early May fell to an 11-year low of 59.1 from 65.2, deep into recessionary territory. The second problem with believing in a soft landing is underestimating the chain reaction impact of even allegedly small corrections in the markets. With global debt at all-time highs and margin debt in the United States alone at $773 billion, expectations of a controlled explosion, where markets and the indebted sectors will absorb the rate hikes without signif-
