by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Good morning.  There are two meetings of note this morning.  First, President Biden meets with Chancellor Merkel for her last official visit before she leaves office in September.  Expect lots of warm comments, but the obvious drift in policy between the U.S. and Germany will continue.  Second, Chair Powell heads to the Senate today for the semiannual testimony to Congress (more on this below).  In Europe, heavy flooding has left 20 dead.  U.S. equity futures are falling this morning.  Our coverage begins with Chair Powell’s testimony and Fed policy.  Up next are comments about the EU’s new climate policy.  China news is followed by economics and policy.  International news comes after that, and we close with pandemic coverage.

Chair Powell:  The Fed Chair will testify before the Senate Banking Committee today, after talking to the House yesterday.  The takeaways are that he admitted inflation has risen faster and greater than he expected, but he continues to hold that the changes will be transitory.  There is evidence to support this position.  The Cleveland FRB trimmed mean measure, for example, up 2.9% from last year, which is elevated but still well below core CPI.  There is no doubt the Fed is trying to navigate a difficult path.  It’s important to remember that in the short run, Fed policy mostly affects aggregate demand.  When it tightens, it weakens consumption to reduce inflation.  Much of what we are seeing on the inflation front is supply driven.  The pandemic affected the economy in a myriad of ways, and many of them will be temporary.  However, some may not be (e.g., the drop in over 65 labor participation probably isn’t returning to pre-pandemic levels).  The longer inflation persists, the greater the chance that inflation expectations change, leading to balance sheet adjustments that foster future inflation (i.e., higher inventory levels, rising wages).  At the same time, tightening into temporary supply constraints will lead to falling demand just as supply is recovering, which could lead to a rapid decline in prices and risk recession.  Thus, we expect policy to remain steady at least through 2021, although pressures to at least slow the balance sheet expansion will be high.  We will have more to say on this issue in the coming weeks, but 2022 could easily become the year of dissent on the FOMC.

A couple of observations—first, there is rumbling on the left to replace Powell next year.  His term is up in February.  The policy establishment likes Powell and is lobbying to keep him in power.  The Chair has cultivated relationships in Congress and would almost certainly be confirmed if reappointed.  The populist left thinks he is too cozy with the financial services industry and wants him replaced.  The establishment hopes that replacing Vice-Chair for Regulation Randy Quarles will placate the left (his term ends in October), but it might not.  If Powell isn’t going to get another four-year term, Biden will need to signal his intentions by September or October at the latest.  If Powell is out, who is in?  The consensus bet is Fed Governor Brainard, but we are keeping our eye on Raphael Bostic, the Atlanta FRB president.  Second, some rethinking about inflation is starting to show up in the media.  Although inflation is complicated, in one sense, it’s a measure of the relative power of labor versus capital.  The rise of profitability over the past three decades is prima facia evidence that 2% inflation is favorable to capital.  It’s also the case that in the early stages of reflation, lower-income groups can benefit.  As inflation and wages rise, the real cost of debt service falls.  This effect is not permanent; as inflation expectations change, borrowing costs rise to reflect anticipated inflation.  Another item of note: because the baby boomers are the last generation to experience significant inflation, the ageing process is removing that institutional memory and younger generations are more willing to take a chance on reflation.

The EU’s climate policy:  The EU unveiled its climate policy today, and it is aggressive.  The plan calls for ending sales of internal combustion engines by 2035.  It will expand the use of carbon pricing.  The often discussed carbon border tariff is part of the plan.  Fuel taxes will be aimed at the dirtiest fuels.  The EU is attempting to have the incidence of carbon pricing fall on European business, but we doubt households will be spared from absorbing the costs.  This plan is ambitious and will face strong opposition both in Europe and abroad.  EU automakers are getting a clear signal to electrify, and foreign firms will at some point face potential tariffs based on their production methods.  It is also worth noting that addressing climate change will fix one problem but create others; for example, mining the metals required for electrification is a dirty process that is probably unavoidable.

China:  Japan is becoming more vocal on Taiwan, and China’s GDP slows.

• Japan has published its annual Defense of Japan report and it makes clear that Japan’s defense establishment is quite concerned about the situation in Taiwan.  Earlier this month, Japan’s defense minister indicated Japan would use its military to defend Taiwan against Chinese aggression even if the U.S. refrained.  It appears that Tokyo is raising the stakes in the Taiwan/China situation.
• China’s GDP for Q2 rose 7.9% from last year, but compared to Q1, growth was a mere 0.5%. There is rising speculation the PBOC will begin to ease soon to lift activity.  However, there are also concerns about rising levels of bad debt, which may limit stimulus.
• Although there has been little written on Chinese debt problems recently, a builder in Sichuan province has apparently failed to repay a local bond, which is the first default on a domestic credit. Real estate developers have been struggling to meet their debt obligations in recent months.  The firm, Sichuan Languang Development Co (600466, CNY, 2.68) has indicated it would not be able to pay back the bond.  S&P has downgraded the firm to “D” from “CCC-.”
  • Meanwhile, the money markets in China are waiting to see how the PBOC deals with CNY 400 billion of medium-term credit facility loans that are coming due today. Financial regulators are increasingly worried about a slowing Chinese economy but are leery of easing credit too quickly and triggering another bout of new lending.
• The U.S. has further clarified its position on U.S. firms conducting business with Chinese companies with ties to Xinjiang. It appears that it will become very difficult for American firms to conduct almost any transactions related to the province.
  • In light of these restrictions, Chinese consumers are increasingly looking to purchase domestically produced goods.
• The position of the Biden administration towards China is looking a bit mixed. On the one hand, Treasury indicated it would extend the Trump-era ban on economic dialogue.  On the other, there are indications that Washington is trying to set up a summit meeting between Biden and Xi.
  • The U.S. wants to create a “hotline” with Beijing, similar to what the U.S. had with the Soviets during the Cold War.
• We continue to monitor the situation with Chinese firms looking to list on U.S. exchanges. Concerns that delisting may occur have led to a decline in the capitalization of over $800 billion in Chinese tech stocks since February.  The State Internet Information Office has published a notice clarifying new cybersecurity measures.  Another interesting development has been emerging; social media nationalists are increasingly criticizing Chinese tech firms listed in the U.S.
• Chinese authorities are increasing their discrimination measures against LGBT groups in China. Given the visibility of such issues in the U.S., we expect this factor to become another point of contention between the two countries.
• China is continuing to close down bitcoin mining operations. The latest region to deny power to miners is Anhui province.
• The Biden administration has appointed Alan Estevez to the Commerce Department. The former Pentagon official will be the undersecretary for industry and security.  This part of the Commerce department regulates technology trade with China.
• Uyghur businessmen in Xinjiang have been arrested as part of China’s security crackdown.
• An increasing number of Hong Kongers are leaving.

Economics and policy:  Chip supplies are projected to improve, and the reason workers are slow to return may be more complicated than generally believed.

• There is some potentially good news; Taiwan Semiconductor (TSMC, USD, 124.39) is indicating that the semiconductor chip shortage that has plagued industries from electronics to automaking will begin to abate in Q3. In the latest inflation data, used car prices soared in part because automakers can’t meet the demand for new cars because of chip shortages.  Increasing chip supplies should improve the supply situation and bring used car prices down.
• A survey by Morning Consult shows that childcare and pandemic fears are the two primary reasons workers are hesitant to return to work. The third reason is unemployment insurance.  Thus, without school reopening and falling infection rates, cutting unemployment benefits may not lead to a rising labor force.
• Checks for the new child care credit are starting to show up; the policy should support consumption but may have surprising tax ramifications.
• One behavior we have noticed over the years is that merchants tend to raise prices quickly when raw materials prices rise but are slow to reduce them when they fall. This is true with gasoline prices and is now being reported as lumber prices drop.
• The ECB is moving forward on the digital EUR.
• Americans are generally upbeat according to a recent Gallup survey.
• Facebook (FB, USD, 347.63) is the latest tech firm calling for Lina Khan to recuse herself from investigating the company on antitrust.

International roundup:  A hacker disappears, and Putin wants Ukraine back.

• Ransomware Evil, the organized crime group that recently launched a massive hack, has suddenly gone dark. It is unclear exactly why.
• Recent comments from President Putin seemed to intimate that Ukraine is really part of Russia and should return to the fold. Kiev is understandably uncomfortable with this position.
• Iran apparently attempted to kidnap an Iranian dissident living in the U.S. with the intent of returning her to Tehran. This news won’t help Iran in its goal to return to the 2015 nuclear deal.

COVID-19:  The number of reported cases is 188,521,901 with 4,060,815 fatalities.  In the U.S., there are 33,947,232 confirmed cases with 608,115 deaths For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 388,295,385 doses of the vaccine have been distributed, with 335,487,779 doses injected.  The number receiving at least one dose is 184,835,149, while the number of second doses, which would grant the highest level of immunity, is 160,126,516.  The FT has a page on global vaccine distribution.

• France is moving aggressively to increase vaccinations by severely restricting the movement of the unvaccinated.
• China is making vaccination mandatory in some areas of the country.
• One downside of lockdowns has been a spike in drug overdose fatalities. Isolation and the inability to maintain counseling are partly to blame.
• The U.K. is using an app created by the NHS to inform people if they have come into contact with a person infected by COVID-19. Apparently, the Delta variant is so widespread that many people have been “pinged” by the app and are required to isolate for 10 days.  The warnings are so widespread that shifts at automakers had to be canceled due to the lack of workers.

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