Inflation
Currencies And Inflation
This is a sub-section that I forgot to include in my previous article that discussed inflation and financial assets. This is for a section of my manuscript that replaced two problematic sections. I kept this new section as lightweight and brief as possible; I might add more content later.
Currency trading is somewhat unusual in that the price reflects what is happening in two different currency zones. If we want to discuss how currencies relate to inflation, we should keep in mind that we should be talking about the inflation rate in the two currencies. For example, if the inflation rate in Canada is 2% and the inflation rate in the United States is also 2%, the effect of inflation on the Canada-U.S. exchange rate should cancel out.
For developed countries (with floating exchange rates), currency values largely reflect what is happening with capital flows, and to a lesser extent, trade flows. The problem with currency forecasting is that is like equity forecasting – there is very little to pin down the fair value of a currency in the short run. If currency traders suddenly decide that inflation data in one country is important, those reports will affect the value of the currency solely based on their mood.
In the longer term, trade competitiveness limits how far a currency can go in one direction or another. For example, if the Canadian dollar drops in value versus the U.S. dollar, Canadian wages will drop versus American ones in U.S. dollar terms. Sooner or later, Canadian businesses get more competitive than American ones, and so the Canadian dollar will get fundamental support from an improved trade balance, and/or investment inflows (both portfolio flows as well as direct investment).
Economists looked at simple macroeconomic models and decided that you can capture this effect by looking at the difference in inflation rates between countries. (Although the principle appears reasonable, we should probably be looking at a price index for traded goods.) For example, if Canadian inflation is 1% higher than in the United States, we are supposed to expect that the Canadian dollar will lose 1% in value in nominal terms versus the U.S. dollar (to aloe the same “competitiveness”). So, we end up with the concept of “real exchange rates,” where we apply the difference in inflation rates to the observed nominal exchange rate.
The figure above shows the real broad effective exchange rate for the United States (as calculated by the Bank for International Settlements – BIS). This is a broad exchange rate, which means that it is based on the exchange rates versus major trading partners, with a weighting based on trade volumes. We see that it does seem to bounce within a broad range (between 80 and 110). This may not be the case for a nominal exchange rate – if a country has sustained high inflation, its nominal exchange rate will just tend to get weaker over time. The figure below shows the experience for the Turkish lira after 2010 illustrating this, which reflects Türkiye’s higher inflation rate over the period. (Since the quote convention is the number of Turkish lira per 1 U.S. dollar, a higher number reflects a weaker lira – it takes more lira to get the same amount of dollars.)
Nevertheless, we see that the currency in real terms can march in one direction within the range for a long time (for example, the depreciation in the 2000s). This means that inflation alone was not explaining the change in the currency value. Which tells us that we cannot make strong predictions about the effect of relative inflation on a currency over the short run.
One reason why relative inflation is not enough to explain currency movements is that business cycles may not be perfectly coordinated. If a country is experiencing stronger growth than another, it would not be that surprising that it has a higher inflation rate. Although the higher inflation should theoretically reduce the value of the currency, the higher growth rates may attract inflows into local risk assets.
(If you read financial and economic commentary, people will often point to interest rate differentials as driving the value of the currency. They might argue that higher inflation will tend to result in the local central bank hiking the policy rate more than the other central bank, which will support the currency value. I think the role of interest rate differentials are wildly overestimated in such commentary, but that debate is tangential to this text.)
Email subscription: Go to https://bondeconomics.substack.com/
(c) Brian Romanchuk 2024
Financial Assets And Inflation
This article is a complete re-write of two existing sections of my manuscript. I was unhappy with the sections, and they were blocking my progress. I decided to throw in the towel, and just cut the text down to the minimum. The text probably needs work, but it is no longer going to be black hole for revisions.
The beauty of the Cantillon Effect is that it gives a simple relationship between inflation and financial asset markets. Allegedly, people who somehow get “new money” first rush out and buy financial assets, driving up their price. This then leaks out into consumer prices. The problem with simple rules related to financial asset prices is: why are the people who discovered them all getting rich using them?
Complicating matters is that different financial assets behave in different ways in response to inflation trends. Since the author does not believe that there are any magic ways to make money in most financial markets based on inflation forecasts, I will just offer general comments on differing asset classes.
Inflation-Linked Bonds
The one market where one can use correct inflation forecasts to make money is the inflation-linked bond market. I discussed this market in my book Breakeven Inflation Analysis. The catch with inflation-linked bonds is that being correct about inflation over the next few months may or may not matter for profitability, you theoretically need to be right about the forecast until the bond matures. Given that inflation-linked bond trading is the domain of specialists, I will just refer readers to that earlier book.
Commodities
Another relatively straightforward asset class are industrial and soft commodities (like grains). Energy price spikes are often associated with spikes in overall inflation rates. If there are supply shortages on a global scale, it is likely going to show up in commodity markets. Hence, commodity prices rose in the 1970s as well as after the pandemic.
Where things get trickier is away from such spikes. The old trader adage in commodity markets is that “the cure for high prices is high prices.” If there is a price spike in a commodity leads to finding alternatives to consuming that commodity, as well as bringing in new sources of supply. We can then see a grinding bear market as the excess of supply is wrung out. This process is largely a global phenomenon, while countries may have their local economies overheating for whatever reason, leading to rising inflation despite commodity price weakness. (This was the experience of the mid-1980s and 1990s.)
Gold
In the Gold Standard era, owning gold was a straightforward way to preserve purchasing power against inflation. But once President Nixon closed the Gold Window in 1971, currencies have been de-linked from gold. It is very hard to see how a return to linking currencies to gold matters for any major economic power. Nevertheless, there is a noisy contingent that fantasises about a return to gold, and the gold market can respond to inflationary vibes.
The figure above shows the gold dollar price from 1990-2018, which captures the end of the secular bear market, as well as the upswing that started in the early 2000s. The bear market followed an earlier bubble that peaked in the early 1980s, as well as central banks slowly unloaded their gold reserves, replacing them with interest-bearing bonds.
Gold is an unusual commodity in that gold consumption (such as making jewelry) is quite small when compared to gold held in inventory. The primary determinant of the price of gold is how it is valued versus other assets, and physical supply and demand is secondary. As a financial asset, its value is somewhat of a puzzle: it costs money to store, while generating no cash flows (without lending it out). As such, its value is driven by “animal spirits” among gold traders (including central banks).
If we look at the above chart, it is hard to see a clear link with inflation. The 1990s was the decade where inflation generally converged towards inflation targets in the developed world, yet gold slowly lost value. The bull market starting in the early 2000s did not correspond to an uptick in inflationary trends. One might be able to massage the data to discover some short-term relationship, but such relationships tend not to persist.
Bonds
The high-level relationship between bond yields and inflation higher inflation tends to result in higher bond yields. (Note that the price of a bond moves inversely to the yield, so a higher yield means a lower price.) The difficulty is that the relationship is less mechanical than market folklore suggests. This relationship relies on central banks acting in a conventional manner. For example, it is possible for the central bank to peg bond yields, breaking the correlation.
The best way to understand bond yields outside of market crises is that they represent an “average” guess of bond market participants for the path of the overnight rate, which is controlled by the central bank. In turn, the central bank is attempting to control inflation by raising and lowering the policy rate. As such, the relationship between inflation and bond yields is that the bond market reacts to data that is likely to cause the central bank to move the policy rate – and the inflation rate is an important variable. However, inflation tends to lag the business cycle, while bond market participants are supposed to be ahead of the business cycle. As such, statements to the effect that the bond market must react to an inflation release misses the reality that the inflation news may have already been built into the market pricing.
The reader is free to squint at the charts above to validate my claims. The top panel shows U.S. core inflation and the overnight (Fed Funds) rate. We can see that the overnight rate does tend to follow inflationary peaks – although inflation was relatively flat in 1990-2020, yet we have policy rate cycles. The second panel shows the overnight rate (again) and the 10-year Treasury yield. The relationship is perhaps less obvious, but it makes more sense if bond market investors tend to expect the policy rate to revert to historical averages. In the 1980-2020 period, there was a sustained downtrend in the policy rate, while the bond market discounted a reversion towards earlier levels (which did not happen until the 2020s).
Since bond prices are moving in an inverse fashion to inflation, the Cantillon Effect does not apply to bonds.
Equities
Equities (and real estate) are usually what people are thinking about when discussing the Cantillon Effect. Although it is possible to see some plausibility to the concept, the problem is that guessing where equities will go is necessarily challenging – you are competing against a lot of other investors attempting to do the same thing.
There are two broad ways of analysing equities.
-
You buy equities if you think you can sell them to somebody else at a higher price relatively quickly. (Where “relatively quickly” depends upon the investor and can range from milliseconds to a couple of years.)
-
You do not try to guess what other people will pay for equities. Instead, you just buy if you think the underlying companies will generate enough profits/cash flow to justify the purchase price in the long run.
The difficulty with equity analysis is that there is only one long run, but plenty of short runs. As such, equity analysis is dominated by analysing what happens over the short run. Unfortunately, equity investors in practice are unhinged, and any number of crazy things can happen over the short run. If equity investors are convinced that “money printing” can cause equity prices to go up, there is very little to stop them if so-called “money printing” happens.
The Cantillon Effect story is misleading in that it seems to imply that “money printing” is something external to the equity market. The equity markets are not static, waiting for outside money to flow into it. Equity market participants can adjust prices instantaneously in response to news (e.g., a bad earnings report), and can use leverage (either by borrowing or using derivatives) on their own if they believe that equity prices are about to rise. Using flows to explain equity prices runs into the accounting reality that for every buyer, there is a seller (or else someone in the back office is going to have a bad evening). In other words, what matters is the belief about “money printing,” not the actual “money printing.”
On the fundamental analysis side, inflation has a somewhat mixed effect. To the extent that higher inflation pushes up interest rates, the discounted value of future cash flows drops. This is countered by the hope that firms will be able to raise prices in line with inflation, raising the nominal cash flows of the firm. (If both revenue and expenses scale by the same factor, profits are also scaled by the same factor.) Meanwhile, higher inflation is typically associated with faster growth of the real economy – which is beneficial for profits. As such, it is not incredibly surprising that both equity prices as well as the price level tend to rise during an economic expansion – and reverse during recessions.
Concluding Remarks
Commodities, real estate, and equities are pro-cyclical and we should therefore expect them to benefit from an economic expansion. Inflation is also pro-cyclical. As such, we should expect a correlation between those asset classes and inflation.
Email subscription: Go to https://bondeconomics.substack.com/
(c) Brian Romanchuk 2024
Australia’s inflation rate continues to fall yet some bank economists think further interest rate rises are possible
Yesterday (April 24, 2024), the Australian Bureau of Statistics (ABS) released the latest – Consumer Price Index, Australia – for the March-quarter 2024. The data showed that the inflation rate continues to fall – down to 3.6 per cent from 4 per cent in line with global supply trends. There is nothing in this quarterly…
Exclusive: Eslamdoust’s bizarre email to TSSA branches attacking staff and their union
‘She doesn’t understand how unions work’ – general secretary of union reeling from abuse scandals sends bulk email to branches attacking staff striking over bullying, and the union representing them
Melissa Heywood, left, and Maryam Eslamdoust (image: TSSA website)
Crisis-hit TSSA rail union general secretary Maryam Eslamdoust and her team have followed up their attacks on the GMB union representing TSSA staff in their dispute with the union’s management over bullying and abuse – by emailing all TSSA member branches with an astonishing attack branding the union’s workers as greedy and lazy, and treating the GMB union as if it, and not the unhappiness of TSSA staff, is the driver of the impending strike action for which more than 93% of staff voted last week.
Ms Eslamdoust was recommended to members, despite what appears to be a complete lack of relevant experience, by the TSSA executive after former general secretary Manuel Cortes was sacked over sexual harassment and bullying exposed in the Kennedy Report, and was supposedly going to clean up the union after the scandal. However, the union has been rocked by fresh allegations of abuse and deep resentment against the new general secretary for the treatment of staff, particularly women.
She recently wrote a bizarre article for the Guardian in which she accused the GMB union of attempting to bully her so it could take over the TSSA and distract from its own renewed sexual harassment scandal, and tried to blame others for her failure to take meaningful action to implement the Kennedy Report’s recommendations, outraging staff members who have pointed out that their dispute pre-dates the new GMB revelations, prompting TSSA staff to pass a unanimous vote of no confidence in Eslamdoust and the union’s president, Melissa Heywood.
Now the pair, along with assistant general secretary Brian Brock, have sent this bizarre message to all the union’s members, via their branches:
Message from TSSA General Secretary
To: Branches
Dear colleagues,
Some of you will have heard that GMB intends to take industrial action against TSSA.
GMB’s dispute with TSSA
TSSA regrets GMB’s decision and wants to resolve the dispute. Thus far GMB have made it impossible to resolve any genuine issues that TSSA staff may have by refusing to set out any specific details of the matters they say are in dispute.
GMB have also refused or ignored every proposal we have made for talks. TSSA have proposed direct talks to resolve the dispute with GMB’s General Secretary, GMB’s Regional Secretary, GMB’s Regional Officials, and GMB’s lay reps among our own staff – all of which proposals have been refused or ignored. TSSA has therefore asked ACAS to facilitate talks, but again GMB have not yet responded to ACAS’ approach for talks.
Nevertheless, TSSA is a good employer, and we will continue to seek resolution with GMB in good faith, just as we have done in all our relations.
There are limits to how far we will go to satisfy demands made to us, and red lines that simply cannot be crossed.
We are seeking to reform and improve TSSA in the wake of failings in our past culture that were identified in the Kennedy and Conley reports.
An example of this is that TSSA proposed to the GMB representatives among our own staff that we would have independent observers in staff recruitment processes, so that everyone could have confidence in the fairness of those processes. Instead of accepting this measure, GMB demanded that there must be 2 GMB appointees involved in every TSSA recruitment process. We will not allow the process of cultural change to be misused to hand control of our staff recruitment to another organisation, removing the control of TSSA’s own democratically elected Executive Committee (EC) and General Secretary. We are completely clear that we will not allow our union to be bullied by anyone.
Many TSSA staff had 3 separate pay rises over the course of 2023, while many of our own members suffered from years of pay freezes. Instead of recognising that TSSA staff are being well paid, GMB have instead demanded that we must reduce staff working hours by more than 10% and increase pay significantly above inflation. Despite our desire to settle disputes with our staff, we will not allow members’ money to be misused for pay awards far in excess of anything that our members could ever expect.
Emphases added by Skwawkbox
Furious TSSA members have told Skwawkbox that Eslamdoust’s proposal to meet GMB general secretary Gary Smith to resolve the dispute shows a fundamental lack of understanding of how unions work and that the attack on workers as greedy and demanding mirrors the tactic of the bad employers that TSSA and other unions are supposed to fight, not copy.
A ‘frequently asked questions’ document issued by the striking workers and their union reps addresses Eslamdoust’s claims:
The General Secretary has claimed that the GMB union are using an in-house agreement to block staff recruitment. Is this true?
GMB members are not seeking to block the appointment of new staff. All we want is for our existing transparent procedures to be upheld, which is not happening. We would welcome recruitment to fill the 9 existing Organising vacancies, which could do much to increase our ability to recruit and organise in the workforce.
When the General Secretary emailed GMB Reps on 16 November 2023 to state that the TSSA Executive Committee had approved recruitment of three new vacancies (Campaigns and Media Role, Stakeholder and Engagement Role, Legal and Governance Role) on an interim basis of six months, we asked for job descriptions so that we could consult over the grading and pay for the roles. This is the same as we would do for any new job role and is in line with our established collective bargaining procedures. Further, it ensures that there is no potential for discrimination.
Five months later the General Secretary has yet to provide us with job descriptions. Had she come to us with the job descriptions at any point in the last five months we would have been happy to consult so that the roles could move forward to advertising. What we couldn’t do is sign off on roles without any information on their grading, pay or duties, or how these new roles fit in within a Staffing and Operational plan (which we have also never seen).
Existing roles do not need negotiation over grading and pay, so over the last six months the General Secretary could have recruited to fill a number of roles, including 9 Organiser vacancies, and roles in the Membership services, and Comms teams. She has not done so.
She has, however, advertised for a part time Political Officer, and appointed an interim HR Manager role (twice in three months, without following any agreed recruitment procedures). She has also appointed a part-time, temporary Assistant General Secretary, (changed from a full time to part time post without explanation) advertising that post in the week before the Christmas shut down with just a two-day window for staff to apply while half the staff were already on leave. Just this week TSSA has advertised for a new Assistant General Secretary.
It is simply not true to say that the GMB is blocking recruitment. We are just insisting that the creation of entirely new roles follows our existing transparent processes.
How about the General Secretary’s claims that the dispute has been fabricated as part of a takeover plot by the GMB, or to distract from other problems within the GMB?
These false allegations seem designed purely to distract from the very real problems at the heart of this dispute.
Our dispute existed last autumn, well before the latest allegations about the GMB came to light. Our General Secretary is well aware of this. We are disappointed that she has chosen to misrepresent our dispute and make false allegations to the Guardian rather than meet us at ACAS.
The accusations of bullying are well-founded, detailed, and were being investigated by the whistleblower service, Howlett Brown, until the EC and GS terminated their service without a replacement lined up. The President has been aware of the bullying allegations against Ms Eslamdoust, for months, but chose not to follow TSSA’s procedures for managing bullying grievances.
The GMB withdrew from merger talks with TSSA in April 2023 and has no desire to change the status of our current relationship.
The idea that the GMB is making staff manufacture a dispute in order to force a merger is insulting to our members who are experienced trade unionists and more than able to make their own decisions.
Why haven’t you met with the EC to discuss your concerns directly?
We have not received any invitation from the EC. We are open to meeting with them and would welcome the opportunity to explain our issues to them. If the EC requested a meeting with the GMB that has not been conveyed to us by the GS or AGS, this is a worrying reminder of the previous Cortes regime when the EC and staff were kept apart from each other.
Three GMB Reps sit on the Change Management Oversight Group, with two EC members and the GS. As part of this group, we have repeatedly expressed concerns that culture change had stalled in the last 6 months and has now in fact regressed.
In addition, since the publication of the Kennedy and Conley reports in February 2023 (14 months ago), the EC have never met with the whole staff once.
We have, however, met with delegates from the EC, including the President and Treasurer, in meetings trying to resolve this issue on several occasions. In addition, the president has been copied in on all the correspondence about issues we have sent to the GS since last December.
The General Secretary says that nothing has been raised through the agreed internal processes? Why not?
The GMB reps have raised collective concerns through the established bargaining machinery at meetings in November, January, and twice in March, and also in correspondence, since November 2023, to no avail.
Individuals have also raised concerns through the internal and external whistleblowing services. Two staff are currently off work sick with work-related stress, which is itself an indicator of problems in the workplace.
Claims that there is no bullying or harassment
The General Secretary is aware of complaints about bullying, and a culture of fear, within the TSSA. They have been raised repeatedly in formal negotiation meetings between November and March.
In addition, one member of staff submitted a complaint under TSSA’s bullying policy against the General Secretary to the independent investigator Howlett Brown in December last year. This was after a vindictive and targeted bullying campaign against this member for a period of months.
At the beginning of this year the contract with Howlett Brown was terminated without any consultation with the GMB reps or any consideration of the consequences to staff with active complaints and queries.
This decision has caused our member additional distress and anxiety seriously affecting their health and wellbeing without any clarity or certainty regarding the status of their complaint, who will be investigating it and when. During this time the General Secretary has gone out of her way to damage the professional reputation of the member, repeatedly criticising and denigrating them.
To date no alternative independent provider has been appointed which is in direct contravention of the Kennedy report.
Bullying of a trade union rep
One of our Trade union representatives has been subject to hostile behaviour and bullying by the General Secretary, since last November. This has included sending an intimidatory email to the rep, circulating that email to every member of the staff body, and repeatedly lying about him and denigrating him to other staff, in what appears to be an attempt to destroy his reputation.
Emphases added
Approached for comment yesterday, the TSSA doubled down on its blaming of the GMB, compounding the impression of a lack of understanding or recognition that the issues are with the unhappiness of people working for the union and not with the management of the union they are instructing to coordinate the strike on their behalf. A spokesperson told Skwawkbox:
We would encourage GMB to start talking with TSSA to focus on resolving the workplace issues they say they have. It is genuinely extraordinary that GMB are so blatantly seeking to interfere in (and misrepresent) the internal administration of a sister union. TSSA EC took the decision that the last tranche of HS2 compensation would be reserved for strategic objectives to grow and strengthen our union. That is what is happening.
Invited to amend its statement in light of how Skwawkbox would be forced to report it, the union declined.
SKWAWKBOX needs your help. The site is provided free of charge but depends on the support of its readers to be viable. If you’d like to help it keep revealing the news as it is and not what the Establishment wants you to hear – and can afford to without hardship – please click here to arrange a one-off or modest monthly donation via PayPal or here to set up a monthly donation via GoCardless (SKWAWKBOX will contact you to confirm the GoCardless amount). Thanks for your solidarity so SKWAWKBOX can keep doing its job.
If you wish to republish this post for non-commercial use, you are welcome to do so – see here for more.
The Argentina of Javier Milei
A seminar organized by the Association for Heterodox Economics with myself, Ramiro Álvarez and the Argentine Senator Carolina Moisés.
The IMF has outlived its usefulness – by about 50 years
The IMF and the World Bank are in Washington this week for their 6 monthly meetings and the IMF are already bullying policy makers around the world with their rhetoric that continues the scaremongering about inflation. The IMF boss has told central bankers to resist pressure to drop interest rates, even though it is clear…
Is It Inflation? Or Is It Greedflation?It’s a paradox. Inflation...
Is It Inflation? Or Is It Greedflation?
It’s a paradox. Inflation is dropping but prices aren’t coming down. How can this be?
Because corporations have enough monopoly power to keep them high.
Here’s just one example that will make you fizz: Pepsi.
In 2021, PepsiCo, which makes all sorts of drinks and snacks, announced it was forced to raise prices due to “higher costs.” Forced? Really? The company reported $11 billion in profit that year.
In 2023 PepsiCo’s chief financial officer said that even though inflation was dropping, its prices would not. Pepsi hiked its prices by double digits and announced plans to keep them high in 2024.
How can they get away with this?
Well, if Pepsi were challenged by tougher competition, consumers would just buy something cheaper. But PepsiCo’s only major soda competitor is Coca-Cola, which – surprise, surprise - announced similar price hikes at about the same time as Pepsi, and also kept its prices high in 2023. The CEO of Coca-Cola claimed that the company had “earned the right” to push price hikes because its sodas are popular. Popular? The only thing that’s popular these days seems to be corporate price gouging.
We’re seeing this pattern across much of the economy — especially with groceries. Inflation is down. You see, the rate of inflation measures how quickly prices are rising. Prices are now rising far more slowly than in the past couple of years. And while supply chain disruptions really did make it more expensive to produce a lot of goods, the cost to produce them now is rising even more slowly than prices.
But consumer prices are still up, allowing most corporations to keep their profit margins near a 10-year high.
They can get away with overcharging you because they have monopoly power — or so few competitors they can easily coordinate price increases.
If Pepsi and Coca-Cola had lots of competitors, they wouldn’t be able to raise prices so high because someone would make cheaper substitutes, and consumers would buy those instead. But Pepsi and Coke own most of the substitutes!
This isn’t just happening with Coke and Pepsi. Take meat products. At the end of 2023, Americans were paying at least 30% more for beef, pork, and poultry products than they were in 2020.
Why? Near-monopoly power! Just four companies now control processing of 80 percent of beef, nearly 70 percent of pork, and almost 60 percent of poultry. So of course, it’s easy for them to coordinate price increases.
And this goes well beyond the grocery store. In 75 percent of U.S. industries, fewer companies now control more of their markets than they did twenty years ago.
So what can we do?
Well, it’s largely flown under the media radar, but the Biden administration is taking on this monopolization with the aggressive use of antitrust laws.
It’s taken action against alleged price fixing in the meat industry — which has been a problem for decades.
It’s suing Amazon for using its dominance to artificially jack up prices — one of the biggest anti-monopoly lawsuits in a generation.
It successfully sued to block the merger of JetBlue and Spirit Airlines, which would have made consolidation in the airline industry even worse.
But given how concentrated American industry has become, there’s still a long way to go. Inflation is down. But many people don’t feel it because prices are still high, and in some cases are still rising because of continued price gouging.
This is where you have more power than you might think.
You might not be able to break up big corporations, but you can keep up the pressure on our government to fight corporate monopoly power.
And help spread the truth by sharing this video.
The transmission channels of geopolitical risk
Samuel Smith and Marco Pinchetti
Recent events in the Middle East, as well as Russia’s invasion of Ukraine, have sparked renewed interest in the consequences of geopolitical tensions for global economic developments. In this post, we argue that geopolitical risk (GPR) can transmit via two separate and intrinsically different channels: (i) a deflationary macro channel, and (ii) an inflationary energy channel. We then use a Bayesian vector autoregression (BVAR) framework to evaluate these channels empirically. Our estimates suggest that GPR shocks can place downward or upward pressure on advanced economy price levels depending on which of the two channels the shock propagates through.
The channels of GPR
To assess the effects of geopolitical tensions on the macroeconomy, it is first necessary to quantitatively measure GPR. Our approach to measuring GPR follows the work of Fed researchers Caldara and Iacoviello (2022), who develop an index GPR based on the number of articles covering adverse geopolitical events in major newspapers. This index reflects automated text-search results of the electronic archives of 10 major western newspapers. It is calculated by counting the number of articles related to adverse geopolitical events in each newspaper for each month (as a share of the total number of news articles).
Chart 1 shows the behaviour of the GPR index from 1990 to 2023. The index is relatively flat during large parts of the sample, and spikes around major episodes of geopolitical tension, such as the outbreak of the Gulf War, 9/11, the beginning of the Iraq invasion in the 2000s, and the Russian invasion of Ukraine in 2022.
Chart 1: The GPR index
Source: Caldara and Iacoviello (2022).
In the same paper, Caldara and Iacoviello (2022) show that on average, an increase in the GPR index is associated with lower economic activity, arguing that these effects are associated with a variety of macro channels, ranging from human and physical capital destruction, to higher military spending and increased precautionary behaviour.
However, episodes of geopolitical tension often involve increased concerns about the supply of energy to global markets. Chart 2 shows the cumulated percentage change in the three months ahead West Texas Intermediate (WTI) futures around key geopolitical events. Oil future prices rose following most of these episodes, potentially reflecting expectations of supply cuts to energy production or disruption of the flow of energy.
Chart 2: WTI futures three months ahead prices during the 30 days following major recent geopolitical events (associated with tensions on energy markets)
Source: Refinitiv Eikon.
This suggests that GPR can also transmit via an additional energy channel, whose effects are more akin to an adverse supply shock. Whether the shock transmits through this channel, and how strong it is relative to the macro channel, will depend on the wider context and/or location of the events relating to the shock. Disentangling the two effects is, therefore, important for correctly assessing the economic consequences of a GPR shock.
Measuring geopolitical surprises
We begin our analysis by constructing a series of exogenous surprises in (i) GPR, and (ii) oil prices that can be assumed to be entirely driven by geopolitical events to a reasonable degree of approximation.
In order to construct our surprise series, we adopt a selection of 43 main GPR events from 1986 to 2020 proposed by Caldara and Iacoviello (2022), which we update to include four important events that have occurred in the past three years: the escalation of the Afghanistan Crisis in August 2021; the Russian invasion of Ukraine in February 2022; the Istanbul bombings in November 2022; and the events in the Middle East in October 2023.
We compute the GPR surprise as the daily log difference in the GPR index around these events. For the oil price surprise, we compute the daily log difference in WTI future prices from one to six months ahead around the same dates. We then take the first principal component of these to capture movements in energy prices driven by the geopolitical shock.
Decomposing the macro and energy supply components of geopolitical surprises
We then use our event-study data set in a Bayesian-VAR setting for the euro area, the UK, and the US from January 1990 up to October 2023 to disentangle the effects of the macro uncertainty channel from the energy supply channel of GPR. We adopt the two-block VAR structure proposed by Jarociński and Karadi (2020), which uses high frequency data combined with narrative and sign restrictions to identify shocks.
Within the high-frequency block, we include our surprise series of (i) log changes in the GPR index in the main geopolitical event days, and (ii) the first principal component extracted from changes in WTI futures from one to six months ahead in the main geopolitical event days, both cumulated at monthly frequency in case of multiple events occurring in one month. Within this block, we impose the sign restrictions at the core of our identification strategy, which we outline in Table A.
We impose that the response associated with the macro channel drives upward surprises in the GPR index and negative surprises in the oil future curve during the first day the news is reported, as oil prices drop following a contraction in economic activity. Conversely, we impose that the response associated with the energy supply channel drives upward surprises in the GPR index jointly with positive surprises in the oil future curve during the first day the news is reported, as precautionary oil demand rises in response to concerns about future supply cuts or shipping disruption.
Table A: The sign restrictions associated with each channel of GPR
GPR MacroGPR EnergyGPR surprises++WTI surprises–+
In our monthly frequency block, we include the GPR index in logs, real Brent crude prices spot in logs, real natural gas spot prices in logs (as measured by the IMF benchmark), and the monetary-policy relevant price indices in levels (in deviation from their long-run trends, as is standard in the VAR literature).
Identifying two distinct channels of GPR
Chart 3 plots the response to a geopolitical shock that leads to a 100 basis points increase in the GPR index. The first row reports the responses of oil and natural gas prices to an ‘average’ geopolitical shock, which does not disentangle the effects of the macro and the energy channel, along the lines of Caldara and Iacoviello’s work. The second and the third rows display the responses when we assume that all of the increase in the GPR index propagates via just the macro channel and just the energy channel respectively.
Chart 3: Impulse response functions associated with an ‘average’ 100 basis points GPR shock, as opposed to a 100 basis points shock acting exclusively either through the macro or the energy channel
In the ‘average’ case, the real Brent price spot rises by about 10% on impact, before then dropping of beyond 10% after around six months. However, these dynamics mask the two underlying channels. On the one hand, the energy supply channel is associated with a rapid 20% surge in the oil price. On the other, the macro channel is associated with a more gradual decline of beyond 20%.
The response of gas prices tends to be more persistent than oil prices: the effect of the energy channel on oil prices is concentrated in the first six months whilst the effect on gas prices wanes only during the second year after the shock.
The response of price levels across regions follows a pattern that is broadly consistent with energy price dynamics. As Chart 4 shows, inflation unambiguously drops in the ‘average’ case: the price level drops persistently by about 0.1% in the US, and shortly by about 0.25% in the euro area, while the response is not statistically significant for the UK. This finding is consistent with the interpretation of Caldara and Iacoviello (2022) of geopolitical shocks behaving, from an empirical perspective, as contractionary demand shocks.
However, this similarly masks the effects of the different underlying channels. On the one hand, the pure macro channel gives rise to a more pronounced drop in the median price level than in the case of the ‘average’ GPR shock, reaching -0.5% in the US and the UK, and -0.4% in the euro area. On the other hand, the response associated with the energy supply channel is inflationary, with the price level rising persistently by about 0.5% in the US, 0.7% in the UK, and 0.6% in the euro area.
Chart 4: Impulse response functions associated with an ‘average’ 100 basis points GPR shock, as opposed to a 100 basis points shock acting exclusively either through the macro or the energy channel
Summing up
This analysis highlighted the existence of two separate and intrinsically different transmission channels of GPR: (i) a deflationary macro channel, and (ii) an inflationary energy supply channel. Policymakers should be aware of these distinct channels: GPR shocks may propagate in different manners and require different responses.
Samuel Smith works in the Bank’s International Surveillance Division and Marco Pinchetti works in the Bank’s Global Analysis Division.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
Comments On Asset Prices And Inflation Targeting
This is an unedited manuscript excerpt, from a chapter that discusses how asset price changes relate to inflation.
Even if one believes that asset price increases represent inflation, the general reaction among North American central bankers would be to think you are crazy if you think asset prices should be included within an inflation target mandate. (I am less sure about the reaction of Continental European central bankers.) Although they might accept that exuberance in financial markets should be toned down, targeting asset prices directly poses many problems.
Embedded in this reaction is the conventional belief that raising the policy rate tends to slow inflation, while cutting them tends to raise the inflation. I must note that many proponents of Modern Monetary Theory disagree with that conventional belief – but explaining that divergence is out of the scope of this book. (It is explained in my book Modern Monetary Theory and the Recovery.) For simplicity, I will accept the conventional view here.
(One related problem is that if interest rates directly feed into inflation, then inflation will rise if the central bank hikes rates. This conflicts with the conventional view. As such, the Bank of England stripped the mortgage interest component out of the Retail Price Index.)
If we just look asset prices, we see two major problems with having them show directly up inside the inflation measure used in the inflation target. Firstly, financial asset prices are quite volatile relative to most consumer prices. Secondly, there is no way of targeting risk asset prices without blowing up the economy. (Although bonds are a financial asset, it is easy for the central bank to stop their prices from changing – they can peg interest rates along the curve. This idea sends most conventional economists straight to the fainting couch, it has been done historically (such as in the Second World War in the United States, and more recently, Japan). However, locking interest rates in this way largely eliminates flexibility in setting interest rates, which is conventionally believed to be necessary for inflation targeting.)
Equity prices go up and down much faster than the business cycle. If the central bank targeted them directly, they would end up cutting and hiking rates multiple times within a business cycle, which is presumed to destabilise the economy. Furthermore, equity prices may react to central bank movements. For example, imagine that equity prices are rising too rapidly. The central bank then hikes rates to counter this. Imagine then that equity holders panic, and prices collapse. What is the central bank supposed to do – cut rates again? (This is obvious to anyone other than the people who pin the blame for their inaccurate equity forecasts on the central bank, which is remarkably common among people who tend to be wrong about equity markets.)
Rapid interest rate movements by the central bank are going to spook borrowers and lenders. Markets would likely build in large risk premia, and pretty much everyone would start sourcing finance in other markets.
Even targeting slow-moving house prices poses dangers. To the extent that house prices reflect long-term interest rates, rising house prices are a side effect of a low interest rate environment. That environment is typically the result of the central attempting to avoid a recession when economic growth is sluggish. Hiking rates to target house prices is runs exactly counter to the desire to boost growth. Meanwhile, interest rates are not the only thing affecting house prices. Idiotic decisions in other spheres of policymaking can generate a housing boom or bust. Finally, the housing market is like any market run by humans – it has mood swings. The housing market may remain impervious to rate hikes for some time – until there is a panic that precipitates a collapse. Given the importance of residential investment within the economy, and the risks posed by widespread mortgage defaults, housing busts generally trigger ugly recessions.
My view is that the belief that central banks can easily target asset prices comes from an extremely dubious analogy to the Gold Standard – where the gold price was pegged. However, the reasons why the Gold Standard functioned no longer apply to any financial asset.
· Once international financial capitalism developed, the Gold Standard is best seen as a currency peg system. What mattered economically was the fixed exchange rates between the major economies. Gold was just the mechanism to adjust for capital flows across currencies. No financial asset can replace this at present -even gold. Unilaterally pegging your currency to a risk asset like gold is not going to change much. If your economy is large, you are just running a price control scheme for one financial asset – which other actors will attempt to exploit. If your economy is small, your exchange rate will fluctuate wildly based on speculation in some other market.
-
The political establishment built its world view around being willing to make sacrifices to restore previous exchange rates. However, only a small handful of people think this is a good idea, and so pegs lack political credibility.
-
Gold is a collectible that generates no cash flow, and its consumption by industry is largely insignificant when compared to existing above-ground inventories. Other assets either have cash flows that need to be priced or are commodities with relatively small inventories. There is no way for them to credibly have constant prices in a dynamic economy.
-
Earlier generations of financial market participants had an ideological belief that the gold peg system was credible. Modern market participants will speculate against any peg arrangement. The problem with defending pegs is that attacking them is a low-risk investment (since the price is largely locked) with a high potential pay off if the peg breaks.
If risk asset market prices reacted in a predictable fashion to the policy rate, it should be easy to generate models that generate massive profits by inputting market-expectations for the policy rate – which are decent over short horizons (outside crises). Such models are noticeably small on the ground. Although people (including myself) enjoy giving central bankers a hard time, most of the sensible ones have come to terms with that observation.
Email subscription: Go to https://bondeconomics.substack.com/
(c) Brian Romanchuk 2024
Markup matters: monetary policy works through aspirations
Tim Willems and Rick van der Ploeg
Since the post-Covid rise in inflation has been accompanied by strong wage growth, interactions between wage and price-setters, each wishing to attain a certain markup, have regained prominence. In our recently published Staff Working Paper, we ask how monetary policy should be conducted amid, what has been referred to as, a ‘battle of the markups’. We find that countercyclicality in aspired price markups (‘sellers’ inflation’) calls for more dovish monetary policy. Empirically, we however find markups to be procyclical for most countries, in which case tighter monetary policy is the appropriate response to above-target inflation.
In a simplified setup where wages are firms’ only input cost, while consumers only buy domestically produced goods, the ‘battle of the markups’ takes an intuitive form (Rowthorn (1977)):
- Workers aspire to have their nominal wage
feature a certain excess, typically referred to as the ‘wage markup’ (
) over the cost of their consumption basket
. This is equivalent to saying that their aspired real wage
equals
- Firms aspire to set their price
’ over their marginal cost of production, which is the nominal wage rate
, implying that the real wage
.
By itself, there is nothing guaranteeing that real-wage aspirations held by workers and firms are mutually consistent in this framework – ie, there is nothing to ensure that
Unemployment as an equilibrating device
Layard and Nickell (1986) argued that the moderating effect from the presence of unemployment acts like a clearing mechanism. They posed that aspired markups 
Here, the structural component ‘
Similarly, price markups aspired by firms also consist of a structural component alongside a cyclically sensitive one:
When it comes to the cyclicality of price markups, it is debated whether they are pro or countercyclical. On the one hand, a slowdown makes firms afraid of having to carry large inventories or suffer from capacity underutilisation. This would imply that aspired price markups are procyclical (
In general, and irrespective of the sign of 
It can be shown that the equilibrium level of unemployment increases in structural aspirations held by workers and firms (
The role of the central bank
The story so far assumes that, somehow, the unemployment rate ‘agrees’ to clear any conflict between firms and workers. In reality, it won’t automatically. There are many reasons for unemployment to exist, eg search frictions (Pissarides (2000)) or providing incentives to limit shirking (Shapiro and Stiglitz (1984)). This implies that the level of unemployment is not ‘free’ to clear any conflict and further action is required.
This is where the central bank comes in. Through its mandate, the central bank is tasked with setting policy to keep inflation at target. In our framework, this implies that the central bank will attempt to set its policy to ensure that cyclical conditions are such that markup aspirations are consistent with the size of national income. And if aspired markups are cyclically sensitive, there is an ‘aspirational channel’ of monetary policy transmission.
If aspired markups of both firms and workers are procyclical (
There is however debate over the sign of 
Consequently, it is important for central banks to know whether firms’ aspired markups are pro or countercyclical. We have estimated the cyclicality of the price markup (
Chart 1: Estimated degree of cyclicality in price markups (
Paying for imports
Recent UK experiences have been more involved than the stylised situation described thus far. Next to domestic workers and firms, foreign exporters also lay a claim on UK output – as output is partly produced with imports, like energy. As energy prices rose around Russia’s 2022 invasion of Ukraine, the UK’s terms-of-trade worsened and the share of national income flowing abroad suddenly went up – leaving less pie to be distributed domestically.
Absent any reduction in the structural components of markups aspired by firms and workers (
Indeed, central bankers appear to have an ‘aspirational’ transmission mechanism in mind as can be seen from Christine Lagarde (2023):
We need to ensure that firms absorb rising labour costs in margins (…) The economy can achieve disinflation overall while real wages recover some of their losses. But this hinges on our policy dampening demand for some time so that firms cannot continue to display the pricing behaviour we have recently seen (emphasis added).
Conclusions and policy implications
A monetary tightening is not the only way via which markup aspirations could be moderated. Faced with an adverse terms-of-trade shock, it is also possible that workers and/or firms internalise the implications (that there is less income to be divided domestically), inducing them to lower the structural components of their aspired markups (
Absent such a co-ordinated response, bringing inflation back to target following an adverse terms-of-trade shock may require a cyclical slowdown to moderate markups aspired by workers and firms. An important caveat is that this strategy might not work if firms’ aspired price markups are countercyclical, but we find no evidence for this in the UK. As a result, the monetary tightening implemented in recent years is likely to aid the disinflation process via our ‘aspirational channel’ (not present in most standard models, featuring acyclical desired markups), which facilitates inflation returning to target.
Tim Willems works in the Bank’s Structural Economics Division and Rick van der Ploeg is a Professor at the University of Oxford.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.