The physiology of an 800 lb gorilla

It's sod's law, isn't it? Macro Man writes a piece that attempts to demonstrate why the ECB ain't cutting rates any time soon, and immediately thereafter we get pretty weak business confidence data from Belgium and Germany. (Receiving less press, of course, was yesterday's EU orders data, which showed industrial orders rising 0.6% m/m and 9.9% y/y.) Still, he retains the view that this market is occasionally guilty of cognitive dissonance, ignoring the evidence the runs contrary to its embedded view. While avoiding this pitfall will not necessarily yield a profit (Macro Man has no desire at the moment to make a P/L sacrifice at the altar of Euribor or short sterling), in the current market the avoidance of loss is just as good.

Anyhow, the weak Euro confidence data has unsurprisingly hit the euro while supporting EMU fixed income. Receiving less support, of course, has been US fixed income, where the market now seems keen to trade the economic recovery. This optimism seems relatively misplaced to Macro Man, given that we seem to have jumped immediately from credit crisis mode to recovery mode without ever trading the recession. Now, granted, the consensus is that the US experiences a "mild" recession, partially as a result of the $600 windfall that will wing its way out of IRS headquarters in the next month or two. However, Macro Man believes that the market is ignoring the 800 lb gorilla in the room; the gorilla whose name is "energy."

Now, Macro Man is not an energy specialist, and has no special insight as to what drives short-term price action in that market (other than the dollar effect, which seems to have become paramount recently.) That having been said, he does like to look at it from time to time, particularly when thinking about the macroeconomic impacts of energy prices.

Simply put, Macro Man believes that energy prices have reached the point where they are exerting a critical (downward) influence on discretionary consumer spending, and influence that may only partially be offset by the coming refund bounty. As such, he believes that there is a real risk for the first consumer-led US recession in a quarter century.

The last weekly retail price data that Macro Man can find on Bloomberg suggests an average US retail price of $3.57/gallon. Now, those of us living in Europe would love to pay so little for gasoline; then again, we tend to drive less (and use more fuel-efficient cars) than residents of the U.S. of A. Macro Man's gas price model suggests that current levels of crude and crack spreads should see retail prices climb towards $4.00/gallon in the next few weeks; further rallies in crude and/or a seasonal rise in cracks could mean gas prices rise by even more.

How significant is this? In Macro Man's view, very. If gas prices follow the trajectory of his model, it would take the real inflation-adjusted price of gasoline back towards the all-time high observed in 1980. More significantly, it would also take consumer gasoline outlays as a percentage of total spending back towards the all time high....a period which accompanied the last real bone-crushing consumer recession.
The rise in gasoline outlays naturally acts as a hit to discretionary spending power, as gasoline demand is obviously price inelastic in the short run. Coming at a time when the labour market is weakening and real disposable income growth has dropped sharply towards critical levels, the rise in gasoline prices threatens, in Macro Man's mind, to push the consumer over the edge. Sure, the forthcoming $600 will act as a buffer, and certainly boost incomes in the short run. But if consumers believe that gas and food prices will continue to rise, they may well choose to save more of the windfall than may have been the case a few years ago.
And that, Mr. Bernanke, is why it is worth paying attention to headline inflation as well as core. Some might argue that for a country like the US, rising food and energy prices represent a relative, rather than absolute, shift in prices.

Macro Man's retort is that for those countries that have been the purveyors of low-cost goods and labour for the past several years, these rises represent a boost to the absolute level of prices, and thus have a larger impact on wages/incomes. And that is why we see statistics like a steady rise in US import prices from China, and why Macro Man believes that the ultimate result of the current credit crisis will be a substantial rise in tangible goods and services prices (i.e., CPI/PCE deflator) relative to financial asset prices, which were the primary beneficiary of the shadow banking system that is at the heart of the maelstrom.

Macro Man has taken a look at the physiology of this 800 lb gorilla......and from what he can see, this sucker's an ugly 'un.