The One-Handed Economist

GaveKal Research daily

"Give me a one-handed economist!" President Truman used to ask. Right now, he would likely have a hard time finding one as the past 24 hours have presented investors with some conflicting macro data points. On the one hand, the July US factory orders and the August Milwaukee PMI came in stronger than expected, and stronger than the prior months, raising hopes that the shockingly weak Philly Fed survey was an outlier. The Chicago PMI was also decent enough and the latest German retail sales were surprisingly steady after a strong spring. On the other hand, Korea (one of the countries more "plugged in" to global trade and typically a decent cycle benchmark) just published a much weaker than expected industrial production number, as did Poland, while Italian retail sales undershot already weak expectations. So what is an economist to do?

As far as the Brazilian central bank is concerned, sitting on the fence was apparently not an option. Last night, the central bank took the market by surprise and cut interest rates by -50 basis points, to 12%, becoming the second central bank, following Turkey, to officially cut policy rates in the face of what seems to be unfolding weaker global growth. Brazil's move is occurring at a time when inflation is running ahead of the central bank's targets. Clearly, the message sent out is that "we are more worried about growth than inflation." Ironically, this last Friday, China sent out exactly the opposite message by raising reserve requirements on off-balance sheet deposits. So which central bank is right?

As far as China is concerned, we are not surprised by the single-minded focus on inflation. After all, China's policymakers may not look very communist any more but the religion in which most were raised remains Marxism. And to a Marxist, revolutions and other paradigm shifts in history do not happen because of individuals, or ideas, but because of economic forces. And there is no economic force stronger or more destabilizing than inflation. After all, Marx did explain that Louis XVI lost his head because of the poor harvests and high food price inflation in the late 18th century. Just as Chinese policymakers explain today that the Tiananmen events of 1989 had little to do with Chinese students wanting more "democracy" or "freedom," but instead had everything to do with the high inflation afflicting China in the late 1980s. Needless to say, this hardcore belief that inflation is the number-one threat to social stability (and Communist Party rule) will have only been amplified by this year's events in the Middle East.

Of course, Brazil's political situation is very different and Alexandre Tombini and Dilma Rousseff do not need to worry as much about angry riots over rising food prices. Instead, they are probably more concerned about the country's growth outlook and the ability to roll out the large infrastructure that Brazil still needs to make it into the "first world" club. But will today's rate cut help Brazil in that task? Unfortunately, here, we are back to our "one-handed economist"! On the positive side, the lower cost of capital should help capital spending. On the negative side, most investors into Brazil have an institutional memory of how devastating inflation can be. Nervousness at the sight of a central bank willing to cut in the face of high inflation may thus increase? Moreover, investors are bound to ask themselves "what does the bank know that I do not?" And if they review the recent experience of Turkey, they may well conclude that the rates cut there seemed to have backfired-they only helped the Turkish Lira become the emerging markets' worst performing currency (-10% ytd) and hardly helped boost the Turkish stock market (-19% ytd in local currency terms).