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Tuesday 19 March 2024

We have spent over 15 years talking about quantitative easing (QE) and quantitative tightening (QT). Each phase of QE has become increasingly more significant, resulting in a huge final dose of monetary creation in response to the COVID crisis. This money is now being cancelled.

To recap QE is the printing of money. Theoretically, this is expected to be inflationary. Increasing the supply of something will reduce its value, all else being equal. Traditionally this was implemented with old world technology: the printing press and then reversed in the furnace. It is now achieved electronically: money created from thin air at the magic press of a computer button, and cancelled in the same manner.

The original fears when this innovative measure was introduced were that the increase in the supply of money  would have the understandable side effect of increasing inflation. This did not occur in the first phases of QE. Therefore, the policy became more acceptable. The link between the money supply and inflation appeared to be theoretical only, given the real world results. However, the empirical evidence of late would point to the opposite conclusion. Too much QE does result in inflation. I discussed this further in my previous September 2022 blog. The central banks are now tackling this inflation and they have been taking aggressive action to solve the problem. They have two prongs of attack: conventional rate hikes – which have been historically strong over the last year – and QT. 

The charts below show the broad relationship between money supply growth and inflation. There is a historical observable link between the creation of money and inflation. This monetary lag of around 18 months is a constant feature of the economy and markets.


Source: Bloomberg, BLS, Federal Reserve, 31 March 2023

From the charts it is pretty clear that the recent inflationary surge is potentially a function of money supply growth. Strangely, this is something central bankers do not focus on. Maybe because of the data set they have from early QE? From a monetarist point of view this is a mistake, as espoused elegantly by Tim Congdon. I have a great deal of sympathy for his views. It seems strange that Central Bankers recognise that supply demand dynamics are important: a shortage of energy, labour and microchips are all inflationary, but they don’t seem to recognise that an abundance of printed money reduces its price  – A.K.A. inflation!

The most interesting point on this chart is the degree of monetary cancellation: it is historically unprecedented. On a simple reading, this is hugely deflationary and  suggests that inflation will reach new lows. The culture of cancelling money has not yet reached its zenith. We know that central banks are signalling that this process will continue and we can assume that money supply growth is likely to remain negative for some time. This is a new grand experiment.

Which is correct? Is money supply growth inflationary or not? One way of squaring the circle of early vs late QE would be to analyse where the printed money went. During early QE, it simply filled the bank vaults to make banks solvent against depositor runs, and paid for previous lending mistakes, refilling the reservoir due to the drying up of financial markets. The later stages of QE resulted in cash overflowing from banks into the real economy, and therefore brought about inflationary consequences. Is it the environment that QE is undertaken in that determines the inflationary outcome?

One way to maybe perceive this is to analyse the recent woes in regional US banks. Cancelling money through QT results in less money in the economy. Therefore, banks will have less deposits on aggregate. If this deposit drain is focused evenly across the system then the effects on each institution are minimal, but if that drain of potential reserves all comes out of one institution, then that bank will face problems. Printing money to provide liquidity and reserves to support the weak banks in the first stage of QE has been replaced with cancelling reserves via QT, challenging the weaker banks.

Most investors didn’t seem to be too worried about inflation 18 months ago when money supply reached a historical high. Now inflation is at the forefront of our minds, but money supply is negative. This cancel culture of quantitative tightening is a new monetary phenomenon. Should we be starting to think more about deflation than inflation next year?

‘inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than the output’ – Milton Friedman


Source: Federal Reserve, 26 April 2023

Quantitative tightening (QT) is due to start in earnest on the 1st November – just in time for Halloween! The Bank of England is scheduled to start a serious active sale programme of the assets it bought during QE, which was a ‘treat’ for the holders of the assets and was a policy measure they had to undertake to stimulate the economy as rates were at the lower bound. It is now time for the ‘trick’. The Bank describes on its own website why it engages in QE… let’s see how they would describe QT:

Edited extract from bankofengland.co.uk, “How does quantitative easing work?”

Source: https://www.bankofengland.co.uk/monetary-policy/quantitative-easing, M&G

QE was stimulative, QT is designed to restrict growth. We believe QE increased inflation – therefore, via reducing the outstanding stock of money, QT will act as an inflation dampener.

One of the potential side effects not mentioned in the Bank of England guide is the potential effect on Sterling. The transmission mechanism of interest rate changes affecting currencies is a potential catalyst for FX moves.

Another direct effect of QE/QT is that the excess supply of something reduces its value and vice versa. We would therefore expect currencies where the central bank pursues QE to have weaker currencies and currencies where the central bank implements QT to have stronger currencies. When all countries are printing or destroying money in unison then the effect is not noticeable. However, when one country is printing and the other is destroying its money, then the latter currency should be stronger. This explains the scary chart below.


Source: M&G, Bloomberg (24 October 2022).

QT will slow the economy and fight inflation for the reasons explained above. This policy aim could be further helped by subsequent strengthening of the currency.

Following on from the recession blog we said we would discuss inflation: this is the big difference in the economic cycle this time around as illustrated in the chart below.

Source: M&G, Bloomberg (31 August 2022)

The common cause of the current inflation according to many commentators is the supply shortage, whether that be commodities, manufacturing or labour. Central bankers frequently have pointed to these effects: “Supply-side constraints have gotten worse,” said Fed Chair Powell at the end of last year. “The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.”[1]

These issues contribute to the inflationary outcome: supply and demand matter. Inflation however is the balance of relative supply of money versus what that money buys. This is an area that central banks are not commenting on as much. We will explore this issue today.

Below shows a chart of the increase in supply of money per unit of output as measured by M2/GDP. Against this we plot inflation outcomes in the same economies. As the economic textbook would say, increasing the supply of money is a major influence on inflation. To put it simply, the supply drought in goods and services has been met by a deluge of supply of money. It can be argued that it is the excessive abundance of money that is contributing significantly to current inflation. 

Source: M&G, Bloomberg (30 June 2022)

We have discussed previously the way helicopter money works. Central banks are now trying to return money supply growth to more normal levels and trying to collapse the outstanding monetary surplus by quantitative tightening. The central banks have 3 policy options to implement if they decide to clean up this flood of cash.

Firstly, they could simply let it dry in the sun. This would involve accepting the inflation they caused, and hope for no secondary inflationary effects embedding into the economy, primarily through changes in inflation expectations. This dovish policy would mean not altering the money stock and letting the impetus of previous policy simply die out.

Secondly, they could mop up the liquidity by doing some quantitative tightening so bringing future inflation under control at a faster pace.

Thirdly, they could implement a cyclone policy of rapid tightened by sucking back up as much money out of the economy as they dare. A rapid collapse in inflation would ensue but this cyclone approach would risk damaging the wider economy.

Central banks are likely to follow a pattern somewhere between the first and second option. This means inflation will persist but will then fall with the usual monetary lag, as indeed it surged with the usual monetary lag. Inflation will therefore likely be temporary but the definition of the period of ‘temporary’ is in central bankers’ own hands.

The current inflation conversation is based around supply constraints of goods and services. Maybe the debate should be more about supply constraints of money being implemented to bring inflation down. Central banks can get inflation back to target – it is a question of how quickly they decide to do it.

 [1] https://www.wsj.com/articles/fed-chairman-jerome-powell-says-supply-side-constraints-are-creating-more-inflation-risk-11634917630

The economic backdrop post Covid remains one of great uncertainty regarding recession risks for credit, and inflation risks for bonds. We will attempt to address these issues in two blogs. The first will focus on our usual starting point over the years regarding the risk of recession; the second will explore the current inflation outlook from a fresh perspective, as we have not faced such high inflation in developed economies for many years.

Over the years we have looked at 3 key indicators of recession risk. The most recent occasions were at the start of the Covid pandemic and again earlier this year. Today we will update this as these indicators of recession risk have moved.

The first of these is the rightly well-favoured primary indication of upcoming recession: the inverted yield curve indicator. This has a good track record and is pointing to a sure recession ahead – it is the most inverted it has been in years as illustrated below, and one would argue is glowing red.

Source: M&G, Bloomberg (31 August 2022)

The second warning light comes from the price of oil. Below we can once again see its predictive powers. Currently the oil price indicator at a formulaic level looks amber, given recent weakness. I would argue that is not a recession warning for the USA, though other significant economies face a more recession risk due to currency weakness – in the case of Europe, the region also faces an historic energy price shock due to its reliance on Russian gas. Given the above I would also argue that energy is a potential red light for some economies.

Source: M&G, Bloomberg (31 August 2022)

Historically we have always looked for a third confirming signal of upcoming recession. The basic premise of this is that the Fed-induced inverted yield curve is created to fight inflation, usually from an energy shock, and this policy must find its way into the real economy. This transmission mechanism has historically happened through the housing market. We plot the likely direction of the housing market by looking at its sales-to-inventory ratio: when it takes a few months to sell available housing stock, the economy is set fair; when it takes longer than around 7 months, the economy faces problems ahead. This is illustrated below.

Source: M&G, Bloomberg (31 July 2022)

You can see from the historical graph above that this is a good indicator. We are faced with a dilemma when we update the data to today however, as we currently have a significant divergence between existing homes for sale inventory and new home for sales inventory. The former shows a robust healthy economy, while the latter implies an economy on the brink of an all-mighty recession. Let’s try to understand the difference.

I think the reason for this divergence is the dramatic move in interest rates, from record lows to more typical rates, shown below. Different households face dramatically different interest rates. New buyers face the full force of Fed tightening, while existing holders will not sell as they will lose their locked in low rates if they move. This results in less demand for new build, slowing demand, and less supply of existing homes, slowing supply and explaining the dramatic divergence. Which is more important for the economy: the GDP impetus from new build housing, or the fact the majority of housing supply is now off market and so supporting prices and therefore consumer confidence? This ambiguity means this indicator could be bright green or bright red.

Source: M&G, Bloomberg (16 September 2022)

There is one other factor that is potentially very different this time and this is our often discussed labour market data. In a recession, unemployment by definition increases as shown below. This time around, we start in a very strange position with excess demand for labour at record levels. We would therefore need to work through this excess demand before we started increasing unemployment and experiencing a recession. This points to a delay or potential postponement of recession compared to a normal economic cycle.

Source: M&G, Bloomberg (31 July 2022)

Traditional measures such as the yield curve point to a recession round the corner, with supporting indicators pushing generally in the same direction. The cushion of labour demand points to a potentially different outcome at least in the short term. Recession is highly probable to be further away than that implied by the most important signal, the inverted yield curve.

One other thing that is different this time is the historic inflation we have that is influencing central bank policy.  We will focus on this in a second blog later today.

“The fundamental change in our framework is that we’re not going to act pre-emptively based on forecasts for the most part and we’re going to wait to see actual data. I think it will take people time to adjust to that and to adjust to that new practice, and the only way we can really build the credibility of that is by doing it.” 

Fed Chair Powell, 17 March 2021 via Bloomberg (19 March)

The market’s very own Top Gun made the Maverick statement above, emphasising the significant change in the monetary policy reaction function that took place just last year. This was a huge signal that they were prepared to run the economy hot, and boy did they break Mach 10! This theme was central to our Bravo Yankee Pappa blog. Central banks were going to escape the zero bound, we thought they would, but not by the stellar amount they actually have with inflation hitting generational highs.

Source: Bloomberg, 31 May 2022 (latest data available). 

This maverick manoeuvre in monetary policy is not what you expect to see from central banks – though given the low inflation altitude going into the Covid shock they needed to ditch the usual playbook. The markets are rightly very concerned now over the immediate outlook as they face a set of dangerous parameters that are new to them. What will the central bankers do next? Powell has two options:

  1. Powell could stick to his words above and stay reactionary, not proactive. Following this flight path implies super aggressive tightening to kill inflation, with recession of various degrees being accepted as collateral damage. This would imply high real yields at least in the short term and be bad news for credit, and likely lead to a high degree of market volatility as the Fed reacts in real time to real time data.
  2. Powell could recognise that he executed a one-off manoeuvre in monetary policy in exceptional circumstances and that we should find a flight path back to the conventional monetary policy of the past.

I think option 1 is not where Powell’s thoughts lie.

A maverick is someone who is prepared to think differently and unconventionally: I don’t think that is the right call sign for Powell or any central banker! In fact most central bankers would aspire to the Iceman call sign: intelligent, analytical, calm, though with the right amount of swagger to get under the market’s skin. How do they get from the current stated policy to the old playbook?

Central bankers could simply recognise the one-off battle predicament they found themselves in during 2020, and announce a return to their more pre-emptive Iceman approach. They can therefore temporarily ignore the ground-breaking inflation as a rule that had to be broken for a greater good. This would mean a period of above average inflation, and no need for a significant economic downturn.

The central banks will have difficulty in transitioning to the old approach: they will push rates higher, they will reverse QE, and maybe fly higher above the zero inflation bound on a permanent basis. Hopefully they do this in the style of Iceman, patient and forward looking as opposed to reactive, and therefore we can escape the current danger zone.

Given the next stage of the monetary cycle is set to be a period of tightening to slow the economy and suppress inflation, it makes sense for us to analyse the probability of recession as they bring significant rate and credit volatility. Our working theory has been that you need 3 economic signals to create a recession outcome.

  • Firstly, an inverted yield curve, the central banks are tightening policy and the market is telling you they have succeeded and are ahead of the curve.
  • Secondly, a tight housing market that confirms that the central banks are indeed ahead of the curve.
  • Thirdly, traditionally in the developed economies, we need an energy shock to depress consumption, and to encourage central banks to overtighten to control inflation.
Source: M&G, Bloomberg, 31 March 2022 (latest data available) *data from 2000 combines both new and existing housing inventory data

From the above we can see the warning signs are there, however we do not have three red lights. Let’s explore the three warning signals individually. Are they as reliable as in the past and is recession around the corner?

If we think of the US economy as being faced with a set of traffic lights, at first glance, we hit two red lights and a green. Not a unanimous outcome, but given that the last few years have not exactly been normal from an economic point of view, let’s explore a pessimistic and an optimistic scenario.

More red lights than green?

The pessimistic scenario would claim that the yield curve is the dominant indicator and the current green light in the housing market could promptly turn red. The argument would be that the last 2 years have resulted in a rapid bubble of housing consumption, due to the unusual monetary policy we have had and the change in consumer behaviour during lockdown. At its simple level, it would seem that if you are to stay at home, you are prepared to spend more of your wealth and future wealth on a home. Undoubtedly, it has been very different this time and therefore this indicator might be unreliable or could rapidly turn red as the economy opens up and the housing bubble ends, and so it is a green light we should ignore.

More green lights than red?

On the optimistic side, the “it’s different this time” argument would say that the yield curve is no longer a true predictor, as its signalling ability is severely impaired by central bank intervention that has forced long term rates lower due to the Quantitative Easing (QE). This would be best typified by the argument that term premium has been crushed by QE, and therefore we should arguably ignore this red light. 

With regard to the oil price traffic signal, currently set to red, one could argue that the dominant, pre-Ukraine related, percentage rise in price was simply a rebound from the COVID oil price crash, and should therefore also be ignored. This is akin to the central bank argument of a transitory temporary rise in price COVID narrative.

All the above arguments have merit, so let’s try to find some other indicators of economic strength that might give us a guide as to whether or not a recession is around the corner.

A recession is defined as two consecutive quarters of negative economic growth, and we care about recession as it increases the level of unemployment. Therefore, I think the first port of call should be an examination of the current state of the labour market. We have used the chart below many times to illustrate how healthy the US economy was/is, as it depicts the excess supply or demand for labour.

Source: Bloomberg, 31 March 2022 (latest data available).

In order to suffer the economic consequences of recession, we need to have an increase in unemployment. From the above, it is pretty clear that we have a long time to go before we are going to generate an increase in unemployment. Given this compelling evidence, I would argue that a recession is not around the corner. 

The economy will slow as the Fed tightens monetary policy working with its usual delay. Economic growth will also be limited as being at full employment potential growth is  – by definition – curtailed by the lack of supply of labour.

From my perspective I think that recession remains unlikely in the near term. This means monetary policy can continue to be tightened, and credit does not need to price in a default cycle in the near future. We will continue to closely monitor the three signals above, and to examine them all on a more detailed basis in future blogs.

Central banks set interest rates and wider monetary policy in order to stimulate demand via low rates, or to increase saving via high rates. Altering the price of money changes the behaviour of individuals and industry. This is an imprecise science with the effect always approximate and the timing usually delayed – empirically around 18 months between the policy change and the lagged outcome to inflation, growth and employment. When exercising monetary powers the central bank will always have an idea of the direction of the outcome but, like investors, will often be surprised by the real world response.

The authorities had to react quickly and decisively given the events of 2020: rates were cut, fiscal deficits increased and money was printed. This was designed to offset the negative economic effects of the pandemic response. The question at the time was: would it work, be enough, about right or too much? Given we can now examine the outcome, let’s take a quick look.

The UK economy is robust. The chart below shows that unemployment is near record lows, with inflationary pressures indicating an economy operating around or beyond full capacity. Thankfully, the financial actions of 2020 worked. What is next?

Source: M&G, Bloomberg, 31 January 2022 (latest data available)

This week the ONS released its data on job vacancies, which are at record levels. Comparing job vacancies to the number of unemployed, the tightness of the UK labour market is clear (see chart below). The Bank of England is well aware of this, as it has shown by its recent and likely continuing action as it tries to reign back on previous stimulus and hit its inflation goal. 

Source: M&G, Bloomberg, ONS, 31 January 2022 (latest data available)

Traditionally one would look to rates being set at above inflation to discourage spending and increase saving; given a 2 percent inflation target, this was generally achieved by setting rates around 5 percent before the financial crisis. This time around, the working assumption is that the world is now different and so the market assumes that 2 percent rates would be enough to get inflation back on track. This assumption can be challenged in a number of ways, particularly with regard to the current dynamics of the UK labour market.

Before the financial crisis, the pool of excess labour in Europe was available to the UK. This has now been severely curtailed after Brexit. This means the vacancies-to-unemployed ratio is now more significant than it was in the past. I blogged specifically on the challenge facing the Bank of England and the need to raise rates in the autumn of last year. The Bank of England has to develop a new understanding of the domestic labour market post Brexit. The current hot economy will be a challenge for monetary policy implementation for central banks, and the bond markets.

The start of each year is the time to reflect, look back and – importantly – try to focus on the year ahead. This is presumably a result of the welcome pause from work over the Christmas festivities, and the move towards longer days. This time of reflection is best typified by New Year’s resolutions. These behaviour changes generally involve giving something up! The quit rate in the US labour market – the rate at which workers give up their jobs – has been rising since well before the end of 2021. This can be seen in one of the first economic releases of 2022: the US quit rate for November was at a record 3.4% in the private sector. This jobs market indicator is something we have constantly focused on over the years. The chart below shows the quit rate and the unemployment rate: as you would expect they are highly correlated. People quit their job when the labour market is strong and vice versa. The Fed is focused on the macro headline unemployment data. I think we should be taking more notice of the microeconomic “man on the street” data. The importance of understanding these numbers is that when we reach the objective of full employment then we will see a potentially highly inflationary bottleneck.
The quit rate is not just about people quitting jobs temporarily for a better job. It is also a function of people quitting for good, most notably retiring. This significant issue was raised by the Fed itself in looking at labour force participation. The combination of a high quit rate and depressed labour force participation due to retirement point towards the conclusion that we are closer to the goal of full employment than to the one set out by the Fed of unemployment returning to its pre-pandemic level. Central banks themselves have one thing they all want to quit this year: Quantitative Easing. Their balance sheets have swollen on a diet of monetary excess. The first central bank to try to stop putting on the excess pounds is the Bank of England; the Fed and the ECB will be next. This is, however, likely to be only the first stage of the monetary diet: the next stage will be the new fad of Quantative Tightening.

As bond investors we constantly focus on economic growth, inflation, and interest rates. In order to understand the potential moves in the above we focus at the crux of the problem which is the labour market. One way we have looked at this over the years is looking at the supply and demand for labour. The most common way we have done this is the chart below.

Source: M&G, Bloomberg, 31 August 2021 (latest data available)
 

This data is one of the reasons we are concerned re US central bank positioning; job vacancies at record levels, more job offers than unemployed, yet fiscal and monetary policy in the US remain exceptionally easy. In this blog we are going to focus more on the UK labour market.

Like the US economy we, in the UK, are coming out of the public health policy slowdown and have an economy being supported by monetary and fiscal policy. We can also see a similar trend in job vacancies vs the unemployment total as illustrated below.

Source: M&G, Bloomberg, 31 July 2021 (latest data available)
 

At first glance we are heading in the same direction as the USA, the UK labour market is looking to be going back to normal. However, we  think the MPC in their next policy meeting this week should look through that number as we believe it is underestimating labour tightness due to a structural change that has been masked by the COVID slowdown.

The much awaited Brexit finally arrived from a labour point of view in the summer of 2020. When you look at the labour market in the UK, the historic supply has been supplemented by the wider European pool of labour. That option has been legally curtailed post Brexit. Whilst in the past this pool of foreign labour had been taking pressure off wage inflation. We can see the flattening of this trend post the Brexit vote below. Anecdotally we are seeing this in the current recovery with comments re staff shortages in discretionary sectors like the restaurant industry, and essential sectors such as truck drivers, both of which would have historically been attractive sources of employment for European citizens. In order to understand the importance of this historic labour participation from abroad we have constructed the chart below, the UK’s labour market was previously supplemented by European labour, this will no longer be the case.

Source: M&G, ONS, 30 June 2021
 

Hopefully public health restrictions on economic activity will continue to reduce, and the UK economy will be vibrant once again. The Bank of England, like the Fed, has to be aware of the inflation implications of the historic monetary and fiscal interventions that were needed through the Covid years. One unique challenge for the UK central bank is trying to understand the tightness of the UK labour market and its inflationary implications post Brexit.

When you take a look at the broad data the Bank of England will have at the September meeting, they will see not only the tightening labour market data we illustrated above, but a booming housing market, whilst the market implied outlook for future 10 year inflation is towards/at its longer term highs.

Source: HM Land Registry, Registers of Scotland, Land and Property Services Northern Ireland, and Office for National Statistics, 30 June 2021

Source: M&G, Bloomberg, 13 September 2021
 

Unlike the Fed, the Bank of England does not do talking about talking about talking about, however in a select committee meeting recently the governor simply stated that the committee is evenly split regarding the time to change policy direction. This, and the above data, indicates that the tightening of UK monetary policy is firmly on the agenda. The old lady that is the Bank of England is likely for turning.

Summary: Normally we refrain from commentating on individual pieces of data, but there has been a streak of interesting, unpredicted and significant economic prints over the last week. What has the economics profession got wrong this time?

The shocks:

  • Payrolls job creations: 218,000 vs consensus 933,000
  • JOLTS job openings: 8,123,000 vs consensus 7,500,000
  • CPI YoY: 4.2% vs consensus 3.6%

Of the three shocks, two traditionally point to a strong rebound (more job openings and higher CPI) one to a weak rebound (lower job creation). Let us examine the labour market data since that is the area the Fed is currently focussing on with its desire to get employment back to pre-pandemic levels.

At first glance the data seem to disagree: how can it be that people not returning back to work, yet there are many jobs to be filled? The two sets of data do not conflict, however: when generating the near 1 million consensus for Friday’s payroll report, economists’ forecast was based on the growing economy. The JOLT jobs opening report confirms that view, in that the missing numbers on the payroll consensus data simply appeared in the JOLTS report: the payroll (job creations) report missed consensus by -700,000, and the JOLTS (job openings) report by +600,000. The two sets of data show the economic surveys were accurate with regard to the current state of the US economy – it is growing on track. Maybe the economists should simply have revised their forecast on the JOLTS data up given the payrolls shortfall!

The surprise is that there seems to have been a change in the reaction function of labour to the job openings that are out there. One way of looking at the labour market is the voluntary quit rate, which we show below versus employment. As you would expect, the quit rate is a function of workers finding a better job and so goes up the tighter labour markets get. The current quit rate, as you can see from the chart below, is actually in line with what you would expect at full employment.

Source: M&G, Bloomberg, 30 April 2021 (latest data available)

The reports show nothing other than an economy on track – or maybe a little hot if anything given this week’s CPI print.

Based on the data snapshot we have, it appears that the labour market is behaving as if it is at full employment. This has been postulated by many to be the result of the extension of a generous unemployment programme, understandable health concerns discouraging the return to work, or a lack of social support infrastructure (e.g. closed schools). These will eventually all come to an end – though, while they persist, there could be a breakdown in the traditional link between demand and supply of labour.

The reopening is very stimulative, fiscal policy is very stimulative, monetary policy is very stimulative, but if the labour force remains unstimulated then demand will exceed supply with inflationary consequences.

Author: Richard Woolnough

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