The Iran War Brings More Inflation and New Strength to the Yuan

Two monetary and currency paradoxes emerge as the war rages.

First, there is likely an immediate episode of some monetary disinflation, never mind the widespread concern about a looming jump in consumer prices. 

Second, the currencies of the US and China, have both gained, but in different ways. The currency of China, a provider of an economic and military lifeline to Iran, is winning international business in consequence of its use in dealings — despite US sanctions — with and between the two states. The US dollar’s observed strength in the war so far stems from US economic resilience to Gulf energy supply shock and a perceived tightening in US monetary conditions.

The good news: the US monetary situation on the eve of the war was inflationary — indeed the longest unbroken monetary inflation in modern history — and so some disinflation now, whether intentional or not, should help reduce the extent of monetary malaise. 

The bad news: the disinflation does not herald a long period of less inflationary monetary conditions. When the energy supply shock goes into reverse the Fed will almost certainly take advantage of price declines to rev up monetary inflation.

A danger — but not the central scenario: the disinflationary intermission now emerging could be a catalyst to severe financial stress and recession.

Transcending the direct monetary implications of the war is the China shock, itself with consequences for the currency scene. The war has revealed the extent to which Beijing has empowered Tehran — whether by oil purchases, inward investment, or direct input into its ballistic missile program — using the yuan to circumvent sanctions.

Back to the monetary paradox — how energy supply shock becomes a catalyst to monetary disinflation. Under our present fiat money regime — the 2 per cent inflation standard — the Fed plots a course for its policy rate which is contingent on the actual profile of consumer prices. The plotted path for the policy rate rises to a higher level in response to a new overshoot of the Fed’s target for reported consumer price inflation. In the first three weeks of the Iran war the 2-year T-bond yield which is a proxy for the path of policy rates has risen by around 70bp. 

By contrast, under a sound money regime there is no presumption that monetary conditions tighten in response to energy shock. In particular, under a gold money regime it is plausible that energy shock would bring about some immediate decline in the demand for money in real terms (in line with a fall-back in real incomes); gold would correspondingly lose some purchasing power and this might correspond to an upward drift in prices on average consisting of spikes in all goods and services with high energy content offset in part by some declines elsewhere (explained by weaker demand there). 

Of course, a 40bp rise in 2-year yields is not necessarily identical to monetary tightening. Interest rate levels are an unreliable guide to monetary conditions. But that is the only guide we have in the present dysfunctional monetary system. Indeed, under the present regime the concept of monetary tightening in the sense of instruments with the quality of extreme moneyness becoming scarce, is to a large degree inapplicable. This leaves us with just policy rates to consider in overall monetary assessments. 

So, suppose the 40bp or so rise in 2-year yields does equate to a significant tightening of US monetary conditions. That would be no bad thing given the likely extent of monetary inflation on the eve of the war. But given the epic length of asset inflation by that point (since say 2010/11) and resulting malinvestment plus financial fragilities, we should not ignore the potential for monetary disinflation to be a catalyst to recession and financial crisis. 

Why are these possible bad outcomes not the central scenario? Well, the monetary tightening, though significant, is not obviously substantial. And almost certainly when the energy supply shock recedes and reverses, the Fed – joined by other leading central banks — will respond to better news on consumer price inflation by cutting policy-rates. The Fed will not foster monetary conditions such that overall consumer prices fall back on average to their eve-of-war level or even to a trend path where prices increase by 2 per cent annually. Instead, it will claim success in getting consumer price inflation back down with no roll-back of earlier excesses.

A possible post Iran war shift to energy glut will likely go along with supply side abundance related to the adoption of AI. There could also be a positive supply impulse from a roll-back of tariffs.

Essentially massive combinations of energy and Asian chips are substituting for human capital in important areas of the US labor force. Accordingly, wage rates and prices come under downward pressure where there is most acute competition with the new technology. Mal-signaling in capital markets, a consequence of monetary inflation, drives the digital and AI transformation faster and much further than would happen under sound money. Firms applying AI, some already possessing monopoly power, others enjoying cheap capital on the promise of future monopoly, can by predatory pricing kill potential competition from pre-AI technologies.

The downward pressure on some prices as described would allow the central bank to pursue monetary inflation whilst counting on its being camouflaged meanwhile in goods and services markets.

Incidentally, the Federal Reserve may take advantage of the camouflage, to justify rate cuts. In support of these it could point to a parallel implementation of balance sheet shrinkage. The plan to reduce the size of the Fed’s balance sheet will most likely involve that institution exchanging much of its holdings of long-maturity T-bonds at the Treasury for T-bills and then selling these off in the open market, a version of quantitative tightening (QT). The new situation, however, of less reserve deposits at the Fed and more T-bills outstanding means virtually nothing as regards the disease of monetary inflation. In the present monetary system Fed deposits and T-bills are almost perfect substitutes for each other across a large range.

Anyhow, these ostensible camouflages to monetary inflation in goods markets in the wake of the Iran war could eventually wither. Spending in all its forms, whether by consumers or businesses, could tend to run ahead of supply across a very wide spectrum of goods and services. Individuals might in aggregate find themselves with a chronic tendency to have excess monetary-type assets (traditional bank deposits plus Treasury bills and short-maturity government bonds) and wish to dispose of part. They could do this by spending more on various goods/services or on assets such as liquid equity paper, credit paper, and precious metals. 

The take-off of asset inflation under those circumstances is not certain. Much depends on the scope and power of speculative narratives, as fostered by monetary inflation. But according to some mainstream scenarios the Iran War and its consequences may at least for some time cramp the spread of those narratives.