Archive for August 31, 2011

Quarterly Inflation Outlook

August 31, 2011 1 comment

For today’s column I’m going to do something a little different. What follows is the Quarterly Inflation Outlook for Enduring Investments. This outlook is ordinarily only available to clients of Enduring Investments, but I am releasing it (a week or two after our clients received it) to a broader audience who may be interested in learning more about EI’s consulting or investment management services. You may do so by contacting Enduring Investments here.

Note that this post may not be redistributed without the preceding explanatory paragraph attached. The information below has been reformatted to conform to blog standards, but the information itself has not been changed.


Quarterly Inflation Outlook (Q3, 2011)

This quarterly report is intended to give our clients and select prospects an overview of the economic and financial conditions as they relate to the possibility for an acceleration or deceleration of inflation.

This is the first “issue” of the quarterly report, and we recognize that it is very much a work-in-progress. Future reports may very well have a different form entirely. We welcome feedback on the form or content of the report, and as always we encourage questions about how our strategies should fare in certain conditions such as, but not limited to, those we discuss here.

This document is not intended to provide investment advice but rather presents our analysis of macroeconomic factors that could impact investment returns and our perception of current conditions. The relationship between this analysis and investment advice tailored for you is not addressed in this document, and you should consult us or another competent advisor for a more personalized discussion of your particular circumstances and needs.

Current Conditions and Trends

The data presented below was collected on August 18, 2011 and is complete as of that date. It incorporates the CPI report that was released on August 18th.

Table 1 – Headline inflation is topping out for now, but Core and Median continue to rise.


1m ago

2m ago

3m ago

6m ago

12m ago








Core Y/Y







Median Y/Y







Table 2 – Surging money supply has buoyed gold but other commodities have lagged.

Annualized rate of change since






9.5167 trln














Retail Unleaded










DJUBS Grains





DJUBS Livestock





DJUBS Industrial Metals





DJUBS Spot Index (all)





Dollar Index





*Changes for M2 are annualized. All others are changes over the period indicated.

Table 3 – Rates have declined to unprecedented levels while stocks have recently fallen sharply.


1m ago

3m ago

1y ago

S&P 500





3m Tbill Rate





10y Note Rate





10y TIPS rate





Table 4 – Most subcomponents of CPI are accelerating.


Y/Y Change

Y/Y Change (3 mo ago)


 All items





  Food and beverages




















  Medical care










  Education & communication





  Other goods and services





Inflation Is Broadening

Even as financial markets shudder from the European sovereign solvency crisis, which calls into question even the very survival of the Euro itself, inflation indications continue to accelerate. Core inflation has tripled since reaching a low in October of 2010, and shows no signs of abating. As Table 4 shows, approximately 90% of the CPI is inflating faster over the last 12 months (July 2010-July 2011) than over the 12 months ending three months ago (April 2010-April 2011).

There are other indications that the inflation process is taking hold at a fundamental level and that this latest rise in core inflation is not a temporary event. The chart below shows core CPI inflation and the Cleveland Fed’s “Median” CPI (also included in Table 1). Since the lows, these two series have moved in lockstep, which is very unusual.

When the median of a distribution equals the mean of a distribution, it typically implies a balanced or symmetrical distribution (it is the case that a symmetrical distribution has a mean and median that are equal; it isn’t mathematically the case that having a mean and median that are equal necessarily means the distribution must be symmetrical. However, it is a reasonable inference).

A more-balanced distribution increases the probability that the main forces on prices are acting uniformly on them. When there is no systematic inflation, prices ebb and flow according to supply and demand interactions in thousands of individual markets. But when the prices begin to move more in unison, we start to get suspicious that there is a larger macro force at work. Picture a large harbor. If some boats are riding higher in the water than others, you may reasonably surmise that it is because they carry different burdens of cargo. But if all of the boats started to rise, you might reasonably suspect that the tide is coming in.

And the tide is certainly coming in. In a section below, we will discuss the money supply in more detail, but the numbers in Table 2 are plain. Over the last three months, M2 money supply has expanded at an annualized rate of 22.4%; over the last year, it has grown at a rate faster than 10%. That is the rising tide that is raising the pricing boats.

Core inflation is as low as it is, in fact, only because the housing market is coming off an epic bubble. The deflation in the housing market has pressured rents lower and as you can see from Table 4 Housing is more than 40% of the consumption basket of the average consumer. It has an even higher weight in core inflation, and this part of the basket has been artificially restrained by the aftereffects of the bubble. In this circumstance, it is reasonable to consider how fast prices are rising in the rest of the non-food non-energy economy. The chart below answers that question. It shows Core CPI as-reported, and then shows what Core CPI would be if Housing was inflating at the same rate as the rest of the basket. Without housing, core inflation would already be over 2% and, on base effects alone, should be approaching 3% by the end of the year. This clearly indicates that inflation is not only a threat, it is significantly here already.

Misguided Fed Policy

At its meeting on August 9th, the Federal Reserve committed to keep interest rates “exceptionally low” until at least mid-2013. Minnesota Fed President Kocherlakota, who dissented from the decision, clarified the statement a few days later by saying

This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months.

The explicit nature of the promise is interesting. It means that even if inflation starts up, the Fed cannot move rates for two years (unless it wants to permanently lose this as a tool, since if it reneges after one year and hikes rates, no one will ever trust them at their word again). [Editor’s note: the minutes from that FOMC meeting recently revealed that the Fed intended to get the benefit from that promise without that promise being binding, but this wasn’t clear when the report was written. But the following statement remains true.]

It is a policy error, with some chance of becoming a colossal policy error. The Federal Reserve is selling an option, by which we mean they don’t gain very much if it turns out to be the right thing to do (after all, they could always have kept rates down without a promise to do so), but they lose an enormous amount if it is a mistake since either reneging or letting inflation gallop away would be a disaster for the institution.

A generous interpretation of the policy might be that the Fed would actually welcome a little bit of inflation, since somewhat higher prices would help reduce the real burden of nominal debt. However, the central bank cannot ordinarily countenance higher inflation without losing credibility. The Bank of England is having precisely that problem now, as they let inflation run higher than their target rate without wrestling it back lower (obviously, they’re doing so because to wrestle it lower would require restrictive monetary policy, which the BoE believes the economy cannot afford). If we want to be generous to Chairman Bernanke, we can suppose that the Fed is intentionally shackling itself so that it will not lose as much credibility when it fails to respond immediately to inflation. Indeed, the central bank in such a circumstance could conceivably gain credibility by sticking to its promise.

From the standpoint of an investor, who needs to consider the possible inflation outcomes, the Fed policy is very bad. It creates the possibility of a long “tail” to higher inflation that the FOMC would be powerless to address; such outcomes are of course bad for the investor who has not taken steps to guard fully against inflation.

The Money Conundrum

It may turn out that the timing of this Fed policy was also exquisitely poor. Over the last few weeks, the M2 money supply has begun to surge (as noted above).

For some time, our fear has been that the enormous quantity of reserves that the Fed pumped into the system over the last three years would not remain relegated to relatively sterile bank reserves. Because the Fed pays interest on these excess reserves, the money it has pumped in has not circulated through the economy, and remains sitting on in excess reserves where it does not place direct pressure on prices since it is not in circulation to support transactions. The chart below shows Excess Reserves at Depository Institutions, which currently stand at $1.6 trillion. Almost every dollar the Fed has spent to increase its balance sheet has gone straight into the vaults (metaphorically) of banks, and not into the economy. This was by design, since the Fed wanted banks to have a bigger cushion more than it wanted to flood the economy itself with liquidity (had it wanted the latter, it needed only to eliminate paying interest on excess reserves and the money would have entered the economy quickly).

The M2 money supply represents the money actually used for transactions in the economy. Currently, the stock of money stands at $9.5 trillion. You can see that the Excess Reserves, if they entered fully into M2, would increase it some 16.8%. But that understates the risk, because reserves that are translated into M2 typically do so at a multiple called the “money multiplier.” In early 2008, every dollar of “base money” supported $9 of M2. If that ratio were to return, then the extra $1.6 trillion would translate into about $14.4 trillion, increasing M2 by more than 150%. That clearly is highly unlikely, but it points out the scale of the risks. These are the variables that the Fed is toying with.

Money matters because monetary theory says MV≡PQ. That is, by definition the amount of money in circulation, times the number of times it is spent in a year, is the total amount of money spent in a year. That’s the left side of the equation. The right side of the equation is national output, which is the price level times real output – or in simple terms, the price of stuff times the amount of stuff that is produced and sold every year. Since the dollar amount of stuff bought (the left side of the equation) must equal the dollar amount of stuff sold (the right side of the equation), we have a clear relationship between money (M) and prices (P). Specifically, with some simple algebra, P≡MV/Q. If real output is fairly stable, say plus or minus 5%, and velocity is stable, then an increase in M causes a direct increase in the price level. And that’s why we need to watch developments in the money stock very, very closely.

Recently, there was an alarming development in that metric. M2 money supply started rising fairly dramatically and without the Fed doing anything in particular to stimulate it. The chart below shows the 52-week change in the M2 money supply. As shown in Table 2, M2 money growth has been surging at a nearly 30% rate over the last month, and more than 20% over the last quarter. This has pushed the 52-week rate of change to levels not seen since the early 1980s, except in rare circumstances when the Federal Reserve was very consciously trying to add liquidity – in the aftermath of 9/11 and during the credit crisis. The fact that this is happening with no Fed intervention at all is incredibly unsettling.

So what is happening with money? One theory is that the instability of the banking system in Europe has caused investors and savers to transfer money balances from Euros on deposit in European banks to dollar deposits in U.S. banks. Also, since many money market funds hold European bank commercial paper, investors with large investments in money market funds have been reportedly withdrawing those funds to put them on deposit in U.S. banks.

There is some support for this hypothesis. Not only does the breakdown of the money supply numbers illustrate that much of the growth is in demand deposits and large time deposits, anecdotal evidence exists such as the fact that Wells Fargo recently announced a policy of charging interest to large, new depositors – in effect, paying negative interest rates on savings accounts.

What is unclear is whether that matters. If money merely sits in bank accounts, and the investor has no intention of spending the money, then it manifests as a rise in the money supply and an offsetting decline in the velocity of money balances – so that essentially MV remains unchanged. In crisis, this is not a ridiculous hypothesis. Perhaps the money that is accumulating is toothless, and we needn’t worry about the inflationary implications.

It is possible, but we believe that even if this is the case, the violent moves in M2 illustrate that the Federal Reserve would face a very difficult task navigating through these waters even if it had not lashed the wheel. This implies to us that inflation markets are worth a premium at this time.


Ironically, while the rise in M2 and other events point up the increasing risks of an inflationary outcome when all central banks are biased towards adding too much liquidity rather than too little, investors have begun to discount inflation markets because of growth fears. We believe there is very little evidence to indicate that growth causes inflation and that a lack of growth causes deflation. Indeed, there are myriad counterexamples, such as the 1970s in the U.S. when we had inflation and stagnation simultaneously…or the last several years, when prices continued to rise even though there was (and continues to be) a vast output gap.

Consequently, while inflation-linked bonds are expensive on an outright (real yield basis), they are inexpensive by recent standards compared to nominal bonds. Investors in nominal Treasury securities will outperform TIPS investors for only a very small range of potential future outcomes. Moreover, your risk in inflation-adjusted terms is dramatically lower when you hold inflation-linked bonds. You can’t ‘blow up’ if you buy TIPS and don’t get inflation; your worst-case in a 10y TIPS bond at the moment is a zero nominal return if there is no inflation at all, or net deflation, over ten years. On the other hand, you can completely ‘blow up’ if you buy nominal bonds and encounter, say, 5% inflation over the next ten years. So while TIPS are very expensive on a real yield basis, we believe they are superior to nominal bonds at these levels.

Commodities, which naturally have a zero real yield over time, typically do very well when real yields are very low (and thus other asset classes are less competitive. Our models continue to indicate that a very high weight in commodities is appropriate.

The table below shows our expected 10-year compounded real return expectations for five major asset classes.

Table 5 – Projected 10-year annualized real returns and risks

Real Risk

Real Return




Nominal Govts












*Note that if held to maturity, TIPS have no risk in real space.

These risks and returns are plotted below. Note that the assets fall in a low-risk and a high-risk barbell. In the low-risk bucket, TIPS are the cheapest asset despite being priced to yield essentially nothing after inflation for ten years. In the high-risk bucket, commodities are still superior to equities although if the equity market continues to decline, dividend yields continue to increase, and valuation multiples continue to improve, they will become more attractive. The slope of the line implies that for an additional 1% of expected real return for ten years, an investor must accept an increase in risk of 3.07 percentage points.


Information included in this report was collected from sources believed to be reliable but no warranty either express or implied is made with respect to its accuracy or completeness. The analysis and conclusions are the responsibility of (and property of) Enduring Investments.