Side Bet With Ben?

The markets are saying pretty clearly that there will be no more business done until the results of the Greek elections are known. For the last six trading sessions, the S&P has traded mostly in a range between 1310 and 1329, having made roughly seven round-trips of that range since last Wednesday’s updraft. Ten-year nominal yields have been between 1.56% and 1.70% for the most part. Ten-year real yields have oscillated between -0.60% and -0.50%. That’s despite disappointing Retail Sales on Wednesday, disappointing Initial Claims (386k, with an upward revision to last week), and a CPI release that bond and equity bulls certainly wanted to seize hold of. Late in the day, Egan Jones downgraded France to BBB+ with a negative outlook, but this news – not really news, in a way – was overshadowed by the rumor which circulated (sourced to Reuters) that said the G20 central banks had prepared coordinated “action” in the event that the Greek election this weekend rattled markets. The S&P spiked 15 points on that story, but then came back to the high end of the range.

Headline consumer prices fell -0.3% on the month, dropping the year-on-year rate of increase to +1.7%. As I predicted, the airwaves were replete with talk about the Fed’s response to an indicator that they largely ignore. According to Bloomberg, the renewed “stimulus speculation” was responsible for the decline in Treasury prices, the rise in oil prices (“The cost of living in the U.S. fell in May by the most in more than three years, Labor Department data showed today, giving Fed policy makers more flexibility to take further action to bolster U.S. economic growth”), and the fall in the dollar, and NASDAQ chimed in suggesting that stocks were rallying on Fed stimulus hopes. So many “hopes” on such a slim reed! To be sure, these articles all mentioned the weak ‘Claims figure, but it wasn’t that far out of line. It has been running around 380k, and 386k appeared on the tape. If that’s good enough for QE, then we should be on about QE14 by now.

Outside of the decline in headline inflation, core inflation didn’t show any signs of rolling over. As I suggested yesterday, economists were looking for a “soft” 0.2% on core inflation, causing the year-on-year rate to drop to 2.2% on a rounded basis. The BLS actually reported something just barely above 0.2%, which caused y/y CPI to stay at 2.3%. Keep in mind that the only reason that a downtick was even threatened was because last May showed a +0.3% and that is now rolling out of the data. Today’s figure, annualized, would produce 2.45%. Over the next few months, the hurdle for core CPI to move higher – or at least to avoid declining – grows easier. We’re unlikely to see core CPI dipping any time soon, so if the Fed wants to do QE, they’ll need to suddenly grow interested in headline inflation. (But if they do, they run the risk of getting caught sounding stupid if there’s a Middle East flare-up, or if Natural Gas follows up on the 14% rally it had today after a very weak inventory build).

That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?

The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:

“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”[1]

But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.

That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.

A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:

That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).

That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.


So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.

Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.

I do not expect core inflation to begin to fall any time soon.

[1] The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.

  1. onebir
    June 15, 2012 at 5:42 am

    Nice article. We are all monetarists now 😉

    • June 15, 2012 at 7:04 am

      Thanks – I felt good about this one!


  2. Lee
    June 15, 2012 at 2:10 pm

    Core inflation has been noticeably sturdy, so thanks for the call that it won’t roll over any time soon. And for the graphs too. Can’t M2 and GDP head south together, taking the deflator with them, if our growth has further weakness to go?

    • June 15, 2012 at 2:18 pm

      Well, because it’s a ratio M2 would have to go down by more than GDP growth went down, and I sure can’t see that happening soon. I think the main risk to an upward-inflation bias is the possibility that velocity might drop again if there are further banking crises. (Although in the US the banks seem to be doing fine at the moment.) Remember that thanks to the algebra, It’s really P=M/Q * V….so if V is falling fast enough, inflation will lag. That’s what happened in 2009 (and part of my thesis is that that’s not permanent!)

      • Lee
        June 18, 2012 at 11:15 am

        Thanks for the answer. I understand math but I guess I don’t understand M2 or why it wouldn’t fall fast enough if the downturn was severe enough. Is it because the Fed now has the QE policies?

      • June 18, 2012 at 12:23 pm

        Well, M2 is just an amount of money – the only thing which changes it is Fed policy. Simplify it a bit and imagine that it’s just physical dollar bills – nothing that a recession can do on its own will create or destroy dollar bills; sure, we can burn them, or spend them less frequently, but those are velocity arguments. There is some evidence that velocity ebbs and flows a little with economic activity, although not since the early 1980s (with the exception of the banking crisis). But as the charts show, that’s always a temporary effect and to a very large extent it can be ignored – in the subsequent expansion velocity returns to normal.

        So this is the argument – the Fed could in principle lean against the wind, easing when velocity declines and tightening when it rises. Except that (a) we don’t know how to measure velocity except as a residual, (b) we don’t know how to model velocity, and (c) so far the Fed has shown no signs whatsoever of tightening, even though velocity seems to have begun to recover!

        Does that help?

      • Lee
        June 18, 2012 at 5:46 pm

        Thanks again. I had it in my head that M2 reflected the bank lending multiplier effect (as opposed to M1 being hard cash) and therefore could fall faster as lending dried up in a downturn. I saw how interestingly the lines tracked on the graph.

  3. bixbubba
    June 16, 2012 at 12:00 am

    I thought the below was interesting and in line with your thoughts:

    June 16, 2012 at 1:26 pm

    The spike in Natural Gas (NG) is a poor indicator of inflation. The recent volatile price trends of NG is tied to micro (supply/demand) rather than macro trends. It doesn’t help your argument to data mine a single price point in time while ignoring the broader trends. Crude oil prices, gold, copper, agriculture, all tell exactly the opposite story and are more representative of macro inflation trends.

    • June 16, 2012 at 2:47 pm

      Er, I wasn’t using Natural Gas as an indicator of inflation…was I? Considering Natty is still down more than most commodities this year, that would be kind of silly, wouldn’t it?

  5. Ray McLaughlin
    June 19, 2012 at 6:29 am

    Do you have an opinion on Japanese 10 Y Bonds in comparison to US 10 Y Bonds?

    • June 19, 2012 at 6:46 am

      I really don’t like either market. I think inflation is a growing concern in both countries (less so in Japan, but core inflation is above zero and rising), and I can’t figure out why the market hasn’t taken a run at Japanese credit yet considering that it has much more debt per GDP than some of the PIIGS and a worse demographic issue. I’d avoid both of those markets.

  1. January 17, 2013 at 6:52 pm
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