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Why the Fed Will Ease in September
On Friday, the long-awaited Jackson Hole speech by Ben Bernanke finally happened. With bated breath, investors waited for news of his oration.
Unfortunately, most investors don’t speak “Fed,” so it was manifestly unclear, or clearly unmanifest, what the Chairman was necessarily getting at. Some investors seemed to be expecting him to say “start the choppers, boys, and let’s light this candle.”
Well, that’s not how Fed Chairmen…or economists…or humans, except for Nicolas Cage…speak. But what Bernanke actually said is still fairly clear to those who have listened to Fedspeak for a long time. An important part of Fedspeak is that the speaker assumes the listener is completely aware of the context, and the subtext, of his remarks. So let us forget our predispositions for the moment, about what the FOMC may decide next month, and dispassionately analyze the arguments currently before the Committee – which constitute the context in which the Chairman delivered his remarks.
The doves, when given the floor at the meeting in mid-September, will say that growth remains unacceptably slow, and that whether the Fed would like to or not, they are not permitted to ignore one leg of their dual mandate. They will observe that year-on-year core PCE for July was just announced at 1.6%, below expectations of 1.7% and well below the March high of 2.0%, which also happens to be the Fed’s target. Although this is likely a temporary phenomenon, the doves will argue that it doesn’t matter if it is; what it means is that they have at least 3-6 months before core PCE could feasibly be much above their target, and perhaps 9-12 months before it could be alarmingly so. The doves will argue that the tail risks to growth are now heavily to the downside. Unmentioned, but a further subtext, will be the recognition that a Romney Presidency is no worse than a coin flip at this moment, and the institution might find itself constrained if it should desire next year to take aggressive action on growth – and if the party of Romney wins, it is likely to also lead to reduced fiscal stimulus, or even a fiscal drag. Finally, they will observe that money supply growth has slowed to only 5.7% on a 52-week rate of change basis, and even corporate credit growth may be slowing (up 5.4% y/y, but only 3% over the last quarter), so that any easing action would be adding fuel to a low fire, not to a roaring blaze.
What is the hawks’ rejoinder, when it is their turn?
The economy is sputtering, but it isn’t actually contracting. Housing prices, which had been the economy’s albatross, seem to have turned higher and inventory is clearing. Previous aggressive monetary policy has not produced very much other than lofty asset prices, and has skewed markets; moreover, there remains a wall of money out there that threatens large future costs and small future benefits. The best arguments that the hawks seem to have, at the moment, is that there are large costs to future action and few benefits to be gained. They can’t win on current inflation – it is too low. They can’t win on current growth – it is too low. They are unlikely to win on asset prices that aren’t affecting consumer inflation, and that many investors don’t see as ‘bubbly.’ They can’t win on the ‘balance of global growth risks.’ They can’t very well argue that fiscal policy should do more when the balance of power in the Executive and Legislative branches is up in the air. The only potentially winning avenue they have is if they can argue that it isn’t worth the risk to add more money, even though adding lots of money to date hasn’t produced runaway inflation. To this end, William White at the Dallas Federal Reserve[1] (where President Fisher is generally to the hawkish side of the ledger) recently posted a white paper entitled “Ultra Easy Monetary Policy and the Law of Unintended Consequences,” which specifically argues that the long-term costs outweigh the short-term benefits of ‘ultra easy monetary policy.’
Now, with this context, let’s look at Bernanke’s speech. Bernanke is not unaware of White’s paper, and he is aware that everyone else in the roomful of economists is aware of White’s paper. He is aware that the hawks rely on this argument, and he cannot leave the topic unaddressed.
So Bernanke includes in his speech a section entitled “Making Policy with Nontraditional Tools: A Cost-Benefit Framework.” In it he declares that “the FOMC carefully compares the expected benefits and costs of proposed policy actions,” but adds forcefully that “The possible benefits of an action, however, must be considered alongside its potential costs.” He then describes the potential costs, as he sees them, of large-scale asset purchases (LSAPs). (It is interesting, as an aside, that he focuses on this one possible policy action.) And he ultimately argues that – and this is the key phrase in the whole speech, as far as I am concerned, given the context and subtext:
“The costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.”
Thus, Dr. White, you are duly answered. We thought about it, and the costs are manageable. Thanks for writing.
Having dismissed that argument, Bernanke sets up the doves’ arguments. Not surprisingly, they are the same as the arguments presented at the August FOMC meeting, which surprised many observers when the minutes were recently released. The Chairman said, predictably, that “Unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time.” And he concluded with “the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
None of this means that the Fed will ease for certain, and I am on record as saying that I think they shouldn’t but will. Bernanke’s speech today strongly suggests to me that they will do something, and since the list of meaningful somethings is very short at the moment, it will likely be one of three things.
- LSAP of some kind, perhaps in mortgages instead of or in addition to Treasuries.
- Lowering of IOER – less likely, although smarter. It’s also possible they could nudge IOER lower just slightly, as was recently suggested.
- Changing the formulation of the ‘extended low rates’ promise, so that it is no longer a date but rather a hard formulation of the Evans Rule that has been in place in a ‘soft’ form since June.
I don’t think that just extending the ‘end date’ for the low rates pledge is a viable option. First, it would disappoint investors, who are expecting something more concrete from the Fed, and thus wouldn’t have the intended effect anyway. Second, many Fed officials have grown uncomfortable with the box they have put themselves in with a hard date that may or may not coincidentally line up with the evolution of economic variables. Third, most investors recognize it’s not a promise anyway, so it has little value.
I believe the Chairman has made clear (or as clear as he is likely to make it in a speech to economists) that more QE is coming, and if I had to order the three options above I would say (1) is most likely, (3) is next-most-likely, and (2) is least likely. Indeed, I think that since the Committee will likely not want to move at the next meeting, which will be quite close to the election, I think there’s a chance they could do some of all three of these.
[1] White is also the chairman of the Economic Development and Review Committee of the OECD and was recently the head of the Monetary and Economic Department at the BIS, so he’s no hack.
Regime Change, Economist Style
While central banks continue to fret about the risks of disinflation and deflation due to expectations of slower growth, the numbers continue to suggest those concerns are misplaced. Yes, I know that inflation is supposed to lag growth, so that this year’s recession is next year’s disinflation, and I know that the S&P/Case-Shiller Home Price Index is also lagged due to its averaging structure. But the HPI is also exceeding economist expectations that ought to incorporate these facts. Consensus expectations were for the index to be flat on a year-on-year basis; instead, it rose 0.50% (June/June for the S&P/CS Composite-20) or 1.22% (Q2/Q2 for the broad US HPI) depending on your preferred flavor.
That news today, however, was blunted by the fact that Consumer Confidence posted its lowest reading of the year, fully 6 points below expectations at 60.6. The good news is that the subindex “Jobs Hard to Get,” which is usefully correlated with the jobless rate, was essentially unchanged at 40.7 (see Chart, source Bloomberg), which is encouraging since the rise to this level augured the bump higher in the Unemployment Rate a few months back.
Incidentally, this is a great illustration of the fact that we are good at internalizing the actual condition of the employment situation. Respondents tend to say that jobs are getting harder to get before the Unemployment Rate actually rises. This is in sharp contradistinction to inflation, which we are very poor at internalizing. Survey responses about inflation tend to lag reported inflation, suggesting that respondents anchor on reported inflation; moreover, survey responses about inflation expectations also have an extremely high correlation to trailing inflation – which also suggests anchoring on the reported number, and by the way makes it hard to argue that “contained inflation expectations” might act as a meaningful brake on actual inflation. We just aren’t good at evaluating the true inflation level, and our ‘personal inflation heuristics’ tend to be misleading because of cognitive biases (noticing rising prices more than falling prices, e.g.).
The weak Confidence number helped push bonds higher, but inflation-linked bonds rallied more than nominals, again. The 10-year inflation swap reached 2.59% today, up 0.26% in just over one month. Ten-year expectations are tracking gasoline prices to an unseemly degree (since 10-year gasoline prices are not moving nearly as much as spot gasoline prices!); retail unleaded gasoline is now over $3.75 and near the highest levels ever recorded for this date. This ought to affect 1-year inflation expectations, and it has: the 1-year inflation swap has risen 100bps since gasoline bottomed at the end of June. But the effect on the 10-year point is surprising, and suggests that investors believe the energy price rise isn’t the usual (mean-reverting) type but driven by different underlying price dynamics.
Stocks were again near unchanged, and volumes again were punk. But we’re yet another day closer to Jackson Hole, to the next Employment Report, to the next ECB meeting, and to the next Fed meeting. Speaking of the ECB, it raised eyebrows today when ECB President Draghi today canceled his trip to the Jackson Hole symposium, citing a ‘heavy work load.’ Poor, overworked Mario! Some investors took this to mean that the “heavy work load” involved imminent ECB actions, but I suspect that too much is being read into this. More likely, he is simply trying to avoid being lectured to about his monetary largesse – which has lifted year-on-year Eurozone money growth to a whopping 3.3%, the highest since 2009 – by policymakers who until recently were sporting M2 growth around 10%.
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Yesterday, in talking about money velocity and the multiplier and so on, I alluded to an interesting relationship that I stumbled upon with respect to velocity. I’m not completely sure what to make of it. Here it is (chart source Bloomberg):
The yellow line above is M2 velocity. The white line is the S&P 500, divided by 10-year average nonfarm, nonfinancial corporate profits before tax (from Fed report F.102), which are easier to find on Bloomberg than S&P earnings. Because the earnings series covers earnings for a much wider swath of corporate America than is included in the S&P, this isn’t an earnings multiple per se. It can fall because equity prices fall, or because earnings rise, or because the share of corporate earnings represented by the S&P declines. (This is the reason that the S&P appears much cheaper on this measure than if you use 10-year Shiller earnings on the S&P itself.) However, generally speaking this chart ought to trace the broad outlines of market valuation.
And this is very interesting. Prior to the first quarter of 1987…really dating right up to when Greenspan took office, plus or minus a few months…equity valuations varied inversely with changes in velocity. After that point, represented approximately by the vertical line, equity valuations varied directly with changes in velocity. In fact, the regime shift is shockingly abrupt, and shockingly clear. Almost every wiggle on the left of the chart is mirrored (the correlation of levels is -0.739); almost every wiggle on the right of the chart is echoed (the correlation is +0.745).
My friends, that’s odd.
And I don’t really know what to make of it, at the moment. What happened in 1987 to change this relationship? Was it one of these things?
- The stock market crashed.
- Alan Greenspan became Fed Chairman.
- The money multiplier peaked. Could the direction of change in the money multiplier have anything to do with the interaction of money velocity and asset prices?
What else? I am not presenting answers today, just more questions – and I am curious what readers may come up with.
What Keeps Me Awake At Night
Well, perhaps we can have one more day of quiet markets. With London closed, volumes were again thin. The most notable movement was the sharp rally in energy markets overnight, led by gasoline. This was provoked by Tropical Storm/Hurricane Isaac, but a huge explosion (killing 41 people) and fire in a Venezuelan refinery helped the rally.
Strangely, though, NYMEX Crude and other non-gasoline products plunged hard once the floor opened. Oil lost about 3% in 45 minutes or so, which is a typical news-reaction signature; however, there seemed to be no news. Bloomberg attributed the selloff to “speculation that Isaac won’t do much damage,” but I have trouble buying that. Such an explanation doesn’t explain the sharpness of the move (it isn’t like that realization abruptly swept the entire trading floor and electronic exchanges simultaneously). Moreover, since the storm track as of late last week hadn’t been expected to take it far into the Gulf, oil prices hadn’t rallied much on the notion that it would do damage. Thus, it doesn’t make sense (to me, anyway) that there would be a sharp correction based on a change in opinion that happened over the weekend.
I never did see any news to explain this sudden move, which makes me suspicious. I would expect that if there is any damage at all to Gulf equipment, the President would rapidly tap the Strategic Petroleum Reserve (given any excuse, so that it doesn’t appear political), but it doesn’t appear likely at this point that there will be any such damage. I probably just missed some news.
Bond rallied, with 10-year Treasury yields down 3.5bps to 1.65%. But 10-year TIPS yields rallied more, 4bps to -0.66%, so that 10-year inflation expectations rose slightly. This seems Bernanke-inspired, since an announcement or hint from the Chairman that QE3 will soon commence would tend to push down nominal yields but push up inflation expectations.
Investors clearly believe that the Chairman will signal QE3 is coming when he speaks on Friday, although the consensus among Bloomberg-polled economists continues to be that it will not happen. I think the fact that markets are discounting such an outcome increases the odds that it will happen, since he probably would prefer not to disappoint markets. Still, he’s not the wimp that Greenspan was in this regard. The ‘Maestro’ very rarely led the music; unlike the typical maestro, he tended to follow and validate what markets were expecting. Bernanke sometimes marches to his own drummer. In this case, though, I think he called the tune, and we’re marching to his beat rather than hoping he marches to ours.
Speaking of that beat, the NY Fed blog had a piece today that is interesting for its timing. Entitled “Interest on Excess Reserves and Cash ‘Parked’ at the Fed,” the authors (Gaetano Antinolfi and Todd Keister) sought to argue that:
Because lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed, it must not change the total size of the monetary base either. Moreover, lowering this interest rate to zero (or even slightly below zero) is unlikely to induce banks, firms, or households to start holding large quantities of currency. It follows, therefore, that lowering the interest rate paid on excess reserves will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed.
While this is true, it is also irrelevant. The question is what would happen to excess reserves compared to required reserves. There are two ways that excess reserves can decline. First, the Fed can reduce the size of the monetary base by selling securities. Second, banks can expand their own lending books, increasing the amount of required reserves. This is, after all, the supposed point of the Fed increasing the size of its balance sheet, a point seemingly lost on these economists. The quantity of balances held by banks at the Fed would be unaffected by a change in IOER, but balances held at the Fed aren’t the important variable – M2 (or some other measure of transactional money) is the important variable, and if bank lending increases, then transactional money increases as the multiplier between base money and M2 rebounds.
Here is the path from base money to inflation, in a simplified framework.
- Base money x multiplier = transactional money (M2)
- P = MV/Q
In a flowchart form:
So, here is what has happened since mid-2008
| Date | Base Money | M2 Multiplier | M2 | V | Q (Real GDP) | GDP Deflator |
| 6/30/2008 | 0.836 T | 9.2859 | $7.763 T | 1.8570 | $13.311 T | 108.302 |
| 6/30/2012 | 2.656 T | 3.7786 | $10.036 T | 1.5540 | $13.558 T | 115.031 |
| % Change | +217.7% | -59.3% | +29.3% | -16.3% | +1.9% | +6.2% |
You can confirm for yourself that the change in base money times the change in the multiplier equals the change in M2 by calculating (1 + 2.177)(1 – 0.593)=(1 + 0.293), and that MV=PQ by calculating (1 + 0.293)(1 – 0.163) = (1 + 0.019)(1 + 0.062).
The first thing that jumps out at me here is that the absolute changes are huge. By itself, this should be scary to a policymaker, since unless there’s some natural reason that things will unwind the same way they built up, there is a big mess to clean up. And I think the Second Law of Thermodynamics (which says essentially that you can’t put the poop back in the goat) makes that optimism ill-placed.
The second thing is that there are two variables in the table above that we are exceptionally poor at forecasting: the money multiplier, and velocity. It seems like the money multiplier responds, or should respond, to incentives to keep money in sterile excess reserves rather than to make loans: Interest on Excess Reserves, the quality of credit in the economy generally, moral suasion, legislation that encourages risk-taking among lenders, and so on. However, we don’t have a good idea how these factors interact to affect the multiplier. We do know that between 1994 and 2007, the only time the multiplier moved outside of the range of 8.2 to 8.6 was right at the end of 1999, when the Fed flooded the banking system with reserves ‘just in case’, but then took them right back out a few months later. In 2007-08, the multiplier rose to 9.4 before plunging once the Fed began QE (see chart below, source Bloomberg).
Velocity, similarly, is something that we don’t fully understand the drivers of (although I stumbled on something really interesting just now that I’ll share sometime over the next couple of days). We do know that velocity was in the range of 1.6 to 1.8 from 1960 to 1990, before rising to just above 2.1 in the late 1990s and then commencing a long slide to its current level, which is the lowest post-war level on record (see Chart). But we’re not totally sure what drives it.
Any way you slice it, the multiplier is at outrageously low levels, as is velocity. It is this combination that has kept the large increase in ‘base money’ from producing sharply higher inflation. If we had a solid understanding of why these two variables behaved this way in the last couple of years, it may not be as much of a concern – but we don’t. And we don’t know where they may go next. I would postulate that recent bank lending increases could presage an increase in money velocity, which in any event is probably more likely to move higher into the historical range than continue to move lower. I would suggest that lowering IOER could cause the money multiplier to rise again, while hiking it may cause the opposite (but, admittedly, we’re not sure what the marginal impact is of an IOER change, since there has only been one in the course of monetary history in the U.S.).
Let’s see why we might care. The table below is derived from the flowchart above, and the assumption that real GDP rises 6% over the next eighteen months (that’s not a forecast, but an optimistic assumption that helps to reduce the inflation numbers in the table below. Good growth, I figure, is more likely to be associated with a rebound in velocity, so I want to be fair.). I am sure we all agree that whether or not IOER declines, it is unlikely to rise appreciably in the next 12-18 months during which Bernanke will still be Chairman and the Unemployment Rate will still be over 6.5%-7% at best.
The table calculates the resultant rise in the price level (aggregate, not annualized) if the monetary base is unchanged, GDP rises 6%, and the multiplier and velocity are as shown on the axes. So, for example, if the multiplier rises to 4 and velocity rises to 1.6 (and growth is a healthy 6%, meaning a 4%-6% annualized pace over 12-18 months), then the GDP deflator would rise a gentle 3%, right in the sweet spot of monetary policy, assuming the money base didn’t grow further. On the other hand, if the multiplier remains around 3.5 and velocity slips slightly further, to 1.55, then in the absence of money growth we would have a 13% decline in the price level.
| Velocity | ||||||||
| Multiplier |
1.5 |
1.55 |
1.6 |
1.65 |
1.7 |
1.75 |
1.8 |
1.85 |
|
3 |
-28% |
-25% |
-23% |
-20% |
-18% |
-16% |
-13% |
-11% |
|
3.5 |
-16% |
-13% |
-10% |
-7% |
-4% |
-2% |
1% |
4% |
|
4 |
-4% |
0% |
3% |
6% |
9% |
12% |
16% |
19% |
|
4.5 |
8% |
12% |
16% |
19% |
23% |
27% |
30% |
34% |
|
5 |
20% |
25% |
29% |
33% |
37% |
41% |
45% |
49% |
|
5.5 |
33% |
37% |
41% |
46% |
50% |
55% |
59% |
63% |
|
6 |
45% |
49% |
54% |
59% |
64% |
69% |
74% |
78% |
More frightening, perhaps, is what would happen if the multiplier rose to 5.5 (which is only 40% of the way back to its 1994-2007 average) and velocity merely returned to the low end of the historical range, at 1.6. Even if the money base didn’t grow one penny, prices would have to rise 41%. In fact, I would argue that while this table shows a path to deflation – we need continued weakness in the multiplier and velocity, coupled with a Fed which suddenly puts the brakes on the balance sheet – it shows many more ways to get truly disturbing outcomes on inflation.
Projecting a correction in these metrics over 12-18 months is probably destined to look bad. If we look at a longer time horizon, then GDP growth can help blunt some of the effect of rebounding multipliers and the price increase would also be smeared over a longer time period. But even here, the news is not great. If the economy grows 3% per year for five years (not shown in the table above), and the money base doesn’t change, the multiplier returns to 5.5% and velocity gets back to 1.6, as above, then the total price rise of 30% would still represent roughly 6% inflation per year.
The only way you can get tame inflation over an extended period, unless the multiplier and velocity are permanently broken (especially the multiplier), is if the Fed shrinks the balance sheet with the same aggressiveness with which it built it.
I don’t see that happening under Bernanke, or under most potential replacements for him.
Tempestuous Times
At last, we are in the home stretch of August. This month has been excruciating by any measure – even by the measure of normal Augusts. Heck, even by the standard of normal Decembers; right now, New York exchange volume is on pace to be 15% less in August than on the slowest December in the last decade-plus.
That’s remarkable, but I remain unsure of the significance of this lull. We are plainly in the midst of a secular decline in trading volumes, and at least some of that is healthy since there was probably too much of the frenetic, momentum-type trading that adds to swing amplitudes. The flip side, though, is that some of the decline in volumes reflects a decline in market-making activities, which are typically ‘speculative’ in that they are short-term in nature but nonetheless add liquidity and decrease swing amplitudes. Again, I don’t have a clear answer to this.
It is tempting to say that it represents part of what Bill Gross means when he says “the cult of equity is dying.” Maybe it does, but I don’t see a lot of evidence that the cult of equity is dying. The average pension fund today has maybe 50% stocks rather than 60% stocks, most 401(k) accounts don’t offer commodity funds or inflation-linked bond funds but instead 12 flavors of equity funds, and Jim Cramer is still on the air.
Still, faith in “the system” is indeed at an ebb that hasn’t been seen since my lifetime, anyway. Perhaps in the 1970s the counterculture lost faith in America, but the majority still believed that working hard resulted in a person getting ahead, and that one’s children were likely to enjoy a higher standard of living than one’s self. Most of us would still like to believe this, but at least one party believes strongly that these days you can’t get ahead without a hand up, and members of both parties (and every sentient being) knows that the entitlements currently promised virtually assure that our young are being yoked to the Medicare plow. And yet, stocks trade above a 20 Shiller multiple and 30-year bonds sport a 2.80% yield!
Tempestuous times tend to produce momentous change.
We remain in tempestuous times, although we heard nary a peep from Europe this month. The global economic system is creaking again. On Friday, Durable Goods was much weaker than expected, with core durable orders -0.4% and revised downward by -1.1% to the prior month (from -1.1% to -2.2%). That produces the lowest year/year growth in core Durables since early 2010. As the Fed pointed out in their minutes, the U.S. economy is not ready to take another punch, and another punch may well be coming from Europe in the next few months.
It is therefore not surprising that presumptive Republican nominee Mitt Romney says that if he is elected, he would not re-appoint Ben Bernanke to be Fed Chairman when his term ends in a year and a half (January 31, 2014). In good times, candidates want to bestow laurels on the Fed Chairman (such as when Arizona senator McCain in a 1999 debate said that if Chairman Greenspan were to die in office, ‘I would do like they did in the movie Weekend at Bernie’s. I’d prop him up and put a pair of dark glasses on him and keep him as long as I could’), whatever his merits.
It is also not surprising, in times like this, that a political party (again, the Republicans) would consider a platform plank calling for a full audit of the Federal Reserve as well as one calling for a commission to study a return to the gold standard. These are momentous proposals! Change is a good thing, but in times like these we must always be careful of deploying change for change’s sake. I don’t think any of those proposals would threaten the republic, but going back to a gold standard would be too much in my opinion.
I don’t think a commodity or gold standard is necessary, if the central bank is run correctly, and in fact such a linkage could create rigidities that prevent some of the automatic stabilizers in the macroeconomy from working correctly. But it comes down to a question of whether central bankers can be trusted to do what they can, and to understand what they cannot do, and to eschew what they can, but should not do. Organizationally, I am not sure any groupthink body can manage something as complex as the U.S. macroeconomy, to say nothing of the world economy.
So what’s the alternative? ‘Ending the Fed’ and returning to a gold standard is one solution, but it sort of throws the baby out with the bathwater. Paul Ryan’s proposal in 2008 to limit the Fed’s mandate to only inflation, rather than the impossible dual mandate, would be significant progress (and is unlikely to happen). Failing that tweak, I still think the Federal Reserve can be more effective than it has been through the last two Chairmanships. The middle road between a gold standard and a continuation of business-as-usual – which would have, incidentally, completely opposite implications for inflation – is to appoint a better Chairman. A person who has a steady hand, a healthy respect for the difference between data and facts (data are just estimates of facts, not the same thing), and a healthy respect for the difficulty of certainty. A person who (as I say in my book) recognizes that the person running the Fed is in a short-options position, and therefore should focus on doing only the things which clearly must be done. A person who won’t tinker.
Now, we’re unlikely to get such a thing, because the prevailing wisdom is that the central banks should do everything they can. They should be in continuous motion, balancing and re-balancing, optimizing and re-optimizing. Choosing between that on one hand, or a gold standard on the other, is a much harder choice.
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Speaking of commodities, the market seems to believe that we’re more likely to keep our activist central banks than to get a gold standard, and hence more likely to get inflationary rather than disinflationary/deflationary outcomes. The chart below shows the current technical condition of the DJ-UBS commodity index. As regular readers know, I don’t spend a lot of time looking at technical analysis; I do, however, think it can be useful in testing hypotheses and in ‘taking the temperature’ of the investing public.
The DJ-UBS chart shows a break higher from a base on the last day of June, followed by a consolidation in early July that produced a second breakout and a longer consolidation band. This second plateau, covering late July through mid-August, seems to be resolving higher as well although without the sharpness of the prior thrusts. But the crucial test is whether the index can remain above 145 here and extend higher.
The evolution of Tropical Storm Isaac may help. While so far all the storm has done has been to cancel one day of the Republican convention, it is moving into the Gulf of Mexico and generating the possibility of disrupting gas and oil production there. It is not expected to strengthen above Category 2, so this isn’t going to have the monstrous effect of Katrina, but it won’t hurt the technical situation of the commodity indices any.
So what do these tempestuous times and momentous changes mean for markets? At the moment, they mean little, because the momentous changes are unlikely to happen if the current Administration wins a second term. But for the first time in a very long time, the two parties are offering very different views of America and very different plans; and that means that for the first time in a while, it actually may matter to the markets which party actually rules once the votes are counted. At present, polls have the Presidential race very tight, but with the Republicans favored to pick up some seats in the Senate and to retain control of the House. There is a chance, although still odds-off, that the Republicans gain control of both houses of the legislature and the executive branch as well. The difference in the policy portfolio in that circumstance, compared to the status quo or one in which the Democrats seize control of the House of Representatives as part of a general electoral landslide (this is much less likely than the reverse, since the House is the body that is most skewed at the moment – towards Republicans), is huge.
Is a Republican sweep good for bonds, since the fiscally conservative credentials (if taken at face value) would imply lower future debt issuance, or bad for bonds, because a President Romney would make QE3 less likely? This isn’t entirely clear to me, but more volatility and consequently more volume seem likely, as more focus turns to these polls over the next month or two. This election will matter to markets.
We Have Been Here Before
We have been here before. Prior to the last FOMC meeting, there were many signs that the Fed was preparing action, and they produced nothing. Prior to the ECB meeting, with Draghi pounding the table about the extraordinary defense of the Euro union that they were prepared to mount, they did nothing.
So, that being said, I will admit to experiencing some pleasure when the FOMC minutes for the August meeting, released yesterday, showed a substantial amount of discussion around the issues of QE3 and of paying interest on excess reserves. Pleasure – although not without some tinge of dread, since I think QE3 is the wrong thing to do – because although I was wrong about what the August 1st meeting would actually produce, it turns out that I wasn’t terribly far wrong about the state of the debate. It is ever the case that predicting a committee’s action on a particular date is difficult, just as it is difficult to predict the winner of any particular baseball or basketball contest. But, if you figure out what argument, and whose voice, is likely to be the overall strongest in the committee, then you’ll be right more often than not, and you’ll get the contours of policy right (to extend the prior analogy, you’ll correctly assess who wins the division, if not the game, if you know which is really the stronger team).
The FOMC minutes expressed as much urgency as we thought they felt at the August meeting; we just didn’t get the result we expected from that urgency:
“Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”
Many members is, if anything, displaying a bit more alarm than I’d thought was present at the Fed. We already knew that the Chairman felt this way, since after the June FOMC meeting he said in his presser: “If we don’t see continued improvement in the labor market, we’ll be prepared to take additional steps if appropriate.”[emphasis added]
Way back in June, I said that I thought a “soft” Evans rule was in place now, and both Bernanke’s statement above and the minutes of this last FOMC meeting suggest that the Fed is growing impatient with growth. To be sure, I don’t think there is anything significant they can do about growth, but what is important is what they believe and, against all evidence, they feel that they can move Q (in MV≡PQ). Soon, they will take another shot at it.
Now, what’s interesting to me is that the market reaction to the minutes was actually rather tepid. On Wednesday, the S&P 500 rallied a grand total of about four points on the release of the minutes, and today prices fell 11 points. But the dollar fell both days, gold was up $32 today (the pit closes at 1:30ET, so there was no reaction yesterday), and gasoline was up both days. Treasuries rallied, which is a response to the notion that the Fed will probably be buying more bonds, but TIPS rallied more, which means that even as rates declined, inflation expectations rose. 10-year inflation swaps are now as high as they have been since early May (see Chart, source Bloomberg), and 5y, 5y forward inflation is approaching 3% again. I don’t think it stops there.
And remember, this is all anti-seasonal. Only three times in the last thirteen years have 10-year breakevens been higher on September 1st than on May 1st. Right now, 10-year breakevens stand higher than they were on May 1st.
Probably, that means that breakevens are due for a correction. Certainly, I think they are vulnerable to a disappointment if, at Jackson Hole next Friday, the Chairman downplays the Fed’s resolve. But right now, I find it hard to imagine that anything has happened since early August that would make Bernanke back away from a very dovish stance. I am not one of those who thinks the Fed will, or should, worry about appearing “political.” Whatever the Committee does in mid-September certainly won’t have any measurable effect on the economy as early as late October! On the other hand, if they were to act on October 24th (at the next meeting), it could plausibly affect short-term confidence – so if you’re going to skip a meeting, it’s that one that you want to skip.
What I think is more important is that with retail gasoline back above $3.70, the window for further dovish action is going to close swiftly. The doves on the Committee have gotten very fortunate to have had core CPI flatten out and even decline a couple of tenths largely on ephemeral base effects, and headline inflation is also low thanks to the prior decline in gasoline prices. By the December 12th meeting, headline inflation will be much higher than it currently is, simply because of the rise in gasoline, and core inflation will likely be upticking again as well. I really don’t think the time for announcing another tranche of quantitative easing will get much better.
Finally, the Minutes reveal a great sensitivity to the vulnerability of the economy to a shock from Europe. If there is going to be a shock from Europe, does it make more sense to take out insurance against it now, or in December?
The September meeting itself is still weeks away, and there is another Employment report and substantial additional data before then. But on the evidence today, I think the Fed is loading the pistol for another shot. Markets will probably spend the next week or so (at least) bracing for it. I’m still bullish on commodities, and bullish (albeit somewhat wary) about breakevens.
It’s In ‘The Hole’
As the end of August approaches, the somnambulation of the markets should be slowly diminishing. Events are still proceeding in slow-motion, but investors will gradually wake up and re-assess their surroundings in the days remaining before the Jackson Hole colloquium that represents the next major scheduled event on the domestic calendar.
But even in the dog days of August, governments borrow and spend money, and sometimes they even have to pay it back. Today, the emerging market of Belize missed a bond payment as its deficit swelled to a level of (gasp!) 2.5% of GDP, and the Prime Minister declared a restructuring is needed since the country simply doesn’t have the ability to pay the 8.5% coupon on its superbond. Isn’t it nice to be a superpower? The U.S. runs a deficit of around 8% of GDP, and our creditors seem to have no quarrels with us – at least, for now.
Of course, we’re too busy to worry about Belize when Greece beckons. Greek Prime Minister Samaras is asking for a two-year extension of the deadline for deep spending cuts and tax increases, but German Financial Minister Schaeuble (among others) said over the weekend that “It can’t be helped – we can’t make yet another new program. There are limits.” http://economywatch.nbcnews.com/_news/2012/08/20/13377541-germany-forcing-greeces-day-of-reckoning Certainly, the suggestion that there are limits to European largesse in the case of Greece is not a new one; the appearance of actual limits is still what all parties are waiting for. We are approaching the next showdown, surely.
More stirring was the report over the weekend in Der Spiegel that the ECB is considering a program to ‘cap’ European rates versus Bunds, such that they would determine an “appropriate” spread (appropriate in a cosmic justice sense, one supposes, not in a ‘market clearing’ sense) and then buy unlimited quantities of bonds of countries whose yields strayed above the cap. The idea, surely, is to make the cap unnecessary, since rational (and, it should be pointed out, credulous) investors would buy unlimited amounts of bonds just shy of the cap, knowing they had a much higher upside than downside, guaranteed. But ask Soros and the Bank of England how that works, when the economics aren’t there.
The Bundesbank, predictably, came out with immediate criticism of such a plan, which isn’t surprising since they had previously spanked Draghi for suggesting that the ECB would do “whatever it takes” to preserve the Euro. The ECB promptly hove to today, as well, muttering something about how it’s “misleading to report on decisions, which have not yet been taken and also on individual views, which have not yet been discussed by the ECB’s Governing Council, which will act strictly within its mandate.” And, of course, that begs the question of why they leaked the notion in the first place. Who’s in charge over there, anyway?
It also was unclear if the idea of an automatic cap replaced the prior assertion that the countries themselves must formally request help, or was in addition to that requirement.
All in all, it should be an interesting autumn.
But I nevertheless contend that the first really important event for the market is going to be the Bernanke speech at Jackson Hole on August 31st. The machine is already at work, setting up the arguments so that Bernanke need only nod in the general direction of what the Fed is going to do. An article on Bloomberg yesterday was entitled “No Inflation Proves Critics of Fed’s Bernanke Wrong.” The content of the refutation is essentially that it’s obvious that Bernanke was right, all of those opposed are just ‘haters, and clearly the money-printing didn’t cause inflation.
However, since the money-printing also didn’t evidently cause unemployment to improve very much, we are left with this: either monetary policy simply doesn’t matter, and affects neither inflation nor growth in any important degree (in which case we can safely disband the Fed since it’s just an economist-employment project), or it does matter, and it’s too early to judge the effects of a rapidly-expanding money supply which, until one month ago was still expanding at better than 10% per annum. After all, along with that expanding money supply we did, until three months ago, have core inflation that was accelerating every month, so that’s hardly an open-and-shut case in favor of the notion that large amounts of money don’t cause inflation. Moreover, clearly the Fed itself believes that QE causes inflation, or it wouldn’t have cited the possibility of deflation as a key reason for QE1! They seem to want it both ways: money-printing causes dis-deflation, but doesn’t cause inflation above target.
In my view, it is very premature to declare victory over core inflation merely because we have had a couple of months where core inflation went sideways – mostly due to base effects.
But as investors, what is more important in the near-term is that this argument is silly to make now, when its veracity won’t be judge-able for at least a year or two, unless the purpose of the argument is to encourage additional monetary easing.
Perhaps you may think that my cynicism knows no bounds. This may well be true, but is not relevant at the nonce. Consider that the Fed also has just released a study (summarized here) that argues there is much more ‘cyclical’ unemployment left from the recession that can yet be reversed. This tends to mean (according to the Bloomberg article) that more can be done on the employment front without spurring inflation. Other economists cited in the Bloomberg piece, who think structural unemployment is higher, figure that if the unemployment falls too fast it could spell inflation.
I have pointed out here a number of times that there is no strong relationship between unemployment and overall inflation, although there is a decent relationship between unemployment and wages (see this article for some pretty charts). Lower unemployment would mean higher wages, and probably higher real wages, but it doesn’t necessarily mean broad inflation (consider the late 1990s).
So we have an argument that inflation is tamed and Bernanke was right, and we have an argument that there is still more room for policy to lower unemployment without triggering inflation. Yes, I am cynical, but as investors it sometimes pays to be that way. If I were looking to push further unprecedented monetary policy on a suspicious investor community, these are just the sort of articles and studies I would like to see floated.
Post-CPI Tweets (And Further Thoughts On CPI)
Here is a collection of my post-CPI tweets (follow @inflation_guy) and some additional thoughts:
- Looks like +0.09% on Core CPI – incredibly, rounded UP. Lots of little drags – vehicles, computers, utilities. Some very curious.
- y/y core down to 2.10%, no rounding needed. This is a BIG downside surprise in CPI, which was biased to a round-up.
- Energy subtracted from headline – last time for that for a while.
- Electricity, which is 3% of overall consumption, fell 1.3% on the month. That’s a lagged response to natural gas’ decline, probably.
- CPI number gives a bit more latitude for the Fed’s QE3. Not that 2.1% vs 2.2% is great, but will make contours of infl look better.
- Primary rents +0.3%, OER +0.2%…together is 30% of overall basket, and the stickier part.
- Accelerating CPI groups: Med Care, Other (12.2% of basket); decelerating: Food/Bev, Housing, Apparel, Transp, Educ/Comm (81.9%!)
- …fair amount of CPI deceleration was base effect of last July falling out. Pressure is on the inflation bulls (me incl) hereafter.
- VERY interesting…Cleve Fed’s Median CPI +0.2%, Y/Y stayed at 2.3%. This is the most that Median has been above Core since 2009.
I don’t think my view of the likely trajectory of core CPI has changed much. Housing remains buoyant, and certainly there are no signs that housing inflation is going to decelerate going forward, since surveys of primary rents are rising comparatively briskly. If housing isn’t going to slow down, then it’s hard to get a meaningful deceleration of core CPI going.
The base effects at work here shouldn’t be underestimated. Apparel prices rose, and rose on a seasonally-adjusted basis, but year-on-year apparel inflation declined. As the chart below shows, however, this doesn’t mean that apparel prices are falling and in fact the character of apparel price inflation still appears to have undergone a tectonic shift.
August 2011 core CPI, which will fall out of the year/year calculation next month, was +0.24% and will create a decent chance of another slip lower in core CPI. But the four months following that were all +0.17% or less, which means that the local low for y/y core CPI is almost surely in August. If traders perceive a bigger swing in the CPI than is actually happening, it will represent an opportunity to get long breakevens or inflation swaps at lower-than-current levels.
Outside of core inflation, there are relevant trends building in food and energy. Although retail gasoline prices are only up about $0.12/gallon from a year ago, they’re also up $0.40 in the last six weeks at a time when most observers were expecting continued low prices. Some of this is Middle East tension, but a fair amount of it is related to domestic refinery issues and, of course, the increase in money. Energy prices will continue to ebb and flow, but gasoline prices within $0.40/gallon of an all-time high at a time when the global economy is sputtering at best should not be discounted. “Slack demand” isn’t working. Since 2004, retail gasoline prices are up at around a 9% per annum pace (and much faster if you measure from the 2008 lows, which erased 2004-2008 gains), while M2 is up at a 6% per annum pace over the same period. This just in: more money in the system means that money depreciates relative to hard commodities.
While the current cycle in grain prices, to be followed soon by livestock prices, is likely amplified by the domestic drought and other food crop problems worldwide, I think it is unlikely that we will see prices back to the lows of a few years ago. As I pointed out here, real grain prices are not particularly high at all, and arguably are low considering the current crop condition.
These are not in core inflation, and there is nothing that Fed officials can do to restrain these prices separately from their efforts to restrain all prices; accordingly, it is still reasonable for policymakers to focus on the more-stable core CPI and median CPI in setting policy. It doesn’t mean they don’t care about food prices going up. It doesn’t mean they want everyone to live without energy. It is just that they need to focus on a less-noisy series. At the same time, though, a rise in food and energy prices narrows the window during which the Federal Reserve can point optimistically at headline inflation being below core inflation. If the Fed is going to ease, I think it is going to be in September or it’s not going to happen. And if that’s going to happen, then I think we’ll hear Chairman Bernanke speak generously about the capabilities of monetary policy at the Jackson Hole conference, which begins August 30th.
Astonishingly, despite weak inflation data and a very weak Empire Manufacturing report (consensus was +7.00 and the print was -5.85, bonds sold off anyway with the 10-year yield up 5bps at 2:40pm (when I am writing this) and real yield actually up more (10y TIPS +7bps to -0.46%). Equities traded listlessly, and commodities rallied. So, even though I was completely wrong yesterday about what was going to happen with core CPI, I was fortunately also wrong about the market reaction. In this case, two wrongs make a right, although I don’t recommend pursuing this method of prognostication on a regular basis.
Cloudy With A Chance of ‘Bummer’
For as quiet as it is, the current selloff in 10-year Treasury yields is the worst since March. The 35-basis point selloff still only puts 10-year yields as high as 1.73%, which is lower than they were at any time in 2011 except for one spike in September.
Real yields, however, have sold off only 17bps (current 10-year TIPS are at -0.55%), and moreover are still far from anything that looks like a reversal on the chart. Heck, the chart (Source: Bloomberg) looks almost linear. The TIPS market has never recovered from the fact that the Fed was for a time buying as much as the Treasury was issuing, so that for about 9 months there was no new supply in the market.
You would think that issuers would be lining up to issue at these real yields, but they are much more excited about issuing at these nominal yields. There just isn’t enough supply of inflation-linked bonds at these levels, which is one of the reasons that TIPS yields will rise, but more-slowly than for nominal bonds, if this selloff continues.
The economic data is not conducive to a continued selloff, at least using the traditional rule of thumb that weak growth is good for bonds and strong growth is bad for bonds. European data today showed the Eurozone in contraction, as expected. Our domestic Retail Sales data was stronger-than-expected, but that was entirely accounted for by the upward revision to the prior month’s data. The data recently have been on a modest upward trajectory, but there is nothing to be seen that smacks of a robust recovery. Meanwhile, some very large trading partners of ours are having serious growth issues. Yields are not 35bps higher because of “green shoots,” that seems sure.
When you think about it, though, the traditional notion about growth being bad and recession good for bonds was largely formed in a period during which growth and inflation tended to move somewhat together because the central bank followed a conservative rule about money growth. There is no reason that it need necessarily be the case that slow growth is associated with low yields, any more than it is necessarily the case that slow growth be associated with low inflation. In the 1970s, yields were much higher than they are now despite similar economic languor. In fact, yields right now are even quite a bit lower than they were in the depths of the Great Depression (see Chart: source Federal Reserve, Technical Data, Bloomberg)!
So the rule of thumb really is that bonds respond to changes in growth expectations when inflation is low, and to changes in inflation expectations no matter what. This happens because while there’s some de facto if not de jure ceiling for real rates – even if it is a little squishy – there is no ceiling or floor for inflation expectations.
Speaking of inflation, and inflation expectations, tomorrow the BLS releases the monthly CPI figures. Last month’s print included a month-on-month core reading of +0.205%: the fourth consecutive month of at least +0.20%. The Wall Street consensus for tomorrow is +0.2% headline and +0.2% on the core, and annual figures of +1.6% on headline and +2.2% on core. Given the base effects, this implies that the true forecast for core inflation is actually in the range of 0.15%-0.22%, because below that range the month-on-month core figure would be +0.1% and above that range the year-on-year figure would be +2.3%. There is a much better chance of a round up to +2.3% than there is of a round down to +2.1%, because the latter would require a +0.12% print on core, a substantial miss that should be hard to come by given the underlying dynamics of housing, apparel, and some other components.
A round up, mind you, would really bum out a lot of people, including Fed governors. For the record, if we got a clean +0.3%, or pretty close to it, on core inflation it would move the year-on-year figure to a new (unrounded) post-crisis high. If we do get a round-up, I’d expect the equity market and the bond market to both perform quite poorly as investors marked down the probability of QE3. Commodities in that situation should get a boost, but that market doesn’t always respond rationally. TIPS would probably also decline, but less than nominal bonds, and breakevens would widen.
I don’t think that’s a terribly long-shot outcome, for reasons I’ve discussed here over the last few weeks.
Let the (Political) Games Begin
The Olympics are over, so the political games begin in earnest. Over the weekend, presumptive Republican Presidential nominee Mitt Romney made his first revealing executive decision when he tapped Wisconsin Congressman Paul Ryan to be his running mate.
The selection changes the contours of the U.S. political race, as veep selections often do. It probably does not create any near-term consequences for the markets, but as and if the Romney/Ryan ticket gains in the polling (as they surely will; for starters, announcing a VP pick almost always produces a bounce but also this tends to energize the base that Romney absolutely needs good turnout from to win) it is likely to be beneficial to equity markets at the margin. The improvement, if it happens, will not be uniform. Some industries, such as autos, which benefit from direct government largesse will probably do worse; but the notion that smaller government may be in train with somewhat greater probability is likely to have positive impact on perceived long-term values. And any possibility that a fiscal conservative (that is, Ryan, not Romney) might be a senior member of the executive branch is likely to have salutatory effects, all else equal, on U.S. Treasury credit as well.
More than likely, these effects will be mere ripples in a much more turbulent pond. In an ordinary Presidential election cycle, markets and market sectors can ebb and flow with the fortunes of the incumbent and challenger; this cycle though is anything but ordinary. European events can, and most likely will, dominate the macroeconomic picture as well as global risk appetites and foreign exchange swings. Which is to say: you can cheer for whoever you want in this election, without worrying whether it will help your investments!
While most of Europe remains on holiday (and more and more Americans seem to want to emulate that behavior), market action remains excruciatingly slow. At 3:15 ET today, New York exchange volume was only 275 million shares and even the usual surge into the close only brought the total to 450 million. In a year of slow days, this was slower than slow. In fact, I was only able to find one session (other than half-sessions around Christmas or Thanksgiving) in the last ten years or so that had a lower volume number: the Monday after Christmas in 2010!
This lack of liquidity, with the stock market so near to setting new (nominal) highs for the year, creates instability even as it appears to suggest stability. As I argued last week, when liquidity is low there is a larger cost to initiating any move – but any move that happens is likely to be bigger.
Add to that the fact that many investors have turned to covered-call writing to earn “extra income.” Admittedly, I only have this anecdotally, as I was approached at a backyard party recently by someone who was writing naked puts (actually, they were writing covered calls, but because of put-call parity we know that that is exactly the same as writing naked puts with the same strike) and seemed to not understand my question about whether implied volatility was high enough to make that worth the risk.[1] Which, since the VIX is at its lowest level since early 2007, it’s probably not (see Chart, source Bloomberg).
If this anecdote generalizes, and there is widespread selling of options, then it takes a dangerously-illiquid situation and makes it even less stable. With lots of gamma outstanding, what tends to happen is that small moves become microscopic moves since long-gamma hedgers try to recapture their time decay (selling rallies and buying selloffs), but large moves become really large moves because short-gamma investors try to save themselves from blowing up (buying into a market rally that they’re missing, or selling stocks that are abruptly plunging, overwhelming their small ‘income’ advantage). I would be a much better buyer of options here, even in the middle of boring August.
Now, although markets are currently quiet, and government committees and the like are less-active as well (and in the U.S., elected officials are heading out to politick for the next few months), it doesn’t mean that there’s a complete lack of action. Indeed, with Dodd-Frank now steamrolling towards implementation, there are pockets of frenzied activity! One story that I saw today (which has nothing to do with Dodd-Frank) is interesting to investors since it lowers the hurdle for eliminating the payment of Interest of Excess Reserves (IOER). The title of the P&I Online story was “Money fund firms prepping in case SEC breaks the buck,” and it described how the SEC plans to vote on August 29th on whether to issue a formal proposal requiring the sponsors of money market funds to either create a ‘capital buffer’ (perhaps similar to what the NY Fed recently proposed, and I mentioned here) or adopt a floating NAV policy rather than guaranteeing a $1 price.
We’ve discussed both of these proposals before in this space, but for today the significance is that if the floating NAV policy is generally adopted by money funds, the argument that a zero IOER could destroy money funds goes away. Since this is very likely to happen soon, either alone or as part of a parcel of monetary policy maneuvers, it is not insignificant that the SEC is pressing this issue.
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Tomorrow the scheduled economic data includes Retail Sales (Consensus: +0.3%/+0.4% ex-auto). Core retail sales have been negative for the past three months in succession, something we hadn’t seen since mid-2010. Four in a row would make the streak the longest since 2008, and I think it would be taken quite negatively by the markets. A positive print by Retail Sales isn’t terribly significant by itself, since the series is quite volatile, but may be enough – even though expected – to continue to push the bond market lower.
[1] Note: if you do not understand and/or are not intimately comfortable with the definitional equivalence between a covered call and a naked put, then I will put my “friendly advice” hat on and beseech you, for your own good, not to sell options until you do!
How Disinflation Could Happen
While the markets are relatively quiet – bond yields rose slightly today and stocks were essentially flat; only commodities were reasonably buoyant – it may be a good time to examine the case for an acceleration of inflation and the risks to that case.
Inflation does not derive from excessive growth, nor deflation from excessive slack. While certain goods and services may experience relative price increases or decreases due to the microeconomic conditions of supply and demand, there aren’t any convincing examples of that happening for “aggregate” supply and demand in the absence of accommodating money supply growth. The clearest counterexample to the notion that growth and inflation are intimately interrelated is that in the period just past, the greatest recession in almost a century, year-on-year core inflation never declined, and if we remove the effect of the deflating bubble in housing, core prices in the rest of the economy never increased less than 1.1% on a year-on-year basis (see Chart, Source: Enduring Investments).
Nor is the expansion or contraction of the monetary base the key element in inflation. At one time, when the money multiplier that maps base money into transactional money (e.g., M2) was relatively stable, it didn’t matter if one used the monetary base – it was incorrect, but the relationship was stable so it didn’t matter. Once the Fed started paying interest on excess reserves, however, the relationship between base money and transactional money was artificially severed and it now matters which aggregate one uses. (See Chart, Source Bloomberg, which shows M2 divided by base money).
When the crisis hit, the velocity of money plunged as commercial bank lending dried up. The Federal Reserve properly countered this drop in velocity by pumping up the raw quantity of money. They did so in an awkward fashion; paying IOER meant the central bank had to add a lot more base money to cause M2 to rise appreciably, but it worked and prices as noted above never declined.
Now, commercial bank credit in the U.S. is expanding again, auguring a turn higher in money velocity in the near future. And yet, the Federal Reserve and other central banks continue to add money, setting up the potential for a long-tail inflation accident if velocity rebounds and the central banks do not begin to tighten in advance of that event. (I find that an extremely unlikely possibility, with Unemployment over 8% in the U.S. and no longer falling, and at least one Fed President calling for unlimited QE!) That doesn’t mean that we will get an inflation spike; in fact, year-on-year M2 growth is now under 7% here in the U.S. If money velocity doesn’t pick up, then core inflation may only rise slowly from here.
But all of that presumes a closed system where only the U.S. central bank affects the money supply that matters. Unfortunately, or perhaps fortunately, that isn’t the case. Inflation is substantially a global phenomenon, and here lies the potential for both optimism and pessimism on inflation.
On the pessimistic side, one must note that even if the Fed does not in fact pursue further QE, other central banks are sure to continue to do so. The Bank of Japan is not about to stop easing when core inflation in that nation remains below zero. The BOE continues to ease and the ECB has little choice but to ease further (or so they believe), and even the relatively responsible RBA is likely to keep money easy with China’s slowdown threatening on its doorstep. More money, all else equal, means more global inflation, and more global inflation – unless the U.S. dollar undertakes a serious and extensive appreciation – means more domestic inflation.
But on the optimistic side – for inflation, anyway – European money velocity may be on the verge of collapsing. If you want to make a case for slowing U.S. inflation, I do not believe you can look to the U.S., but rather must look to Europe. If domestic lending (and hence velocity) is rising partly because European lending (and velocity) is contracting, then some of the inflation potential is being sucked out, at least temporarily, by financial and credit strains in Europe.
In my view, the only plausible way we get appreciably lower inflation is if central banks abruptly stop quantitative easing (I don’t think there’s any measurable chance that they tighten) and the velocity of money in Europe (and Japan) drops faster than the velocity of money in the U.S. rises. In fact, I can make up a deflationary scenario, in which U.S. velocity rolls back over – perhaps because of some unforeseen consequence of the Volcker and conflict-of-interest rules, which some believe may impair securitization markets if the regulators don’t clarify certain issues – and central banks actually choose that moment to swear off QE. It’s very unlikely – mainly because I don’t think central banks will ever do more than pretend to care about inflation, and will keep on adding QE until inflation is not just a danger, but actually high enough that it becomes considered a bigger problem than persistently high unemployment.
However, if I’m wrong, I think the ‘optimistic’ (in a sense) scenario above is how mild disinflation could come to pass.
