Time is Running Out
All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.
The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).
I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.
And all it took was a few trillions!
It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.
So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.
We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.
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Thanks for another good article.
My own opinion, for what it’s worth (hint: nothing), is: I am a little leery of assuming that this expansion will *necessarily* be the same length as average prior expansions. We’ve just never, ever had such aggressive manipulation of the economy. Easy Al’s machinations in the 90s, which helped that expansion get to double the historical duration, don’t hold a candle to what’s going on now. You can certainly argue about how effective all this stimulation is, but to my simple mind, it seems like a different enough situation that it makes me nervous to assume the expansion will end like other ones have.
I guess my point is, I wouldn’t be surprised if things play out exactly as you say. But, I wouldn’t be surprised if they didn’t. (And that’s not necessarily a bullish view… I also wouldn’t be surprised if they keep this thing shambling along, letting the imbalances build up and up, followed by an even worse day of reckoning down the road).
Just some thoughts from a person who has found it very difficult to make predictions in this unprecedented, artificially manipulated environment. (Well, to make GOOD predictions, anyway).
I don’t disagree with a single word you said! I thought about reporting the variances around the average. They’re huge. 🙂
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Mike, on another note, I wonder if you might tell me what you think of a little theory I have.
I will admit that I am in the camp that was surprised at how little inflation we’ve had in the past couple years, given the aggressive level of Fed monetary policy. The Krugman camp has declared victory and taken this as proof that a “liquidity trap” is in play which allows for (and in fact necessitates) even more aggressive fiscal and monetary stimulus, without any apparent negative consequence.
But to me, a more simple explanation is that over the past 2 years, the rest of the world has been in an economic slump. Europe was in outright recession, and the emerging world (big trading partner to Europe) really slowed down. It seems like this should have had a big disinflationary effect as global demand was down. (I am in your camp that in the end, money supply is the more important determinant of inflation, but in the shorter term I do think higher economic activity pushes up inflation and vice-versa).
Now, there are a number of things in play here and I do actually suspect that private sector deleveraging has had a disinflationary impact as well. But it seems to me that the global slowdown was probably a big factor too. And, I really haven’t heard any commentary along those lines. So, it seems like if the worldwide economy does bounce back further (a process which already seems to have started), a lot of people could be surprised at what happens to inflation rates.
Any thoughts?
I find that the longer I watch inflation, the fewer variables I have in my models. Growth isn’t in my models. At one time I put great store on debt, because over the longer-term the level of private compared with public debt does have an impact on inflation. But you’ve seen my charts of interest rates versus velocity. This basically resolves what economists used to call the “price puzzle…” that when the Fed starts to push interest rates higher, quite often inflation accelerates. The predominant theory these days is that inflation never goes up. The second-most predominant theory is that “anchoring” will prevent that. The third-most relies on deleveraging. But the basic monetary theory ties velocity to interest rates…so it really isn’t much of a surprise. I sometimes wonder if when this is all over, we will be amazed at how “normal” this all acted with respect to the economic laws. It’s just that we have forgotten those economic laws, or are only just discovering them.
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Thanks Mike. I’ve been mulling this topic over a lot, and I’m having some trouble getting my head around it. (“It” being the idea that growth doesn’t matter, I guess, but also that rising interest rates cause inflation to increase).
For instance, I made this FRED graph: http://research.stlouisfed.org/fredgraph.png?g=nPf
It shows that recessions have been very disinflationary (ie, that the rate of inflation almost always turned down sharply during recessions). I graphed the Fed funds rate there too. Now I guess you could say that the reversal of inflation could be caused by the Fed lowering rates during the recession, as opposed to the slower growth. But the more widely accepted view would be that the slower growth pushed down velocity/inflation, and also prompted the Fed to lower rates. So there’s a correlation between rates and velocity, but couldn’t it just be because they are impacted by the same thing (growth)?
You explained the possible causality with the idea that higher rates put a greater cost on holding cash, so they cause people to spend more. But the problem I still have understanding this is that people really don’t hold “cash”… they hold bank deposits, which do pay a rate of return that goes up with the Fed funds rate, so there isn’t necessarily a penalty for keeping money in the bank if rates go up. (As long as they are short rates).
So I’m just generally having a tough time understanding why growth doesn’t necessarily matter… I certainly don’t agree with the mainstream view that it’s the only thing that matters (which leads to the “print away, you can’t have inflation with low growth” conclusion). But I don’t see how it doesn’t matter at all. There just seems to be such a good correlation there, and it makes sense intuitively that slower growth would temporarily slow velocity.
Sorry for the ramble. 🙂
Well, you’re looking at headline inflation, which is highly correlated to energy prices, and energy prices are highly correlated to economic activity. Also, as Fama pointed out long ago, it is usually the case that money growth declines in recessions (the Fed tightening is often what precipitates the recession).
So much of that correlation is spurious. If you graph core inflation, you won’t see a meaningful relationship (especially if you control for changes in money growth).
I’ve spent a lot of time trying to find something that’s well-correlated to velocity. I’ve written before about P/Es, for example. But if you go back to the original theory – read Friedman – and you find that interest rates are expected to be directly related to money velocity. I actually read that before it occurred to me to test it. Then I tested it, and the correlation is in the “no contest” category. It doesn’t necessarily imply causation, but the inverse doesn’t have a plausible argument.
By the way, “real cash balances” doesn’t necessarily mean bank deposits. Indeed, what we’re really talking about is demand deposits, where people can spend it easily. It is true that the nature of “cash” and “real cash balances” has changed dramatically since the 1970s, but that makes it even more remarkable that the correlation is so terrific. It probably means that our money measures are the problem – whatever the “spendable money” category is in the world today, that’s what is changing…but those accounts are not the same accounts as they were thirty years ago.
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nah, that’s an easy one. Rates are so low because the Fed has bought a couple of trillion dollars’ worth of Treasuries and mortgages and continues to buy them. Inflation expectations are low, but not THAT low – real interest rates are terribly low, though, thanks to the Fed. And it’s real interest rates that in principle should drive balances (although the correlation is actually higher with nominals).
But there is definitely a virtuous cycle that can cause rates and inflation and velocity to fall together. But it doesn’t last forever, and the flip side is a vicious cycle. The Fed seems not to understand that inflation has come down partly because they got lucky with that cycle and that if it reverses, there won’t be a lot they can do for a while. Higher rates will produce higher velocity and higher inflation…and not slow money supply! It’s likely to get ugly.
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Love your stuff….
My personal view is that most of the world has a broken paradigm. Instead of 2006 being the endpoint of a long term series of sustainable growth, it was the ne plus ultra of debt-fuelled growth — think Arnold Schwarzenegger at the height of his juicing. Just as Arnold was forced to shrink and eventually become a more normal size (even if still a world champion), the United States needs to accept a lower, longer period of slow growth. This is no new insight (think New Normal) but people do not seem to draw the correct conclusion: namely, that there is no further recovery around the corner; we’ve had the recovery. Furthermore QE is administering the wrong medicine: continual steroids to a roided out economic body that is incapable of that growth. And Dr Feelgood, Paul Krugman, is the most misguided of the commentators.
Thanks. It is so EASY to claim victory when the cycle is only half over, isn’t it??? Poor Krugman. They may take his Nobel back when he’s all done. But then again, he never should have won it in the first place.
oops, forgot to close the blockquote tag, sorry… amateur hour!
OK, so if that’s the explanation, then QE has actually LOWERED inflation? (By lowering rates, and thus velocity, without much increasing the transactional money supply)?
You are blowing my mind here, Mike. Blowing my mind! 🙂
I wouldn’t say QE has lowered inflation, but by helping to push velocity down it has become part of the treatment for its own disease. Unfortunately, it only treats the symptoms…the disease, which is too much money, will still be there once rates stop going down. And make no mistake, they don’t need to go UP…if they merely stop going down, velocity too with stop falling and then 7% money growth with 2-3% real growth implies 4% inflation!
Oh, AND note the corollary (and this leads to what economists call the price puzzle, which is that inflation tends to accelerate a bit AFTER the Fed starts tightening): once the Fed tightens, velocity will rise. But in the past, tightening has also lowered money growth; in this case, that won’t happen because excess reserves have to be drained first before any Fed action can directly affect the money supply…so, once the taper begins, inflation and rates will both pick up pretty quickly from wherever they are at that point…
Thanks for these great comments, Mike, you have really given me a lot to think about. Which I will continue to do (and I must warn you, I will likely be back with some more deep thoughts). In the meantime, if you haven’t seen this, I think you will enjoy some of these charts on the Phillips Curve: http://www.hussmanfunds.com/wmc/wmc131104.htm