Archive
Guide to My Recent Re-Posts
I hope that folks are enjoying the “best-of” re-blogs I’ve been posting over the past week. Here is a summary of what has been posted and the basic topic in each case:
“I Am Become Debt, Destroyer Of Worlds” – the connection between the federal deficit, the trade deficit, and the Fed’s balance sheet.
Groucho And Holiday Inn Express – long-run real returns to equities
Why CPI Is Not Bogus – combination of two previous posts, illustrating how we know that CPI is approximately correct and explaining why inflation tends to feel higher than it is reported.
Tales of Tails – the implications of the Kelly Criterion for “the optimal bet size” in the context of investment decisions.
Perfect Drugs From Perfect Pharmacists – a discussion of Janet Yellen’s (weak) defense of Large-Scale Asset Purchases (LSAP).
U.S. Wages and Egyptian President Employment – why the Phillips curve does not imply that high unemployment should lead to disinflation, or vice-versa.
My Two Cents On Nonsense – a reminder of the bogus-ness of the “bank stress tests.”
Side Bet With Ben? – a really important post illustrating the critical – and beyond rational argument – relationship between transactional money and the price level.
Keynes, Marx, and Bernanke – a short post on the interrelationship between real wages and the real cost of capital.
Some Useful Charts And Thoughts About Personal Investing – well…this is pretty much what it says it is!
I hope you enjoy some of these “classic” posts. As always, feel free to post any comments you like and to follow me @inflation_guy on Twitter. Happy New Year!
RE-BLOG: Some Useful Charts And Thoughts About Personal Investing
Note: The following blog post originally appeared on March 12th, 2013 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
I just finished a paper called “Managing Laurels: Liability-Driven Investment for Professional Athletes,” and I thought that one or two of the charts might be interesting for readers in this space.
An athlete’s investing challenge is actually much more like that of a pension fund than it is of a typical retiree, because of the extremely long planning horizon he or she faces. While a typical retiree at the age of 65 faces the need to plan for two or three decades, an athlete who finishes a career at 30 or 35 years of age may have to harvest investments for fifty or sixty years! This is, in some ways, closer to the endowment’s model of a perpetual life than it is to a normal retiree’s challenge, and it follows that by making investing decisions in the same way that a pension fund or endowment makes them (optimally, anyway) an athlete may be better served than by following the routine “withdrawal rules” approach.
In the paper, I demonstrate that an athlete can have both good downside protection and preserve upside tail performance if he or she follows certain LDI (liability-driven investing) principles. This is true to some extent for every investor, but what I really want to do here is to look at those “withdrawal rules” and where they break down. A withdrawal policy describes how the investor will draw on the portfolio over time. It is usually phrased as a proportion of the original portfolio value, and may be considered either a level nominal dollar amount or adjusted for inflation (a real amount).
For many years, the “four percent rule” said that an investor can take 4% of his original portfolio value, adjusted for inflation every year, and almost surely not run out of money. This analysis, based on a study by Bengen (1994) and treated more thoroughly by Cooley, Hubbard, and Walz in the famous “Trinity Study” in 1998, was to use historical sampling methods to determine the range of outcomes that would historically have resulted from a particular combination of asset allocation and withdrawal policies. For example, Cooley et. al. established that given a portfolio mix of 75% stocks and 25% bonds and a withdrawal rate of 6% of the initial portfolio value, for a thirty-year holding period (over the historical interval covered by the study) the portfolio would have failed 32% of the time for, conversely, a 68% success rate.
The Trinity Study produced a nice chart that is replicated below, showing the success rates for various investment allocations for various investing periods and various withdrawal rates.
Now, the problem with this method is that the period studied by the authors ended in 1995, and started in 1926, meaning that it started from a period of low valuations and ended in a period of high valuations. The simple, uncompounded average nominal return to equities over that period was 12.5%, or roughly 9% over inflation for the same period. Guess what: that’s far above any sustainable return for a developed economy’s stock market, and is an artifact of the measurement period.
I replicated the Trinity Study’s success rates (roughly) using a Monte Carlo simulation, but then replaced the return estimates with something more rational: a 4.5% long-term real return for equities (but see yesterday’s article for whether the market is currently priced for that), and 2% real for nominal bonds (later I added 2% for inflation-indexed bonds…again, these are long-term, in equilibrium numbers, not what’s available now which is a different investing question). I re-ran the simulations, and took the horizons out to 50 years, and the chart below is the result.
Especially with respect to equity-heavy portfolios, the realistic portfolio success rates are dramatically lower than those based on the “historical record” (when that historical record happened to be during a very cheerful investing environment). It is all very well and good to be optimistic, but the consequences of assuming a 7.2% real return sustained over 50 years when only a 4.5% return is realistic may be incredibly damaging to our clients’ long-term well-being and increase the chances of financial ruin to an unacceptably-high figure.
Notice that a 4% (real) withdrawal rate produces only a 68% success rate at the 30 year horizon for the all-equity portfolio! But the reality is worse than that, because a “success rate” doesn’t distinguish between the portfolios that failed at 30 years and those that failed spectacularly early on. It turns out that fully 10% of the all-equity portfolios in this simulation have been exhausted by year 19. Conversely, 90% of the portfolios of 80% TIPS and 20% equities made it at least as far as year 30 (this isn’t shown on the chart above, which doesn’t include TIPS). True, those portfolios had only a fraction of the upside an equity-heavy portfolio would have in the “lucky” case, but two further observations can be made:
- Shuffling off the mortal coil thirty years from now with an extra million bucks in the bank isn’t nearly as rewarding as it sounds like, while running out of money when you have ten years left to lift truly sucks; and
- By applying LDI concepts, some investors (depending on initial endowment) can preserve many of the features of “safe” portfolios while capturing a significant part of the upside of “risky” portfolios.
The chart below shows two “cones” that correspond to two different strategies. For each cone, the upper line corresponds to the 90th percentile Monte Carlo outcome for that strategy and portfolio, at each point in time; the lower line corresponds to the 10th percentile outcome; the dashed line represents the median. Put another way, the cones represent a trimmed-range of outcomes for the two strategies, over a 50-year time period (the x-axis is time). The blue lines represent an investor who maintains 80% in TIPS, 20% in stocks, over the investing horizon with a withdrawal rate of 2.5%. The red lines represent the same investor, with the same withdrawal rates, using “LDI” concepts.
While this paper concerned investors such as athletes who have very long investing lives and don’t have ongoing wages that are large in proportion to their investment portfolios (most 35-year-old investors do, which tends to decrease their inflation risk), the basic concepts can be applied to many types of investors in many situations.
And they should be.
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You can follow me @inflation_guy, or subscribe to receive these articles by email here.
RE-BLOG: Keynes, Marx, and Bernanke
Note: The following blog post originally appeared on April 4th, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
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I routinely deride economists who rely on the discredited notion that growth in excess of a nation’s productive capacity is what causes inflation – and, conversely, a surplus of productive capacity is what causes deflation. See, for example, here, here, and here. And that is just in the last month!
I want to point out that it isn’t that I don’t believe in microeconomics (where an increase in supply causes prices to fall and a decrease in supply causes prices to rise). I believe deeply in the supply-demand construct.
But the problem with applying these ideas to the macroeconomy is that people get confused with real and nominal quantities, and they think of the “productive frontier” of an economy as being one thing rather than a multi-dimensional construct.
When an economy reaches “productive capacity,” it isn’t because it has used up all of its resources. It is because it has used up the scarcest resource. Theory says that what should happen isn’t that all prices should rise, but that the price of the scarce resource should rise relative to the prices of other resources. For example, when labor is plentiful relative to capital, then what should happen is that real wages should stagnate while real margins increase – that is, because productivity is constrained by the scarce resource of capital, more of the economy’s gains should accrue to capital. And so Marx was right, in this sort of circumstance: the “industrial reserve army of the unemployed” should indeed increase the share of the economic spoils that go to the kapitalists.
And that is exactly what is happening now. In the banking crisis, the nation’s productive capacity declined because of a paucity of available capital, in particular because banks were forced to de-lever. Output declined, and after the shock adjustments the margins of corporate America rose sharply (which I recently illustrated here), near record levels from earlier in the decade of the 00s. And real wages stagnated. Be very clear on this point: it is real wages which are supposed to stagnate when labor is plentiful, not nominal wages.
Now, what should happen next in a free market system is that the real cost of capital should decline, or real wages should increase, or both, as labor is substituted for capital because of the shortage of capital. We indeed see that the real cost of capital is declining, because real rates are sharply negative out to 10 years and equities are trading at lusty multiples. But real wages are stagnating, going exactly nowhere over the last 36 months. Why is the adjustment only occurring on the capital side, with bull markets in bonds and stocks?
We can thank central bankers, and especially Dr. Bernanke and the Federal Reserve, for working assiduously to lower the cost of capital – also known as supporting the markets for capital. This has the effect, hopefully unintended, of lowering the level at which the convergence between real wages and the real cost of capital happens; and of course, it obviously also favors the existing owners of capital. By defending the owners of capital (and, among other things, refusing to let any of them go out of business), the Fed is actually helping to hold down real wages since there is no reason to substitute away from capital to labor!
But all of this happens in real space. One way that the real cost of capital and the real wage can stay low is to increase the price level, which is exactly what is happening. We call this inflation.
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You can follow me @inflation_guy, or subscribe to receive these articles by email here.
RE-BLOG: Side Bet With Ben?
Note: The following blog post originally appeared on June 14, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
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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. [Editor’s Note: While core inflation in fact began to decelerate in the months after this post, median inflation has basically been flat from 2.2% to just above 2.0% since then. The reason for the stark difference, I have noted in more-recent commentaries, involves large changes in some fairly small segments of CPI, most notably Medical Care, and so the median is a better measure of the central tendency of price changes. Or, put another way, a bet in June 2012 that core inflation was about to decline from 2.3% to 1.6% only won because Medical Care inflation unexpectedly plunged, while broader inflation did not. So, while I was wrong in suggesting that core inflation would not begin to fall any time soon, I wasn’t as wrong as it looks like if you focus only on core inflation!]
[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.
RE-BLOG: My Two Cents On Nonsense
Note: The following blog post originally appeared on March 13, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).
…
And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”
Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.
Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).
So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?
Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.
The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).
Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.
You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.
Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).
By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”
When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.
I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.
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You can follow me @inflation_guy, or subscribe to receive these articles by email here.
RE-BLOG: U.S. Wages and Egyptian President Employment
Note: The following blog post originally appeared on February 3, 2011 (with an additional reference that was referred to in a February 17, 2012 post) and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
Rising energy prices, if they rise for demand-related reasons, needn’t be a major concern. Such a price rise acts as one of the “automatic stabilizers” and, while it pushes up consumer prices, it also acts to slow the economy. This helps reduce the need for the monetary authority to meddle (not that anything has stopped them any time recently). It doesn’t need to respond to higher (demand-induced) energy prices, because those higher prices are serving the usual rationing function of higher prices vis a vis scarce resources.
But when energy prices (or, to a lesser extent, food prices) rise because of supply-side constraints – say, reduced traffic through the Suez Canal, or fewer oil workers manning the pumps in a major oil exporting region – then that’s extremely difficult for the central bank to deal with. More-costly energy will slow the economy inordinately, and higher prices also translate into higher inflation readings so that if the central bank responds to the economic slowdown they risk adding to the inflationary pressures.
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One of the ways that we can restrain ourselves from getting too excited, too soon, about the upturn in employment is to reflect on the fact that surveys still indicate considerable uncertainty and pessimism among the people who are vying for those jobs (or clinging to the ones they have, hoping they don’t have to compete for those scarce openings). This is illustrated by the apparent puzzle that Unit Labor Costs (reported yesterday) remain under serious pressure and Productivity continues to rise at the same time that profit margins are already extremely fat. Rising productivity is normal early in an expansion, but the bullish economists tell us that the expansion started a year and a half ago. We’re about halfway through the duration of the average economic expansion (if you believe the bulls). And fat profit margins are not as normal early in an expansion.
Now, we don’t measure Productivity and Unit Labor Costs very well at all. Former Fed Chairman Greenspan used to say that we need 5 years of data before we can spot a change in trend, and he may be low. But it seems plausible that there remains downward pressure on wages. Call it the “industrial reserve army of the unemployed” effect. While job prospects are improving, they are apparently not improving enough yet for employed people to start pressing their corporate overlords to spread more of the profits around to the proletariat.
Fear not, however, that this restrains inflation. The evidence that wage pressures lead to price pressures (and conversely, the absence of wage pressures suggest an absence of price pressures) is basically non-existent. Let me present two quick charts that make the point simply.
No surprise: tighter conditions in the labor market tend to be associate with wage inflation.
The chart above (Source for data: Bloomberg) shows the relationship between the Unemployment Rate and the (contemporaneous) year-on-year rise in Average Hourly Earnings. I have divided the chart into four phases: 1975-1982 (a period which runs from roughly the end of wage-and-price controls in mid-1974 until the abandoning of the monetarist experiment near the end of 1982), a “transition period” of 1983-1984, the period of 1985-2007 (the “modern pre-crisis experience”), and a rump period of the crisis until now. Several interesting results obtain.
First of all, there should be no surprise that that the supply curve for labor has the shape it does: when the pool of available labor is low, the price of that labor rises more rapidly; when the pool of available labor is high, the price of that labor rises more slowly. Labor is like any other good or service; it gets cheaper if there’s more of it for sale! What is interesting as well is that abstracting from the “transition period,” the slopes of these two regressions are very similar: in each case, a 1% decline in the Unemployment Rate increases wage gains by about ½% per annum. Including the rump period changes the slope of the relationship slightly, but not the sign. This may well be another “transition” period leading to a permanent shift in the tradeoff of Unemployment versus wage inflation.
But clearly, then, when Unemployment is high we can safely conclude that since there are no wage pressures there should be no price pressures, right?
The Phillips Blob
The second chart puts paid to that myth. It shows the same periods, but plots changes in core CPI, rather than Hourly Earnings, as a function of the Unemployment Rate. This is the famous “Phillips Curve” that postulates an inverse relationship between unemployment and inflation. The problem with this elegant and intuitive theory is that the facts, inconveniently, refuse to provide much support. [Note: the above chart is very similar to one appearing in this excellent article by economist John Cochrane, which appeared in the Fall of 2011.]
Why does it make sense that wages can be closely related to unemployment, but inflation is not? Well, labor is just one factor of production, and retail prices are not typically set on a labor-cost-plus basis but rather reflect (a) the cost of labor, (b) the cost of capital, (c) the proportion of labor to capital, and importantly (d) the rate of substitution between labor and capital. This last point is crucial, and it is important to realize that the rate of labor/capital substitution is not constant (nor even particularly stable). When capital behaves more like a substitute for labor, a plant owner can keep customer prices in check and sustain margins at the same time by deepening capital. This shows up as increased productivity, and causes the relationship between wages and end product prices to decouple. Indeed, in the second chart above the R2s for both periods is…zero!
This isn’t some discovery that no one has stumbled upon before. In a wonderful paper published in 2000, Gregory Hess and Mark Schweitzer at the Cleveland Fed wrote that
It turns out that the vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation. In fact, it is more often found that price inflation causes wage inflation. Our recent research, which updates and expands on the current literature, also provides little support for the view that wage gains cause inflation. Moreover, wage inflation does a very poor job of predicting price inflation throughout the 1990s, while money growth and productivity growth sometimes do a better job. The policy conclusion to be drawn is that wage inflation, whether measured using labor compensation, wages, or unit-labor-costs growth, is not a reliable predictor of inflationary pressures. Inflation can strike unexpectedly without any evidence from the labor market.
The real mystery is why million-dollar economists, who have access to the exact same data, continue to propagate the myth that wage-push inflation exists. If it does, there is no evidence of it.
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RE-BLOG: Perfect Drugs From Perfect Pharmacists
Note: The following blog post originally appeared on January 11th, 2011 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
…Looking over the Atlantic, ECB President Trichet offered what some observers saw as a threat that the ECB would raise interest rates to combat inflation if energy-price increases pass through to broad price increases. The German bond market, and others, sold off on his “conditional warning”:
“We see evidence of short-term upward pressure on overall inflation, mainly owing to energy prices, but this has not so far affected our assessment that price developments will remain in line…Very close monitoring of price developments is warranted.”
This is an empty threat. There is no chance that the ECB will raise rates to combat inflation while they are simultaneously buying every bond in sight to try and lower borrowing costs for member nations (and especially the periphery countries). The ECB may be slightly more politically independent than the Fed, but tightening while member nations are trying feverishly to balance their budgets – with their only chance being either a strong resurgent economy or a cheapening of their nominal liabilities through inflation – is highly unlikely.
Trichet has more credibility, though, than our own domestic monetary policymakers. I have to take some time here to mention Fed Vice-Chair Janet Yellen’s speech from last weekend, since I have been meaning to for several days. It is important because the speech was an important defense of the Large Scale Asset Purchase (LSAP) program that the Fed has been conducting, and in that context we should be very afraid of what comes next. Because if this is the best thinking they have to share on the subject, then we are in a situation not unlike the baby who finds Daddy’s firearm in an unlocked position. Tragedy is likely to ensue.
In a nutshell, Dr. Yellen’s argument boils down to this:
- The LSAP program is not affecting the dollar.
- The LSAP program is not triggering “significant excesses or imbalances in the United States.”
- The LSAP program does not risk markedly higher inflation because there is slack in the economy.
- However, the LSAP program has had an enormous effect on jobs, adding about 3 million jobs to the economy.
So, the program has been hugely successful in the ways they needed it to be, without any side effects and no chance of anything going wrong. Does it make me a bad person that I am naturally suspicious of a drug that will make me immensely strong, lengthen my life, improve my love life, and cure hangovers but has no negative side effects? How about if that drug worked as intended the first time it was tested?
Incidentally, the claim that the LSAP program has created about 3 million jobs is interesting because the Administration claimed 2 million jobs were saved or created through fiscal stimulus. Each is not claiming that their policy in conjunction with other policies not under their control created jobs, so these must be additive. Fiscal policy, plus monetary policy, saved or created some 5 million jobs. Right now, the Civilian Labor Force is 153,690,000 and unemployment is 14,485,000 (9.4%), so these actions have prevented an Unemployment Rate of about 12.7%. This is interesting because no one was forecasting a 12.7% Unemployment Rate before these programs were put into place, so the people who are now telling us that the drug is working perfectly are the same people who had previously told us that no drug would be needed.
These results – the 2 million, 3 million jobs – are coming from time series regressions that are conducted with high mathematics and great rigor. But there are lots of reasons that econometric analysis should not be expected to work well in this case:
- The distributions you are trying to analyze are not static, which is a precondition for most time series analysis, nor normal. Indeed, you are actually trying to change the distributions with your policy.
- It is pretty plain that the model is not completely specified. That is, the people who were examining whether fiscal policy was effective didn’t include the separate effect of monetary policy, and vice-versa, so they both think it was their policy which worked. The fact that both of these policies are pushing in the same direction at roughly the same time also creates a problem of multicollinearity, a technical condition that basically means that with two people pulling on the same rope at the same time it is hard to tell who is pulling how much.
- The noise in the relationships far outweigh the signal, which means that all conclusions will (or should) have massive error bars on them.
- The analyst is analyzing the result of a single experiment. It is like trying to divine the laws of motion after hitting a cue ball a single time on the break of a game of billiards, except that the balls aren’t round, you can’t measure anything directly, and you have dirt in your eye. But in this case, the implications of reaching incorrect conclusions are far greater than if you were lining up your next shot in a game of pool.
Econometricians ought to be more guarded about conclusions such as this. Indeed, any reasonable experience with financial data sets tends to produce the realization that it is often hard to get any conclusive information out of them, although it is very easy to generate suggestive relationships that can’t be rejected simply because the error bars are too large to reject any particular hypothesis. It may be that the econometricians within the Fed who are actually doing the dirty work are providing the policymakers with all of the proper caveats, and warnings about the usefulness of the data, and that they policymakers are simply ignoring it. Or it may be that econometricians at the Fed feel pressure knowing that while 90% of the time there is nothing conclusive to say, it is hard to support your case for continued employment when your results most of the time are indistinguishable from not working.
The Fed continues to be especially cavalier about the end game. Yellen says the Fed remains “unwaveringly committed” to price stability, but says:
“I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes. The FOMC will be able to increase short-term rates by raising the interest rate that we pay on excess reserves–currently 1/4 percent. That ability will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.”
Oh really? And you’ll be able to do that, politically, with unemployment at 9%? And you’re so sure that the effect will be immediate, perfectly calibrated, and won’t have any unanticipated side effects? She also suggests that they can withdraw stimulus by offering deposits to member institutions through a Term Deposit Facility, and also by selling portions of their holdings. The notion that you can have a huge effect by implementing a policy, but that reversing the policy will have little effect, is an offense against common sense. No, it’s an offense against financial physics. Yellen isn’t the first Fed official to make statements like this, and won’t be the last. And then, we’ll have several years of apologies when it doesn’t work out the way they said it would.
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RE-BLOG: Tales of Tails
Note: The following blog post originally appeared on June 27th, 2010 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
…I also raised my eyebrows at an article in the UK Telegraph which declares that the Fed is considering a “fresh monetary blitz” since the recovery is faltering. I am always happy to be skeptical when an article doesn’t name names, but this seems to me to be fairly likely to be true:
“Key members of the five-man Board are quietly mulling a fresh burst of asset purchases, if necessary by pushing the Fed’s balance sheet from $2.4 trillion (£1.6 trillion) to uncharted levels of $5 trillion.”
The strategy makes sense, if you believe that the long-term effects of dramatic monetary policy movements can be evaluated over a period of a couple of quarters. I would not be surprised at all to discover that the thinking at 20th Street and Constitution Avenue is something along the lines of “hey, we did it once and didn’t cause inflation, so why not take out the paddles again? CLEAR! ZAP.” I’ve written before of the odd set of speeches we saw earlier this year describing a wondrous alchemy that the Fed seemed to believe they could accomplish: buy assets rapidly to save the economy by keeping rates low and adding liquidity. Sell the assets without completely reversing the effect by doing so slowly. Clearly, if there is real belief that the Board can pump and dump without the “dump” causing any problems, then for God’s sake why not pump?
Obviously, that’s a bunch of hooey, but I remain wary that there may be those who believe it.
The market on Friday was led (and maybe even supported) by financial stocks, because the market finally learned the form of the financial reform bill. It is bad, and will cause severe damage to bank earnings. It isn’t as bad as some people feared, but it is about as bad as was ever likely to become law. Prop trading at banks is still banned, and banks will have two years to push trading of commodities, non-investment grade bonds, and CDS that are not cleared through an exchange to separately-capitalized subsidiaries. Most derivatives will have to be cleared and traded on exchanges, which means less customization (bad for dealers, and bad for clients too). This law will be bad for turnover, bad for margins, and will cause leverage ratios to decline (probably the only reasonable part of the prescription, from my view). The Dupont model tells me those three things imply much lower ROE.
So why did bank stocks rally? This is worth a deep reflection because it explains something about markets.
Bank stocks rallied because as bad as the legislation is, the fact that we now know the form of the legislation removes the most onerous tail risks.
Bob Merton, many years ago, observed that the equity of a company can be thought of as a call option on the value of a firm: the value can only go to zero, if the firm is insolvent, but can be worth a great deal. So what do we know about options? One of the things we know is that a great deal of the value of an option comes from the expected value of unlikely, extreme outcomes. If you remove the chance at the home run, an option gets much cheaper.
This is one big reason that bear markets often end with a sharp rally off the lows (although please note that it does not follow that every sharp rally implies an end to the bear market!) – once the disaster case, the chance of an outright crash or broad economic or financial calamity, recedes in probability, the value of equities rise appreciably. A company which avoids bankruptcy by a hair will see its stock rise dramatically when the chance of losing everything goes away. Observe the behavior of many of the financials during the crisis. When TARP and other bank-supportive mechanisms began to have traction the sector leaped, not because earnings were about to be multiplied 10 times but because the fear of zeros greatly receded.
(Aside #1: Most analysts, of course, look at equity values as related linearly to earnings, and in normal circumstances they are. …a PE of 25x is rich, 15x is cheap, for example. But this is likely because behavioral biases prevent analysts from considering the value of the disaster which they think is very unlikely. In any case, a 15x multiple might be quite expensive indeed compared to a 25x multiple, if the former company is about to receive a legal judgement that could potentially destroy the firm. Indeed, one real problem with conventional investment analysis is that the 15x multiple stock might be cheap, or the multiple may in fact be a sign that tail risks are higher for this equity than for the 25x one. Buying enormous dividend yields is often unproductive because the high yield implies a market belief, often correct, that the dividend is not likely to be paid or paid in that amount.)
(Aside #2: Because so much of the value in an option comes from the tail, evaluating options using simple Black-Scholes when the underlying risk isn’t lognormal can be extremely dangerous, especially with exotic options that have path-dependent valuations and with options on underlying instruments that are known to have a high likelihood of non-linear performance – near-bankrupt equities, for example. Black-Scholes implied vols are nearly useless in such a case).
So, owning a stock or stocks generally when the tail risks are about to recede is a good recipe for making sparkling returns. But we have another name for this sort of investing strategy: “catching a knife.” You can own an AIG-like bounce, but also get run over by Lehman. On the flip side, because as an equity investor you own these negative tail events naturally, you can add a lot of value by avoiding the blow-up.
Rising volatility, then, tells you two things: first, it tells you that the market’s sense of the risk of a possible calamity is growing; second, it tells you that once these fears recede you might earn a solid return. You already knew this; it’s why the VIX is considered a contrary indicator by some.
Does it make sense to be investing more, then, when a blowup might happen, or investing less? As it turns out, the answer to this question is not entirely clear but thanks to the Kelly Criterion we can make some observations. The Kelly Criterion describes the optimal bet size, as a proportion of the bankroll, for a series of uncorrelated bets with a given edge and payoff. The simple observation (which becomes a lot less simple after they start involving the math) is that you want to bet more of your payroll if you are (a) getting good odds and (b) are very confident of the outcome. That is, your bet size should increase if you are getting good odds, and have a good edge. Kelly worked out the math to determine what the optimal bet size should be under certain conditions.
The relevance here is as follows: when a crisis hits, two things are happening to you as an equity investor. First, you are becoming more confident that the market will reward you for buying when everyone else is selling, because (as noted above) unless the world actually does end you are likely to be getting a good price. Second, though, you need to recognize that the increasing chance of debacle implies a worse payoff. In April of 2008, the chances of losing everything the next day were pretty slim. In mid-September 2008, the chances were appreciable that a bunch of your portfolio might be in trouble. So your edge (confidence in winning, if the bet was repeated a bunch of times) was growing, but your odds (payoff if you win, relative to your loss if you don’t) were worsening.
The schematic below shouldn’t be taken literally, but is meant to illustrate the basic relationships.
These lines are the pure results from the Kelly formula for the indicated inputs. Perhaps an investor might consider his/her “bankroll” in this case to be the maximum portfolio concentration in equities. Obviously, if you are extremely confident that you are going to win, then no matter what the payoff you should be making a pretty reasonable bet; therefore, the lines converge on the right. But as we move left, we get a sense of the tradeoff between the edge and the odds. When volatility is rising, the investor is moving to the left, implying a lower confidence of a payoff; if the market is trading to lower prices, it improves your odds but you can see that you would need vastly better odds to counteract the effect of increased uncertainty. I would suggest that in the range of normal investor confidence, rising volatility implies that you should tend to be taking chips off the table, even though it means you may miss a minor pop if the world doesn’t end.
We are not currently in a crisis quite like what we saw in 2008. But the elevated levels of implied volatility suggest that crisis is not so far off as we would like to see it. I think this means that we should be avoiding the possibility of the long negative tail, and taking chips off the table.
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Artful Dodger
On some level you have to respect, even admire, Ben Bernanke for his clever announcement of the taper yesterday. The Fed surprised many long-time Fed watchers who figured that a major change in policy wouldn’t happen with an outgoing Chairman in the illiquid end-of-year period when the economic backdrop is essentially the same as it was at the prior meeting. I am one of those who was surprised, and I was not planning to write an article today because I didn’t think there would be much to write about! (But do be sure to tune in for the “reblogging best-of” series, which continues through month-end).
I was fascinated at the widespread confusion about the ultimate meaning of the FOMC statement, which seemed quite clear to me. This state of confusion is itself a very good thing. When investors are confused, they tend to keep a wider margin of safety. As long-time readers know, probably the biggest complaint I have with Fed policy of the last twenty years is the movement to transparency, which has made our markets no more predictable but dramatically less safe, with more-frequent small moves and much larger tails when highly-levered investors are surprised by something – Fed policy, banking crises, hedge fund failures, etc. So if this were to kick off a new period of opacity in Federal Reserve communications, it would be terrific. But I am not hopeful on this point.
But I have to have grudging respect for the people who formed the new “communications policy.” They used a practice long used by companies who see one of their jobs being to manage the stock price (personally I agree with Buffett here and think management’s job is to manage the company value and let Mr. Market set the price, but this is no longer a widespread view at least in the money management community). A company that is reporting “disappointing” earnings will very often simultaneously “guide higher” in future earnings. It is very rare, with certain companies – and you know who you are – to have poor earnings and poor guidance. The point is to blunt the market price reaction to real news that is bad – “the company made less money for shareholders” – with squirrelly expectations that are good – “but we’ll probably make lots more money in the future!” Incredibly, this seems to work even though we all know that the positive guidance will get battered down repeatedly before the next report.
And that’s what the Fed did. And here is what the statement said:
- The Fed is going to be buying fewer Treasuries going forward. This is real. There are going to be fewer purchasers of US Treasuries than we expected there to be just a few days ago. To be sure, they didn’t pledge to continue the taper, and made it data dependent, etc…but everything the Fed does is data dependent. In all likelihood the taper will continue, but I don’t know that. What I know is this: after no move in September and October, I didn’t expect one until March. So I thought there was a 3-month fuse. Now I know the fuse has already been lit. That’s meaningful in ways we will shortly discover.
- The Fed said they expect to keep interest rates really low for a really long period of time, based on their projections of how inflation and employment will evolve over the next couple of years. This is entirely “forward guidance,” but it’s not even for next quarter. The Fed knows no more about what inflation will be in one year – and even less, growth – than they knew two months ago. So any promise along these lines should, and shall, be overtaken by events. That is, the guidance will be watered down into the next meeting if it behooves the Fed to do so. And they will tighten when they feel the need to do so, and make up the reason to do so at that time.
That’s it. That’s what the statement says. There should be no confusion here. The $10bln taper was at the hawkish end of expectations and it matters to asset markets (year end and reluctance to take profits rather than let it ride for a week may delay asset market reactions, but it matters). The “communications” were dovish but…who cares? We already knew we have a very dovish Chairman coming in next year. No surprise there, and anyway if you’re leaning on the Fed for your two-year forecasts – good luck and Godspeed.
One final note and reminder: none of this affects the inflation outlook at all. The Fed is increasing excess reserves still, and more slowly than before. The transfer of excess reserves to required reserves and to money, by the making of loans, is a decision in the hands of the banks. Not until the Fed starts operating on required reserves, years from now, with reserves be constraining on banks. Higher interest rates will help banks make loans that are more additive to value relative to the cost of equity capital, and so money growth will stay too high and velocity will rise going forward. But none of this has anything to do with the Fed, for quite some time.
What the Fed action does do is affect the market-clearing levels of assets such as stocks and bonds because of the decline in Fed buying. I would expect interest rates to rise from here, and that will eventually get the attention of equity investors.
RE-BLOG: Why CPI Is Not Bogus
Note: The following blog post originally appeared as two blogs on February 16, 2010 (“Oh, (Yeah!) Canada!”) and August 17, 2010 (“The ‘Real-Feel’ Inflation Rate”). I have combined them because they speak to the same topic, and given the resulting dual-article a more representative name. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original posts here and here.
RE-BLOG of “Oh, (Yeah!) Canada!”:
On Friday the BLS will release the Consumer Price Index, which is a very important release and one of the most maligned even though CPI is one of the more carefully-designed and researched numbers in the entire list of government releases. This is partly because so much is riding on it, between securities linked to non-seasonally-adjusted CPI (such as TIPS) and contracts such as Social Security and others. To some people, this just opens the door for more government shenanigans, since arguably the government stands to gain the most from monkeying with CPI.
But if people with lots of money on CPI didn’t fundamentally believe in the veracity of the number, then the $500billion-plus TIPS market would be in real trouble. Indeed, in some countries where there is better reason to doubt the government’s accountability on such matters, there are private as well as public inflation indices and there are securities are linked to each index. (Brazil is one example.)
That doesn’t mean that these investors are right, of course, but you can believe that they’ve looked pretty hard at the number. Sure, investors have also looked very hard at equities and concluded that they are entitled to a very lofty multiple right now, so we can’t just rely on that. I will tell you, though, why inflation cannot possibly be as high as some folks believe it is, and why you very likely feel that inflation is higher than is being reported by the government.
What follows is an enumeration of some of the cognitive errors that people make with respect to CPI. The list isn’t complete, but I think I’ve hit on the biggest of them.
As a first point: CPI does what it is supposed to do very well, but that might not be what you want it to do. CPI is a cost-of-living index, which means that if your standard of living improves then the price you pay for that standard of living should also increase (that is, your outlays should increase faster than general inflation); if your standard of living is static then your outlays should increase with inflation. CPI measures, in other words, the cost of an unchanged standard of living.
This important point gives rise to the concept of hedonic adjustments, which adjust the price recorded by the BLS for a particular good to account for changes in the quality of those goods. This is a crucial adjustment for certain goods that change significantly in quality, such as cars, computers, and medical care. But this is one source of complaints of people who don’t bother to understand the CPI: people don’t mentally record hedonic adjustments; people measure cash out of their pockets. So when you buy a new computer and it’s lots better than the last one but costs the same, you experienced deflation in the sense that the cost of your old lifestyle…which you no longer have…costs less. Since you spent the same amount, it doesn’t feel like deflation to you, but since your standard of living improved while the costs were unchanged, that’s deflation in a cost-of-living-index sense.
Second, your consumption basket may vary. For most people, the broad CPI index is a reasonable measure, but each person’s consumption is different. Some people spend more on Apparel and less on Recreation; others are the opposite. CPI is supposed to measure the average experience, and no one is exactly average.
Third, CPI excludes taxes that don’t have anything to do with consumption, since CPI is only supposed to measure changes in the costs of things you consume. But taxes definitely affect our standard of living, so if income taxes rise and that causes a decline in your standard of living, that sucks but it’s not inflation. Don’t blame CPI – blame the dudes who are taxing you!
Fourth, people tend to remember price changes of small, frequently-purchased goods rather than large, infrequently-purchased goods even though the latter are more important to your cost of living. For example, your house is typically no more than a once-a-year negotiation (if you rent) or even less frequent if you own. But it is a huge part of your cost of living. When milk doubles in price, or gasoline spikes, you notice it a lot but it’s a much smaller portion of your consumption and matters less.
Fifth, you may be the victim of classic attribution bias. When you go to the store and you come home with a bunch of stuff at higher prices, you say it’s inflation; when you come back with a bunch of stuff at lower prices, it’s “good shopping.” Combined with the prior effect, the rapid oscillations in food and energy prices seem to us to be lots of inflation interspersed with lots of good shopping.
These are the predominant cognitive and comprehension errors that most people make when they think about inflation. But some complaints about CPI go way beyond these innocent and entirely normal perceptual biases.
Some complaints of CPI are just silly. Shadow Government Statistics, which has made quite a great business catering bad data to conspiracy theorists – and I won’t link to the site; if you need to find it for some reason I am sure you can – has a chart of what inflation would be if the BLS used 1980 methods, with the implication being that the guvmint is trying to hide the 9% rate of inflation (the site says inflation is understated by about 7%). The choice of 1980 is very adept, since it was in 1982 that the BLS changed the method of computing the cost of housing to remove investment-value-of-the-home considerations (such as the mortgage rate) and focus on the consumption-value-of-the-home (which is best represented by what it would cost to rent). This was done after much research, many public papers and debate, and is absolutely the right way to measure inflation in the cost of housing consumption as distinct from changes in the value of the home as an asset. There are lots of other improvements that have been made to CPI, and they really are improvements. Not everything from 1980 is better than the 2010 version. Computers, cars, medicine. I’ll concede music.
But we can rely on a very simple argument to prove that true inflation cannot be at 9% (but it involves math). I presume that most readers can recall what they were paid ten years ago, or at least can very easily figure out what their income was back then. Government statistics say that the average increase in wages and salaries (in the Employment Cost Index) has been about 36% over 1998-2008 (for some reason I am having trouble finding 2009 data, perhaps because it is subject to revision). I assume that we don’t think the government is exaggerating that number on the low side for some sinister reason. Now, if inflation is really running at the 9% or so that Shadow Government Statistics says it has for the last decade, then while your wages have grown 36%, cost of living has risen 136% (the government says inflation has been more like 29%).
More concretely: suppose you made $60,000 in 1998, took home $40,000 after tax and were just breaking even with your cost of living at $40,000. According to the government, you ought to be making about $81,500, and if taxes were the same your take home pay of $54,333 would leave you about $3,000 better off, with your cost of living about $51,500. If, however, inflation was really at 9%, then your cost of living is now $94,700, and you declared bankruptcy several years ago. You don’t have to be able to track your receipts to see that 9% is not the right rate of inflation – you just need to look at the compounded outcome.
Consider a longer period of time for a more-poignant comparison. The person making $30,000 and taking home $20,000 in 1980 is now making $89,000 and the $59,300 take-home pay (2/3, assuming improbably that taxes were unchanged) has improved his/her standard of living somewhat as the old standard of living now costs $52,800 using CPI. Using a 7% higher rate of inflation, the same standard of living this person enjoyed in 1980 for $20,000 now costs $353,000.
That is nonsense. And by the way, it also means that housing over the last decade not only wasn’t in a bubble, it didn’t even come close to keeping up with inflation, and neither did any other asset in the world. That’s worse than nonsense; it is an offensive ignorance of mathematics.
CPI is not a perfect number, and moreover it may not be a perfect number for what you want it to do. But it does what it is supposed to do, and it does it very well. I am certainly no apologist for the government and the way it is run, but on the occasions that the bureaucrats get something basically right, I think it’s okay to say so.
RE-BLOG of “The Real-Feel” Inflation Rate:
In today’s comment, I would like to talk about inflation as it is measured, inflation as it is perceived, the difference between the two, and the implications of that difference. First, I want to thank the readers of this column for helping me by taking the poll on my website; the poll supported certain hypotheses of mine (or, more technically, it failed to reject them) that I will discuss here. Read on for poll results!
But first, let me discuss CPI (inflation as it is measured). The vitriolic rants that occur against this measure were one of the motivations for my research. As an inflation trader, I have had to become intimately familiar with the CPI and its quirks, and also have had to explain it many times. Since I believe that CPI does what it is supposed to do very well, I have occasionally become a target of the ranter and called a government stooge, conspirator, or worse. And so I have always wanted to figure out the difference between inflation as it is calculated and inflation as it is perceived, since it is this difference that leads to the vitriol.
Let me get this out of the way: yes, I think CPI accomplishes its mission. But its mission may not be what the ranter thinks its mission should be. It is not supposed to measure (nor could it ever measure) the change in prices that any individual faces. It is an aggregate, meant to reflect the average experience of consumers. You are not average. And you are not an average consumer. And so your experience may vary.
Moreover, it is not supposed to measure the average change of prices in the economy. It is closer to a cost-of-living index, which means that it is meant to answer the question “what is the cost of achieving today the standard of living actually achieved in the base period?” This is a difficult goal, since your “standard of living” must necessarily incorporate your preferences about how different goods and services are better or worse than others and we can’t directly test your preferences. All that the Bureau of Labor Statistics can do is to survey prices and quantities consumed, to draw inferences about consumption patterns, and to calculate the change in prices of the consumption basket that keeps the average consumer’s standard of living approximately unchanged. That’s difficult, and they do it remarkably well at that. The fact that they do it pretty well is evidenced by the observation that, if the BLS were appreciably wrong about the rise in prices for a given standard of living, over long periods of time we would see a substantial difference in standards of living compared to what we expect. The difference between 2% and 5%, compounded over 40 years, is huge. If prices rise 2% over 40 years, the same standard of living now costs 2.2 times what it did back then. If the compounding rate is 5%, the same standard of living costs 7 times as much. So while it is reasonable to ask whether the BLS is off 0.2% or 0.5% here or there, it is very unlikely to be meaningfully biased over long periods of time.
It is a very separate question, though, what inflation feels like. Moreover, it is very relevant. Modern monetary policy considers inflation expectations a metric of signal importance in the formulation of monetary policy. While the Taylor Rule provides a well-known heuristic for monetary policymakers that relies on actual, not expected inflation, policy discussions rely very heavily on the question of whether inflation expectations are, and will continue to be, “contained.” Current Federal Reserve Chairman Ben Bernanke himself described the importance and significance of inflation expectations in a speech in 2007 by saying “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”
So how does the Fed measure inflation expectations? Generally, with surveys – including the Livingston survey, the Survey of Professional Forecasters (SPF), and the Michigan Survey of Consumer Attitudes and Behavior. Some of these measure the expectations of economists about CPI, which isn’t really helpful – the Fed already has their staff economist forecasts, so checking a survey essentially of the people they hang out at the club with would give a false sense of security.
The Michigan survey asks consumers for their views about “the expected change in prices.” But here’s the problem, as illustrated by the survey I took on my website recently: normal humans are not capable of conducting in their heads the monumental tasks of cataloging all of the year’s purchases and calculating the differences from the same basket from the year before. Price changes are not homogeneous, and this leads to seat-of-the-pants adjustments. Consider this very thorough explanation from one person who answered my survey and then wrote to explain her vote:
“My personal experience has been that big ticket items have gone down, but small ticket items have gone up (example fast food ice tea prices or Frontline for my dog). It is crazy that I spend almost $2 for a glass of ice tea that is just water and a tea bag with some ice. But the cost has gone up around 20 cents at most places in the past two years. Conversely, grocery store prices are very mixed with some real bargains, but I do see vast differences between the same good at Wal-Mart and at Krogers. Sometimes Kroger prices are 25% higher for the identical item. I stopped drinking Coke over six years ago. A bargain then was three cases for $10. I saw a display at Wal-Mart the other day of one case for $5.25. It may have had 18 cans instead of the 12 of old. It looked bigger, if so, that would indicate not much price pressure. I recently bought a fan to replace one that died. The new one was by the same company and almost identical, but cost the same after 3-4 years. Of course I bought the first one at a department store and the second one at Wal-Mart. (FYI Walmart is about the only store less than an hour and fifteen minutes from my house other than dollar stores or local hardware stores. Did you know that each Wal-Mart sets its own pricing? There can be noticable price differences sometimes on the same item at my two nearest Wal-Marts. The slightly closer one has less competition and they told me that lets them price some goods higher than the other store.) But, TVs and computers are a lot cheaper, so much so that it has induced me to buy. My telephone and cable bills haven’t changed in years. These conflicting observations made it very hard for me to answer your question.”
Yes, exactly!!
Clearly, the FOMC would like to sample the perceptions of the people who are involved in price-setting and wage-setting behavior. But consumer surveys are not ideal instruments for at least two reasons. First, as some researchers have pointed out, taking the “median” expectation obscures a lot of information and it isn’t exactly clear what role the variation in expectations should play. Second, and more importantly, surveys of inflation don’t work well because consumers do not discern inflation properly. Perceptions of inflation are muddied by a myriad of practical problems (such as those described so clearly by my correspondent above!) and behavioral biases that tend to impair accurate assessment of price changes. For example:
- Quality change and substitution adjustments are not recognized viscerally by consumers, although they are a necessary part of a cost-of-living index. It might also be the case that people notice downward quality adjustments (“my insurance coverage is shrinking”) more than upward quality adjustments.
- Consumers have an asymmetric perception of inflation as a whole, as well, so that they tend to notice goods that are inflating faster than the overall market basket, but to notice less the goods that are not inflating as fast. This sense is enhanced by classic attribution bias: higher prices is inflation, lower prices are “good shopping.”
- Items whose prices are volatile tend to draw more attention, and give more opportunities for these asymmetries to compound, so they tend to factor more heavily into our sensation of inflation.
- People notice price changes of small, frequently-purchased items more than they notice large, infrequently-purchased items even though the latter are a bigger part of consumption basket. Gasoline is hugely important even though it’s not a huge part of the basket because (a) it is purchased frequently and (b) it is volatile, which means attribution bias acts constantly.
- Consumers do not viscerally record imputed costs, such as owners’-equivalent rent as distinct from what they see as their costs (principal plus interest, taxes, and insurance). Even though the former is better for CPI, the latter (which is the pre-1983 method, basically) affects perception more directly.
- People perceive increased changes in income taxes as inflation.
So what is the result of this complex problem? Well, here are the results from the poll I conducted. The question was “Consider your personal experience of inflation over the last year. Would you say that the prices you pay have generally (choose the best answer):” There were 355 votes, 22 of which (6%) were “I don’t know.” Here are the percentages of respondents who perceived different price increases.
Two immediate observations, both of which support my general contention: first, the average response (coarsely, if we take the first category mid to be 0.50%, the second to be 2.5%, the third to be 4.5%, and the fourth to be 6.5%) is 3.45%, obviously much higher than the official CPI (1.2%). Clearly, consumers perceive higher inflation than what is calculated, which is the direction in which I would expect the behavioral biases to operate. Second, there is no general agreement about whether inflation is low or high, much less how low or high it is. A small plurality prefers the “4-5%” answer. The sample size is small, but not that small…we should have expected, if humans were coldly rational calculating machines who have generally similar consumption baskets, to see at least something of a bell curve developing. The difference in experienced price increases is probably not this wide; at least some of this is because while consumption baskets are in fact more similar than you might think, we have wildly different heuristics and biases that we use when answering this question.
In my paper, I attempt to correct for a few of these biases. If we can model inflation perceptions this way then we might not only be able to identify changes in inflation perceptions but to also understand the drivers of those changes in any particular episode. The monetary policy prescription might vary if, for example, elevated perceptions of inflation were driven because of an increase in taxes than because of an increase in the volatility of price changes in the consumption basket.
I don’t attempt to correct for every bias here, but for some of the more important ones. I correct for the misperception of quality and substitution effects (specifically, I remove all of the quality adjustments that tend to decrease CPI while retaining all of those that tend to increase it), for the asymmetric perception of price changes, and for the perception of volatility (big changes in prices) as inflation. You probably don’t want to see the math, and if you do then you should wait for the paper itself, but as an example here is the adjustment I make for the perception of volatility as inflation:
where lambda is a coefficient of loss aversion per Kahneman and Tversky; w is the weight of an item in the CPI basket; and σ is the standard deviation of the item’s price over the past year. This adjustment is derived from a result that tells us the expected future value of a one-period, at-the-money option.
The details, as I say, are probably not of much interest to most readers of this column. But the charts will be. The tricky part is calibrating the lambdas, and this can and should be done more diligently in a behavioral economics laboratory. But with the choice of lambda that I thought to be “about right,” here is the aggregate upward adjustment that should be made to CPI to get to perceived inflation.
And, combining this with year-on-year CPI, the chart below shows the difference between the official CPI and the perceived CPI, incorporating my adjustments.
This chart suggests that one reason that 6%+ may have been so prevalent as a poll answer is that until a few months ago, that is how it actually felt. The most-recent point, incidentally, is 3.4%, so thanks again to everyone who took the poll – I couldn’t have hoped for a nicer match!
Let me return one more time to the reason for this exercise, this time with a simple analogy. There is clearly a reason that we need to measure the CPI with as much exacting, mechanical precision as we can muster. Knowing how prices are actually changing in the economy is important for consumers, wage-earners, and investors. Similarly, it is very important to have a good thermometer that can tell you just how cold it actually is outside in Chicago in January. But before venturing outside in Chicago in January, you ought to also consider the “wind chill” or “real feel” temperature, because it has great relevance for your real-life behaviors. The “true” temperature is given by the thermometer, but in many situations the wind chill is what actually matters (it is connected more directly, in this case, to your survival chances if you under-dress).
In the same way, policymakers need to know not only what prices are actually doing, but what the “real feel” inflation rate is, because it is relevant for many consumer decisions. My research here is a first step, I hope, to developing such a tool.
[Editor’s Note: The paper referred to here was eventually published in the journal Business Economics; you can find a link to the full published article here.]
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