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Wimpy’s World
Would you rather have a bar of chocolate today, or one year from today?
Most of us, if we like chocolate, would prefer to have a bar of chocolate today rather than at some point in the future. If you don’t care for chocolate, how about money? Would you rather have $100 today, or $100 next year?
The reason that Wimpy’s “I’ll gladly pay you Tuesday for a hamburger today” ploy doesn’t work is that we would prefer to have the money today compared to the money on Tuesday. If Wimpy wants his burger today, but doesn’t have the money for it, then he must borrow the money and pay that money back on Tuesday. Because of our time preference for money, this will cost Wimpy something extra, as he needs to incentivize us to part with the money today so that he can get his burger now.
This is where it gets weird.
We are now in a Wimpy world. Not only can Wimpy get his burger today, it costs him less if he borrows the money because interest rates are negative. That is, “I’ll gladly pay you less money than the burger costs, and not until Tuesday, for the burger today.” And we are enthusiastically answering, “Sure! Sounds like a great deal!”
This is one weird implication of negative interest rates. If the yield curve was flat at a negative interest rate, it would imply that the further in the future something is, the more valuable it is. A dollar next week is worth more than a dollar today. With negative discount rates, a chocolate bar next year is preferable to a chocolate bar today. And poor Wimpy…being forced to have a hamburger today when a hamburger on Tuesday would be so much better!
It gets even weirder if the yield curve is initially negative but slopes upwards and eventually becomes positive. That implies that discount rates (time preferences) are negative at first, but then flip around and become normal at some point in the future. So there is one day in the future where value is maximized, and it’s less valuable to get money after that date or before that date.
You think this is mere theory, but this is happening internally to derivatives books even as we speak. The models are implying that money later is worth more than money now, because money now costs money to have. And from the standpoint of bank funding, that is absolutely true.
Another strange implication: in general, stocks that do not pay dividends should trade at lower multiples (relative to the firm’s growth) because, being valued only on some terminal cash flow date (when a dividend is paid or when the company is bought out), they’re worth less. But now it is better for a stock to not pay dividends; those dividends have negative value. Technically speaking, this means that companies which cut their dividends should trade at higher prices after the cut.
I can think of more! Ordinarily, if your child enters college the institution will offer you an incentive to pay four years’ tuition at a reduced rate, up front (or at a frozen rate). But, if interest rates are negative, the college should demand a premium if you want to pay up front. Similarly, car companies should insist that you take out a zero-interest-rate loan or else pay a premium if you feel you must pay cash.
In this topsy-turvy world, it is good to be in debt and bad to have a nest egg.
Neighbors appreciate you borrowing a cup of sugar and frown at you when you return it.
Burglars put off burglaries. Baseball teams sign the worst players to the longest deals. Insurance companies pay out life insurance before you die.
And all thanks to negative interest rate policies from your friendly neighborhood central bank. I will thank them tomorrow, when they’ll appreciate it more.
Summary of My Post-CPI Tweets
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.
- whoopsie daisy! core CPI +0.3%.
- …actually +0.29%, so not just a barely-round-up thing. Y/Y t0 2.22%. Both comfortably above consensus.
- Next month, we drop off a +0.16% from last year so even a +0.20% print on core would push us to 2.3% in Feb.
- Core converging with median, as expected. Look at chart. What impression will it give FOMC?
- core services +3% from +2.9% y/y; core goods to -0.1% from -0.4%. least-negative in two years.
- I am not sure the core goods improvement can be sustained, yet, given lagged effects of dollar. Will eventually, though.
- dealers holding all those 30y TIPS from y’day auction feel better today.
- Cpi breakdown shortly. Taking unusually long to parse the data. Really need to optimize my database.
- OK! Housing 2.10% from 2.07%. Primary rents 3.71% from 3.68% and OER 3.16% from 3.14%. So housing isn’t the big story.
- Medical care: 3.0% from 2.58% y/y. As the mythbusters would say, “there’s yer problem.”
- Medicinal drugs 2.21% from 1.66%; Professional svcs to 2.08% from 1.92%, Hospital 4.32% from 3.96%.
- Medicinal drugs is what to watch going fwd. That’s in core goods & in 2015 fell from 5% to 1.7%
- motor vehicles +0.51% from +0.14% y/y. Also in core goods.
- Of interest – the fall in energy prices has reduced “food and energy” to 21% from 22.3%. So core is bigger.
- Core ex-shelter 1.47% from 1.29%…highest since 3/2013. I think @TheStalwart showed a picture of that earlier.
- This is less and less just a housing phenomenon.
- OK, good news is that it looks like median CPI ought to be about 0.18%ish, so y/y will inch back up to 2.5% but not jump to 2.6%.
- Also interesting is that the diffusion indices didn’t go wacky. So this number is not QUITE as bad as it seems at first blush.
- Still the overall trend is clear: housing and now core ex-housing inflation are headed higher.
- Still very hard for the Fed to ignore the core CPI chart. And PCE will be worse, because it is heavier in medical care.
- I think March just went back on the table for the FOMC.
So, here are the main takeaways from this month’s report:
First, inflation in medical care is coming back, and that is starting to blunt the deflation in other core goods. At this point, the question is whether medical care inflation goes back to what it was prior to the Affordable Care Act, or goes higher. Although I am a staunch opponent of Obamacare, and I believe it will drive costs higher overall, I think anecdotally there are some signs that the free market is working to correct some of the most egregious failings of the Act. So it may not be quite as bad as it otherwise would be. Still, it appears the temporary lull in medical care inflation is past us.
Second, the fact that medical care was a big driver in this month’s CPI report means the core PCE report will likely be worse, since medical care carries a much larger weight in core PCE. This is why core PCE has been weaker than core CPI for some time, but that will correct.
Third, and a related point: the lagging measures of inflation are catching up with median CPI. The chart below, which is really just an expanded version of the chart above, doesn’t have the updated median CPI, which will be released later today, but that line won’t look much different. And it doesn’t have the updated core PCE, which will be released next week. But you can see what is happening to core CPI, which is the middle line.
Fourth, core goods prices are not likely to suddenly explode higher. The delayed impact of dollar strength, while it will not drive deflation broadly, will keep a lid on core goods inflation for a while longer. However, the core goods part of CPI is the less important and persistent part, and services (driven by housing, but no longer just by housing) continues to accelerate.
Fifth, the Federal Reserve had been inching away from the expectation that they would tighten in March, due to weak global growth and domestic equity markets. I think that possibility just landed back squarely on the table. If folks don’t realize it today, they will realize it when core PCE “surprises” higher next week.
And all of this means that higher inflation remains in our future. The notion that deflation is some kind of existential threat makes as much sense as the notion that alien invasion represents an existential threat: possible, but not something that ought to keep us awake at night worrying. Inflation expectations do not drive inflation – it is the other way around. Inflation is headed higher, whether people – and the FOMC – expect it, or not.
First Ballots are in on Results of Fed Tightening
It fascinates me how bear markets all feel alike in some ways. What I remember very clearly from the equity bear markets of 2000-2002 and 2007-2009 is that bulls wanted to bottom-tick the market at every imagined opportunity. Every “support level,” for the first half of each decline at least, saw bulls pile in as if the train were about to leave the station without them on it. Of course, the train was about to leave the station, but it was backing up.
Today, the S&P didn’t quite touch 1810 on the downside, basically matching the 1812 low from January. Bulls love double-bottoms. Of course, many of those turn out not to be double-bottoms after all, but the ones that are look very nice on the charts. So stocks rocketed off the lows, rising 25 S&P points in a matter of minutes after briefly being down 51. The rally was helped ostensibly by comments from the UAE oil minister, who claimed OPEC is ready to cooperate on a production cut. But that isn’t really why stocks rallied so dramatically; after all the news only pushed crude oil itself up about a buck. The real reason is that bulls are crazy maniacs.
They’re that way for a reason. If you are benchmarked against an equity index, it is very hard for an unlevered fund manager to beat that index in an up market. Once you subtract fees, and a drag from whatever cash holding you must have, you’re doing well to match the index since your limitation is (by definition of ‘unlevered’) 100% long.[1] Where a fund manager must beat his index is in a down market, by participating less than 100% in a selloff. But being an outperformer in a down market is less valuable since customer outflows are likely to outweigh the inflows if there is a serious bear market. Therefore, fund managers naturally fall into a pattern of scalping small selloffs for outperformance. But since they can’t really afford to miss being long in a bull market, there is a serious tendency to dive back in at any hint that the decline may be over.
So we get these entertaining, furious bear market rallies, which tend not to last very long. Of course, my entire premise is that this is an equity bear market, and I could be completely wrong on that. If I am, then ignore the prior paragraphs.
Where I am more confident that I am right is on the monetary policy side. Get this: since the Fed hiked rates, year-over-year M2 money growth has gone from 5.7% to…5.7%. Lest you think this anomaly (because tightening is supposed to involve a deceleration in money growth, right?!?), the 26-week growth rate in M2 has gone from 5.3% to 6.8%, and the 13-week growth rate from 2.9% to 7.3%. The annualized growth rate of M2 from mid-December to February 1st (the figure that was released today) is 11.2%. In other words, money supply growth is clearly not decelerating.
Now, in a traditional tightening, the Fed would restrict reserves and this would have the effect of reducing, or at least causing a deceleration in the growth rate of, M2 through the money multiplier. As a side effect, interest rates would rise but the point of tightening is to reduce the growth rate of money. Or, at least, it used to be.
With the Fed’s current operating framework, in which interest rates are moved around like magnets on a refrigerator to the desired level, there should be no meaningful effect on money supply growth. That’s not to say that money growth rates should accelerate (as they evidently have), merely that the growth rates should be stochastic with respect to authoritarian interest-rate manipulation. They may fall, or they may rise, but it should not be related to the Fed’s “tightening.” I’ve been saying this for a long, long time and the first evidence is in. The Fed’s rate hike has done nothing to reduce the growth rate of money, and therefore ought to do nothing to restrain inflation. Indeed, if higher interest rates follow from a series of Fed hikes – which they haven’t, but mainly because no one believes the Fed is going to hike again while their precious stocks are only 35% above fair value rather than 50% – then the expected effect would be for monetary velocity to rise and inflation to accelerate.
At this point, the Fed can thank the market that their moves haven’t accelerated the already-established trend towards higher inflation. But the clock is ticking. If the Fed does indeed hike rates next month, the bond market may start taking it seriously and start the rates-inflation spiral.
[1] Unless, of course, you’re adding alpha. But the universe of fund managers adds approximately zero alpha – slightly positive, and negative net of fees. Except whoever your manager is, of course. I’m sure he’s the best. Good job finding him!
Fed Nonsense and Error Bars
Today’s news was the Employment number. I am not going to talk a lot about the number, since the January jobs number is one of those releases where the seasonal adjustments totally swamp the actual data, and so it has even wider-than-normal error bars. I will discuss error bars more in a moment, but first here is something I do want to point out about the Employment figure. Average Hourly Earnings are now clearly rising. The latest year-on-year number was 2.5%, well above consensus estimates, and last month’s release was revised to 2.7%. So now, the chart of wage growth looks like this.
Of course, I always point out that wages follow inflation, rather than leading it, but since so many people obsess about the wrong inflation metric this may not be readily apparent. But here is Average Hourly Earnings, y/y, versus Median CPI. I have shown this chart before.
The salient point is that whether you are looking at core CPI or PCE or Median CPI, and whether you think wages lead prices or follow prices, this number significantly increases the odds that the Fed raises rates again. Yes, there are lots of reasons the Fed’s intended multi-year tightening campaign is unlikely to unfold, and I am one of those who think that they may already be regretting the first one. But a number like this will tend to convince the hawks among them otherwise.
Speaking of the Fed, last night I attended a speech by Cleveland Fed President Loretta Mester, sponsored by Market News International. Every time I hear a Fed speaker speak, afterwards I want to put my head into a vise to squeeze all of the nonsense out – and last night was no different. Now, Dr. Mester is a classically-trained, highly-accomplished economist with a Ph.D. from Princeton, but I don’t hold that against her. Indeed, credit where credit is due: unlike many such speakers I have heard in the past, Dr. Mester seemed to put more error bars around some of her answers and, in one of the best exchanges, she observed that we won’t really know whether the QE tool is worth keeping in the toolkit until after monetary conditions have returned to normal. That’s unusual; most Fed speakers have long been declaring victory. She is certainly a fan and an advocate of QE, but at least recognizes that the chapter on QE cannot yet be written (although I make what I think is a fair attempt at such a chapter in my book, due out in a month or so).
But the problem with the Federal Reserve boils down to two things. First, like any large institution there is massive groupthink going on. There is little true and significant diversity of opinion. For example there are, for all intents and purposes, no true monetarists left at the Fed who have any voice. Daniel Thornton at the St. Louis Fed was the last one who ever published pieces expressing the important role of money in monetary policy, and he retired a little while back. As another example, it is taken as a given that “transparency” is a good thing, despite the fact that many of the questions posed last night to Dr. Mester boiled down to problems that are actually due to too much transparency. I doubt seriously whether there has ever been a formal discussion, internally, of the connection between increased financial leverage and increased Fed transparency. Many of the problems with “too big to fail” institutions boil down to too much leverage, and a transparent Fed that carefully telegraphs its intentions will tend to increase investor confidence in outcomes and, hence, tend to increase leverage. But I cannot imagine that anyone at the Fed has ever seriously raised the question whether they should be giving less, rather than more, information to the market. It is significantly outside of chapter-and-verse.
The second problem is that the denizens of the Fed overestimate their knowledge and their ability to know certain things that may simply not be knowable. Again, Dr. Mester was a mild exception to this – but very mild. When someone says “We think the overnight rate should normalize more slowly than implied by the Taylor Rule,” but then doesn’t follow that up with an explanation of why you think so, I grow wary. Because economics in the real world, practiced honestly, should produce a lot of “I don’t know” answers. It may be boring, but this is how the question-and-answer with Dr. Mester should have gone:
Q: What do you think inflation will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think short rates will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think the Unemployment Rate will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think the Unemployment Rate will do in 2017?
A: I don’t know. I can tell you my point estimate, but it has really, really wide error bars.
Q: What do you think the consensus is at the Fed about the optimal pace of raising rates?
A: I don’t know. Each person on the Committee has a point estimate, each of which has really wide error bars. Collectively, we have an average that has even wider error bars. We cannot therefore usefully characterize what the path of the short rate will look like. At all.
Indeed, this is part of the problem with transparency. If you are going to be transparent, there is going to be pressure to provide “answers.” But a forecast without an error bar is just a guess. The error bars are what cause a guess to become an estimate. So we get a “dot plot” with a bunch of guesses on it. The actual dot plot, from December, looks like this:
But the dot plot should look more like this, where the error bars are all included.
Obviously, we would take the latter chart as meaning…correctly…that the Fed really has very little idea of where the funds rate is going to be in a couple of years and cannot convincingly reject the hypothesis that rates will be basically unchanged from here. That’s simultaneously transparent, and very informational, and colossally unhelpful to fast-twitch traders.
And now I can release the vise on my head. Thank you for letting me get the nonsense out.
Why So Negative?
The news on Friday that the Bank of Japan had joined the ECB in pushing policy rates negative was absorbed with brilliant enthusiasm on Wall Street. At least, much of the attribution for the exceptional rally was given to the BoJ’s move. I find it implausible, arguably silly, to think that a marginal change in monetary policy by a desperate central bank on the other side of the world – however unexpected – would have a massive effect on US stocks. Subsequent trading, which has reversed almost all of that ebullience in two days, suggests that other investors also may agree that just maybe the sorry state of earnings growth rates in this country, combined with a poor economic outlook and still-lofty valuations, should matter more than Kuroda’s gambit.
To be sure, this is a refrain that Ben Bernanke (remember him? Of helicopter infamy?) was singing last month, before the Federal Reserve hiked rates impotently, and clearly the Fed is investigating whether negative rates is a “tool” they should add to their oh-so-expansive toolbox for fighting deflation.
Scratch that. The Fed no longer needs to fight deflation; inflation is at 2.4% and rising. The toolbox the Fed is interested in adding to is the one that contains the tools for goosing growth. That toolbox, judging from historical success rates, is virtually empty. And always has been.
Back to Japan: let me point out that if the BOJ goal has been to extinguish deflation, it has already done so. The chart below (source: Bloomberg) shows core inflation in Japan for the last 20 years or so. Abstracting from the sales-tax-related spike, core inflation has risen fairly steadily from -1.5% to near 1.0% since mid-2010.
They did this, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015 (see chart, source: Bloomberg).
Not rocket science, folks. Monetary science.
Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that and wants to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was exactly the wrong thing to do. The regression below (source: Bloomberg) illustrates in a different way what I have shown here before: interest rates and money velocity are closely tied (as Friedman explained decades ago). The r-squared of this relationship – assuming that functionally a linear fit is appropriate, which I am not sure of – is a heady 0.822.
You may notice the data is from the US; that’s because Bloomberg doesn’t have a good velocity series for Japan’s M2 but the causal relationship is the same: lower term interest rates imply less reason not to hold cash.
Now, it may be the case that this relationship ceases to apply at negative rates even though the idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as if investment opportunities suddenly appeared. And rates, not just overnight but term rates, just went negative in Japan. The chart below (source: Bloomberg) shows the 5y JGB rate.
Several observations:
- The speculation that sub-zero rates might cause a rise in velocity is just that: speculation. There’s no data to suggest that this effect exists.
- Frankly, I suspect it doesn’t, but it’s possible. However, if it does I would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.
- If it does exist, it still doesn’t mean that cutting rates to a negative rate was wise. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same. Lots more.
- More likely, the BoJ is doing this because they believe that negative rates will stimulate growth. This is much more speculative than you might think, and I may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.
- Whatever the point of the BoJ’s move, the size of any growth effect from currency reactions is utterly dependent on the reaction function of trading counterparties. If other countries seek to devalue their currencies as well, then the whole operation will be inert.
So, will the BoJ’s move save US stocks? Heck, it won’t even save the Japanese economy.
