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“The Great Demographic Reversal”
I don’t often write book reviews and, strictly speaking, this isn’t one. I am not going to go into great detail about The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan. And yet, if you are reading about inflation – and in particular, you’ve read what I’ve written about inflation – then I think this is a book that you should read. It is important.
One of the dilemmas that people who model inflation have is that any given model of inflation in the United States tends to have a state shift around 1992 or so. Any model that you design works at best on the pre-1992 period or the post-1992 period. I mention this a lot, because while modern-day economists and policymakers are very content with their models because they’ve worked well for nearly 30 years (until 2021-2022, when the Fed has been so befuddled that Chairman Powell last week admitted that “We’ve lived in that world where inflation was not a problem. I think we understand better how little we understand about inflation”), in my view they don’t really understand the underlying dynamics of big inflation shifts unless they can explain the state shift in or around 1992.
The most popular explanation is that inflation expectations abruptly became anchored at that point, causing inflation to suddenly become mean-reverting in a way it never did before. There have been plenty of takedowns of this idea, most notably by the Fed’s own Jeremy Rudd. My theory for some time has been that the sudden globalization and expansion of Free Trade following the fall of the Berlin Wall and the disintegration of the Soviet sphere of influence in the late 1980s, most-aptly summed up in this chart from Deutsche Bank, gave us a better tradeoff of growth and inflation for a given amount of money supply growth, but that that game was coming to an end at about the time Donald Trump was elected.
Goodhart and Pradhan, in the book I’ve referenced above, provide some additional support for that view but also go much farther and highlight the massive demographic wave that was cresting over the last quarter-century. It isn’t just the Baby Boom generation in the United States, but also (and critically) the opening up of China and the movement of rural Chinese to the cities that caused a massive outward shift of the labor supply curve. Since the title of the book gives away the ending I don’t mind sharing the point they make that the China demographic is shifting into reverse (as a foreseeable consequence of the one-child policy) and many other demographics-related trends are also. One of their big conclusions is that “for the past few decades, central banks have given too much credit to their own inflation targeting regimes and too little to demography in accounting for the disinflation we have seen.” (p.189-190)
The authors discuss the changing demographic landscape, and how this leads to a resurgence of inflation. They address a number of counterarguments, including (thank heavens) the “Why Didn’t It Happen in Japan” argument, and examine whether there is likely to be sufficient contrary forces coming from (for example) automation and the continued growth of India and Africa. They tinker with various policy proposals. I should say that I disagree with many of their policy proposals, which are redolent of some of the redistributional schemes common on the left.
But while I don’t like their solutions, I agree that they’ve identified the right problems and supported those views with plenty of charts and data. The book was published in late 2020, before the current inflation spike makes them look prescient. It was written prior to the COVID crisis, and there is an addendum chapter where the authors discuss whether and how Coronavirus changes their views. However, I think the authors would admit that they weren’t writing about the inflation spike of 2021-202x. They are really looking farther out. In their view – which I share – the basic forces which made the disinflation of the last 40 years possible (and possibly even inevitable) are moving into reverse, and we will struggle for many years with the difficult choices an underlying inflationary dynamic forces upon us.
I highly recommend this book.
Book Review: The Mandibles (related to inflation)
For something a little different, I wanted to write a book review today. But this is not as far removed as it seems, from my normal beat. In fact, this book could actually be a companion piece to my own book published last year, What’s Wrong with Money?: The Biggest Bubble of All. I really mean that.
The book is “The Mandibles: A Family, 2029-2047,” by Lionel Shriver. This is a terrific work of fiction, especially if you like futuristic dystopian novels. From the jacket:
In 2029, the United States is engaged in a bloodless world war that will wipe out the savings of millions of American families. Overnight, on the international currency exchange, the “almighty dollar” plummets in value, to be replaced by a new global currency, the “bancor.” In retaliation, the president declares that America will default on its loans. “Deadbeat Nation” being unable to borrow, the government prints money to cover its bills. What little remains to savers is rapidly eaten away by runaway inflation.
The Mandibles have been counting on a sizable fortune filtering down when their ninety-seven-year-old patriarch dies. Once the inheritance turns to ash, each family member must contend with disappointment, but also—as the U.S. economy spirals into dysfunction—the challenge of sheer survival.
This book was recommended to be by a friend who knows of my background in inflation – many years of study of the topic, and the fact that I founded and run a firm that’s dedicated to inflation hedging of various kinds (e.g., college tuition or healthcare, but also things like commodities and inflation-linked bond strategies). I took up the novel with some trepidation, since most treatments of inflation in fiction…heck, in non-fiction…are shallow and generally just plain obtuse. I’m including works by famous economists. So I didn’t have high hopes for this book.
I was completely wrong.
When I said that this book could be a companion book to my own (non-fiction) work, I wasn’t kidding. The author got virtually every detail right, about how the pieces fit together, about what causes inflation – including the question of how moderate and high inflation can turn into hyperinflation, a transition that has little to do with monetary policy actions and everything to do with confidence in the monetary unit. And that’s actually why my book is titled “What’s Wrong with Money…” the fact that confidence is the underlying unit (in a fiat currency) creates the potential for an outcome such as Ms. Shriver describes. It isn’t a likely outcome, but it is entirely plausible that it could work out in this way.
Ms. Shriver skillfully works current events of today into the novel, as characters occasionally recollect some old policy from the 2000s or 2010s and explain why that policy didn’t work. I was amazed at the competence with which she tackled all of these subjects.
All in all – if you like the things I write, and especially if you read my book and liked it (or even if you didn’t read it, and probably even if you didn’t like it), you will really like The Mandibles. I highly recommend it.
Book Review: “Where Keynes Went Wrong”
Last week I mentioned something about what Keynes said in the General Theory, and promised to expand on that a bit this week. I will do so, in the form of a book review.
I can’t remember who it was, and I’m sorry, but one of the people who read my articles suggested a book to me a year or so ago published in 2009 and called Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts by Hunter Lewis, and I finally got around to reading it. I am very glad I did – this book is terrific, and is a must-read if you are either pro-Keynes or anti-Keynes.
Of course, readers will know from my articles that I am anti-Keynes, although more precisely I am anti-Keynesian in the modern sense of that word. I never read very much of the General Theory, because honestly it is poorly written in the sense of its prose, and I always assumed that Keynes probably had some great insights and it was the later Keynesians that screwed up what he said.
Oh, I was so wrong. Keynes was looney tunes. A bona fide lunatic. He proved masterful in manipulating the cult of personality that existed at the time he was writing, however; he was adept at destroying his opponents in ways that sounded erudite and like certain later personalities the media adored him. All of this is well-documented by Mr. Lewis, although the looney tunes conclusion is my own.
The book is put together brilliantly. The author quotes passages from Keynes, using actual quotes interspersed with paraphrasing – which is necessary because, as I said above, the General Theory is poorly written and opaque. But it isn’t the paraphrasing that is damning. When Mr. Lewis wants to indict Keynes, he does it with his own words. For example, in unraveling the absurd (and often self-contradictory) prescriptions that Keynes had for managing the macro economy, Mr. Lewis declares that Keynes thought government should never raise interest rates. That’s right, never.[1] But you needn’t take Lewis’ word for it. Here’s Keynes, cited in the book:
“The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”[2]
If you are anything like me, that sent a shiver down your spine right now. Does that sound at all familiar? Keep in mind that Lewis wrote this book in 2009. He could not possibly have anticipated that interest rates would not move away from zero for seven years (and counting, in some countries). And yet this quote sounds to me so much like what the Mount Rushmore of Fed speakers seemed to be suggesting last week. “It worked,” Bernanke was saying. “We’re not in a bubble economy,” said Yellen. None of them saw any signs of serious imbalances, except Volcker (and he was fairly circumspect about how worrisome they were).
In my own book, I indict Keynesianism in the simplest way: I simply point out that the prescription of the Keynesians hasn’t only not worked, it also has failed in every major prediction since, basically forever. But Lewis attacks Keynes himself, with his own words, from the original source. He explains, very clearly, where Keynes went wrong. If you wonder why world governments keep screwing up economies…you should read this book.
[1] Apparently elsewhere Keynes said different things but in the General Theory he was consistent on this point.
[2] Keynes, General Theory, p. 322; quoted on page 20 of Where Keynes Went Wrong by Hunter Lewis.
How the Trading Floor Really Works
I have a book on my shelf, called The Money Market, by Marcia Stigum. It covers the workings of the capital markets, from basic instrument details of bonds, commercial paper, and so on to detailed discussions of how banks operate in the money markets to service client needs. There are chapters on futures, options, and swaps, government securities, repo markets, and bankers’ acceptances. When I first came into the market, in 1990, I bought a copy of this book and read it cover to cover – all 1250 pages of it. Together with Money Market Calculations: Yields, Break-Evens, and Arbitrage (also Stigum), it was absolutely essential reading for people entering the bond market.
The third edition was published in 1989, and is fairly out-of-date by now. Unfortunately, Ms. Stigum died in 2003 and so the fourth edition (now called Stigum’s Money Market
But I have another book that I would recommend both to the people who are thinking of trying to get onto a Wall Street trading floor to pursue a career in finance as well as to those people who are just curious about how the trading floor really works. It is called, appropriately enough, How the Trading Floor Really Works
This is not meant to be a mechanically precise book, like Stigum’s books on money market calculations. For example, in the section on derivatives, Duhon dispenses with such details as the fact that in a USD interest rate swap Libor is typically paid quarterly on an actual/360 day count basis, while the fixed side is paid semi-bond. That’s a detail that is utterly irrelevant for the purposes of this book, which is to illustrate how and why a Wall Street broker/dealer does what it does: how it makes money, how it services clients, how it balances the short-term profit and long-term profit motives, and what the different functions on the trading floor are (and how they fit together). The book begins with chapters on “What Are Financial Markets,” and “What Role Do Banks Play in Financial markets,” and later discusses “How Do Traders Make a Market,” “How Is Proprietary Trading Different from Market Making,” and “What Is the Relationship Between Sales and Trading?” The book addresses cash, derivatives, how “structurers” and “quants” are engaged in the bank’s business, and how risk is managed.
Crusty Wall Street veterans will not find anything in here that is terribly surprising, but most people with a “Main Street” view of Wall Street probably will. One really neat feature of the book is the generous sprinking of market anecdotes describing actual episodes on various trading floors (thankfully without names). These give the book an honest verisimilitude – I can attest that these things actually happen on trading floors, and indeed I am pretty sure that I was actually present for one of the vignettes.
I really enjoyed the book. If you are curious how Wall Street actually works – this is a book you should consider reading (and it’s only about 1/3 the cost of the Stigum book!). You can go to the Amazon page from the link above.
Getting Chippy In The EU
Things are getting a little chippy in the EU, and I don’t mean on the soccer pitch. While in the U.S., the economic data continues weak (with Consumer Confidence and core Durable Goods the latest numbers to fall short of expectations, although not terribly so), the important drama is still on the continent.
Temperatures are rising, at the EU summit meeting and outside of it. George Soros has started the Countdown to Disaster; the three days he declared Europe had left to act to avoid a “fiasco” ends tomorrow (generously, let’s give him until the end of the week). But years from now, we may look back on the behind-closed-doors, but widely-reported, declaration by German Chancellor Angela Merkel that Eurobonds and other forms of pan-European debt sharing would not happen “as long as I live” as being the moment of clarity. If it were just Merkel saying this, it would mean little. But Merkel’s position has not been softening with time, but hardening; she is, in short, moving to a position more in tune with her electorate. Germany is not going to agree to Eurobonds. Europe better hope that the EFSF and ESM are enough, because that seems to be about the extent of what it is willing (or able) to give.
Some observers think this is just a hard bargaining line, and that Germany will agree to union as long as it’s a German-dominated union. I don’t think it is a bargaining line, but for a minute let’s suppose it is and let’s ignore the touchy question about whether the other creditworthy Eurozone entities – Finland springs to mind – will blithely hand the checkbook over to Germany. If such a fiscal and political union actually happened, it might defer the Euro crash for years or even a decade or two. But European union will not work in the long run if one country is put in the driver’s seat. Because what happens when Germany’s time to be ascendant is over? Can you imagine if the EU was led today by Italy? Well, between 300BC and 300AD, Rome was the unquestioned seat of European power. Spain was also a world power once, as was Portugal, and of course France during Napoleon’s time. The only way that a confederacy works, such as the one that includes such different populations as Texas and California, is if none of them is in charge.
In other words, the best chance that Germany has to remain the unquestioned leader of continental Europe is for it to remain independent, not for it to accept vassal states. To me, it looks like that nation is gradually figuring out that its interests are not in fact shared sufficiently with its neighbors to continue down an irrevocable path. I suspect Greece is as well, for the opposite reason.
Meanwhile, although U.S. growth indicators have been surprising on the downside (the Citi Economic Surprise Index for the U.S. is at -60.9, but it was as low as -117.2 one year ago), European indicators are significantly worse. The Citi Economic Surprise Index for Europe is at -90.5, just about as bad as in the months following the Japanese disaster last year and otherwise the worst levels it has seen since 2009 (see Chart, source Bloomberg).
The chart doesn’t illustrate the level of economic activity, but rather the severity and frequency and degree of the miss of the actual data relative to expectations. A big negative number means things are getting worse faster than economists predicted (or it could mean, in a different context, that they’re not getting better as fast as they had predicted). In that context, consider the next story, which ran on Bloomberg today: “Draghi May Enter Twilight Zone Where Bernanke Fears to Tread.” The article suggests the ECB is considering cutting interest rates to zero in fairly short order, and might even make ECB deposit rates negative as a spur to get banks to take money out of the ECB vaults and lend it. Gee, what a fine idea – I wonder where I’ve heard that before?
The Fed doesn’t want to lower the overnight deposit rate below 0.25% because they are afraid of damaging the money market industry irreparably. The lack of confidence that the Fed has in capitalism to figure out a way that the money market can survive and/or regenerate once rates rise again is appalling. Sure, I know that the government is doing everything it can to destroy the finance industry so that it can never regenerate, but I think Fidelity would figure something out if money market interest rates were negative. For example, it could design a money market fund that wasn’t guaranteed at a buck. See? That wasn’t hard.
Yes, doing this would hurt the credit quality of the European banks. Golly, that was hard to even write with a straight face. Look, the sovereigns will end up bailing out many or most of the banks anyway. So what if they make some negative-expectation loans? Isn’t that whole point of forcing negative real rates anyway?
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I have some comments on oil and TIPS but I will save them for tomorrow. I want to make sure I say congratulations and welcome to a professor (and good friend) of mine who recently posted his first on-line article here. Dr. Huston is an outstanding economist, a very creative thinker, a fine nurturer of student minds, and an enthusiastic lecturer. His article points out the current status of the “Fed model,” and illustrates the point that stocks are quite cheap relative to bonds on that model (although it’s a bad model for trading decisions!). I agree that stocks will probably outperform nominal bonds over the next ten years, although neither return series will be very exciting and inflation-linked bonds stand a chance of beating both of them depending on how much margins compress and multiples fall when inflation first rises. Congratulations on your first post, John. (By the way, he and co-author Roger Spencer – both of Trinity University – wrote an outstanding quantitative history of the Federal Reserve called “The Federal Reserve And the Bull Markets: From Benjamin Strong to Alan Greenspan.” At $110 I can’t recommend you buy it, but persuade your local library to buy it so that you can check it out! Or better yet buy it, donate it to the library when you’re done, and get a tax benefit.)
Not Out Of The Woods Yet (And A Book Review)
Over the weekend, the Spanish crisis was semi-resolved with the EU agreeing in principle to give money from the ESM (which isn’t operational yet) or the EFSF to the FROB (the Spanish banking entity). The €100bln will likely be senior to other Spanish government obligations, although this is not clear.
In fact, there is a fair amount that isn’t clear. Equities shot higher by 20 S&P points overnight, only to fall back to +7 before the NY open and finishing the day down 16.7 points, -1.3% on the day.
Stocks may have been taking a cue from Spanish and Italian bonds, which were smashed today. Spanish 10-year yields rose 30bps (see Chart, Source: Bloomberg) while Italian 10y BTP yields rose 12bps.
It may seem like the market is lodging a no-confidence vote, but I am not so sure that’s indeed what is happening. Yes, in general it has been a good trade over the last couple of years to bet that the grand plans will come to nothing, and quickly, but this is still the most decision-like announcement that we have yet seen come out of one of these weekend meetings. Yes, this only helps the Spanish banks, and Spain is likely to still need money while the ESM/EFSF now has €100bln less in capacity. But depending on the details, this isn’t a horrible attempt to address a very specific problem. The question, of course, is whether this is a specific problem, or a general one! (Pete Tchir had a great line; he said “Fixing Spanish banks is a bit like drowning one lawyer – a good start.”)
But the rise in Spanish government bond yields doesn’t necessarily mean investors view the announced measures as a failure. Rather, it might indicate that investors view the announced measures as a success and likely to happen – since once element of that program would be (probably) the subordination of the claims of Spanish government debt holders. It is entirely rational to mark yields higher when debt goes from a senior position in the capital structure to a junior position in the capital structure. The question is, what does it do next? That will be the real indication that the announcement quelled some of the fear that had developed…or did not.
Let’s not forget that Greece goes to the polls next weekend, so even if you thought the result of this weekend’s meeting was terrific, we still might be sitting here in a week staring down a Euro exit or breakup.
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Book Review: Finance and the Good Society
Today’s is a short article, so I thought I would take a few paragraphs to review briefly a book I just finished reading: Bob Shiller’s Finance and the Good Society
I took up this book expecting, frankly, that it would be far too left for my personal tastes. I have great respect for Dr. Shiller, and like many other people I thoroughly enjoyed Irrational Exuberance
The reason that redistribution schemes don’t tend to work well in real economics can be illustrated with a simple, familiar example. Suppose that in a poker game, whenever a player won a pot he collected only a fraction of the pot; specifically, the larger his stack of chips already is, the smaller a share of the pot he gets and the more is distributed to the shorter stacks. Obviously, such a scheme is redistributionist, but if the measure of “good” is taken to be the Gini coefficient or some other objective measure of the evenness of the wealth distribution then this may seem to be a positive improvement to the normal way of winner-take-all from each pot. But advocates of this sort of policy tend to overlook what will happen to the game: if you are sitting on a big stack, you will tend to avoid playing most hands, since your benefit from victory is less the larger the stack you start with.[1] The economic equivalent is that in heavily-taxed societies, the wealthy do not provide as much capital to the system – and so it isn’t a priori clear if more-progressive tax rates will create a more-balanced distribution of wealth. Unless you force them to ante, via a wealth tax…but let’s not go there.
Anyhow, I’m drifting off-topic: Finance and the Good Society pleasantly surprised me. What is great about the book, and surprising I suppose, is that Dr. Shiller spends a great deal of time explaining why the practice of modern finance is mostly good. In Part I, he devotes one (short) chapter each to CEOs, Investment Managers, Bankers, Investment Bankers, Mortgage Lenders and Securitizers, Traders and Market Makers, Insurers, Market Designers and Financial Engineers, Derivatives Providers, Lawyers and Financial Advisers, Lobbyists, Regulators, Accountants and Auditors, Educators, Public Goods Financiers, Policy Makers in Charge of Stabilizing the Economy, Trustees and Nonprofit Managers, and Philanthropists. In each chapter, he explains why this particular role is necessary. Honestly, it’s worth the price of the book just to read an outstanding explanation of why Derivatives Providers, Financial Engineers, and Mortgage Securitizers aren’t inherently evil.
In Part II, Shiller dwells on the problems of modern finance. These we know all too well due to the events of the last five years: problems like “An Impulse for Risk Taking,” “Debt and Leverage,” and “Some Unfortunate Incentives to Sleaziness Inherent in Finance” among others. But unlike in his book Animal Spirits, he does detail some policy prescriptions (including how certain institutions could be redesigned to have the proper incentives). I must be very clear that I don’t agree with all of his policy prescriptions, but I tended to agree with his assessment of the problems.
All in all, this is an even-handed book that makes a distinction that has been rarely made in the post-crisis witch-hunt: hate the sin, love the sinner. The people involved in finance are, in general, good people and the structures, in general, work well most of the time. Improvements can be made, and when the serial crises are over in a few years, hopefully we can discourse intelligently on these improvements. Dr. Shiller has made a good contribution to that discourse with this book.
[1] In fact, if the proportion of the pot that you get to keep if you win is p, and the expected amount that you have to invest in the pot to win, as a share of the total pot, is y, then you will only play in a hand if your expected probability of winning the hand is at least y/p. Therefore, you will only play if you can win very large amounts of money relative to the amounts you bet, or if the odds of your winning are high. In normal poker where p=1, you will bet if your “pot odds” are better than your chance of winning. But in “taxed-winnings” poker, you need much better pot odds relative to the chances of winning.
If The Change In Our Pockets Isn’t Enough
I begin to wonder how much more ‘flight to quality premium’ there can be in U.S. Treasury bonds. Today Greek 10-year yields rose 59bps to match the old highs around 17.7%, Italian bonds rose 20bps to a new high of 5.95% (and the 10y BTPei real bonds +33bps to 4.13%), and Spanish bonds rose 25bps to a new high of 6.27%. The dollar rallied (a little), and equities dropped fairly sharply for a day with no news although indices recovered half of their losses by the close (S&P -0.8% and now down for the month after a torrid start).
And Treasuries? Unchanged.
TIPS rallied 3bps to 0.50% on the 10-year issue – I pointed out last week that weakness in Italy could perversely benefit TIPS and other ILB markets – but the real winners on the day were Precious Metals, +2.1%. Are precious metals becoming the new flight-to-quality (FTQ) instrument?
Please, gold bugs, don’t plaster me with hyperventilated assertions that precious metals have always been “the” safe-haven instrument. They have always been “a” safe-haven instrument, but as they are less liquid than Treasuries and much more volatile, they have not traditionally been a flight-to-quality investment for institutional investors. Buying a billion dollars’ worth of gold is not something you can do in ten minutes to hide out for the weekend, but you can do that in T-Bills. Actually, in T-Bills it will take you less than a minute.
Perhaps a more-nuanced answer (that will keep my house from getting egged by “the gold people”) is that while precious metals are not a flight-to-quality instrument for normal crises, they do serve as a FTQ instrument for catastrophic crises, and while we have never really had one of those during the life of this republic, arguably our crises are starting to look less and less normal and more and more catastrophic.
But the simple answer to my hypothetical question is “no,” for the reasons I have just given. But then, what is the FTQ investment these days?
It needs to be something with a stable value (preferably, stable in real space), and part of a deep and liquid market. This is why short-dated Treasuries have historically been the FTQ investment: the market is huge, you can buy and sell a whole lot of them very easily, and for short-dated maturities there isn’t much price risk (because you’re assured of par at maturity). TIPS would be better, because you’d be protected from inflation (albeit with a lag), but there aren’t nearly enough short-dated TIPS to serve the function. T-Bills historically have tracked inflation with a lag and provided a small negative real return; in a crisis this isn’t going to happen since the Fed will tend to clamp short rates at zero and intentionally produced a large negative real yield, but it’s as good as it gets.
However, if the crisis involves the solvency of the U.S., then what?
We don’t have to worry about that yet. T-Bills can trade (and have in fact traded) with negative nominal yields, so there’s always a price at which you can buy some. But the reaction today in fixed-income land despite significant moves in some other markets suggests that investors who are buying Treasuries – especially longer Treasuries – for something otherthan a FTQ reason are already paying a not-insignificant FTQ premium to do so. There are other solutions, but this article is too small to contain them.[1]
The main U.S. contribution to trading intrigue will actually come in the evenings. Kansas City Fed President Hoenig will be speaking on Tuesday night on “Monetary Policy and Agriculture.” As a frequent-dissenter, his speech will be a decent indicator of how tight Chairman Bernanke has pulled the choke-collar with the new communications policy. On Wednesday the head of the NY Fed’s Markets Group, Brian Sack, will be speaking to the Money Marketeers. That’s the group before which, in December 2009, he delivered a great speech (which I discussed and excerpted here) about the effects of large-scale asset purchases on market rates that had one glaring error. I like to call it “Dr. Sack’s Perpetual Motion Money Machine.” Dr. Sack proposed ways to drain liquidity from the market when it was time to do so, and seemed to think that although the Fed pushed rates lower by buying securities (anyway, that was the whole point of it), they wouldn’t push rates higher by selling securities. If that’s true, then the Fed ought to do this constantly, in the largest size they can, because they can add tons of liquidity without any market cost and can drain it at will without ill effect. I discussed the perpetual motion machine here. There is another speech by Dr. Sack that I excerpt here.
Dr. Sack is unusually clear in his exposition, and worth listening to for several reasons. One is that you will usually get something pretty close to the party line; the other is that you’ll probably learn something about how monetary policy works – or how the Fed thinks it works, which is even more useful.
However, I probably shouldn’t beat up Dr. Sack too much, since I will be a presenter myself tomorrow evening (which is the reason I am mentioning Wednesday’s data – I won’t be posting tomorrow). I will be speaking at the NY QWAFAFEW meeting on the topic of “Quantitative Estimation of Inflation Perceptions.” Let me know if you’d like me to come speak to your group about something exciting like that!
[1] A reference to Pierre de Fermat’s teasing theorem in the margins of a copy of Arithmetica. For a wonderful, entertaining, and easy-to-read book about Fermat’s “Last Theorem,” I heartily recommend Fermat’s Enigma: The Epic Quest to Solve the World’s Greatest Mathematical Problem
Conflict Abounds
Energy prices jumped today on news that OPEC was unable to reach consensus on an increase in the output ceiling. This would be much more important – and NYMEX Crude prices would have risen more than 1.7% – if OPEC wasn’t already exceeding the quotas by 2mbpd, as I pointed out yesterday. Moreover, there is no real reason, other than political posturing, to raise the quotas in order to lower prices. The world can already take pretty much everything that OPEC can pump right now. When is a cartel unnecessary? When prices don’t need to be jacked up!
Still, equities and bonds hardly needed anything that might be construed as bad news. The S&P dropped -0.4%, while the 10y note rallied 6bps. Now, notice that the Dow fell only -0.2%, and the NASDAQ dropped -1.0%. That is a subtle “flight to quality” into bigger stocks while maintaining exposure to the market, and is consistent with investors’ fear that growth is hitting a rocky patch longer than one month in duration. The old maxim was that in a bull market everything goes up and in a bear market everything goes down, so if you’re bearish you should just get out of the market. But many, many investors these days aren’t motivated by absolute return. Active equity managers are still equitymanagers. Pension funds have policy weights that are adjusted infrequently and don’t usually vary a ton anyway. So much of the money flow isn’t in and out any more, but up and down (in size and quality). CDS spreads have also been widening, with the Markit Investment Grade 5y (June) index up to about 98 from 89 last Tuesday (although as the chart below, of the June14 basket, shows that’s not entirely surprising. Actually, I also throw the VIX on here – the VIX and CDX are inverted – and you can see these are all virtually the same charts. You can buy equity risk in equities, in vol, or in corporate bonds. It’s all the same risk).
CDX, VIX, SPX. Source: Bloomberg. Note the VIX and CDX are inverted.
This is a good old fashioned growth scare budding. And yet, I am amazed at how much I am reading about inflation. Really, with housing prices dipping again and 10-year inflation swaps 20-25bps off their highs (see Chart below – in fact, since early May the decline in inflation accounts for all of the decline in nominal rates since real rates are approximately unchanged over that period while nominal 10y rates have fallen 20bps or so), you would think that inflation chatter would be ebbing.
10y US CPI swaps are 25bps or so off their recent highs.
But just today, the NY Fed blog had a piece called “Will ‘Quantitative Easing’ Trigger Inflation” from old friend Ken Garbade, who was once the chief bond strategist at Bankers Trust. Ken is a very sharp guy and his 1996 book “Fixed Income Analytics
Anyway, Garbade in that blog article gives the best and simplest explanation I have seen about why the Fed’s payment of Interest on Excess Reserves (IOER) is crucially important in keeping QE1 and QE2 from flowing out into the market and affecting economic activity. Of course, it begs the question what the hell is QE doing if it isn’t supposed to affect economic activity! And there are added questions around the policy, such as whether the Fed is really prepared to continue to pay higher and higher IOER in order to keep that money out of the economy, and also whether they can really calibrate policy so finely. Garbade highlights the issues well.
But that isn’t the only recent piece on inflation from Fed sources. Last week there was this one from the Atlanta Fed’s blog [my comment: inflation traders have long known that the core and headline inflation converge over a period of roughly 15-18 months, so this isn’t exactly innovation but the interesting point is that they’re discussing inflation]. The same day, the NY Fed blog had another piece, by Eggertsson, entitled “Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?” Here is a teaser:
“The Mistake of 1937 was to relinquish the benefits of reflation and to set all policy levers in reverse. The Fed and key administration officials hinted at interest rate hikes and endorsed austerity in fiscal policy; the key concern now was containing inflation rather than sustaining recovery.”
Just yesterday there was another NY Fed blog piece called “A Closer Look at the Recent Pickup in Inflation,” which made the surprising argument (coming from the Fed, anyway) that
“the recent pickup in inflation is indeed quite widespread across a broad swath of CPI goods and services, but no one item has registered inflation increases that are clearly outside the norm of the last decade, not even among the volatile food and energy categories.”
…although they somehow take a benign message out of that when prospective monetary policy is considered. And, finally, last month the Chicago Fed Letter was on the topic “What are the implications of rising commodity prices for inflation and monetary policy?”
This flurry – this is just over a period of a week or two – is noteworthy since the behavior at the top (i.e., Bernanke) is so boringly stable right now. As QE2 winds down and growth is weakening, there is an increasingly wide range of plausible arguments. While Dr. Bernanke has made clear a number of times that he has no concerns at all about making an error (which implies that either the path forward is clear, or that it doesn’t matter), plainly not everyone in the Federal Reserve System is as sanguine. So on the one hand some observers would consider QE2a, reinvesting the maturing bond proceeds ad infinitum, others would wind down the balance sheet over time and still others would start winding it down aggressively. The response of inflation to these actions, indeed the response of inflation to actions already taken, is open for debate.
But while debate is good for the soul, too much of it can be bad for organizations since it tends to produce wishy-washy decisions that displease the fewest number of decision-makers. And in the case of the Fed, too much of it in public is especially bad. The Chairman is trying to appear calm and placid, but his minions are anything but. There is conflict and disagreement around.
And this makes more obvious the fact that the path forward is fraught with risks. And that, in turn, should increase the discount afforded risky assets (actually, the notion of a discount for risky assets is kinda quaint, since most of them are trading with hefty premiums).
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Tomorrow is Initial Claims (Consensus: 419k from 422k), the only important data of the week. Look out if the number actually rises, rather than shrinks. That shouldn’t be a terrible surprise at this point, since the context has changed quite meaningfully since April when the series first started to rise. We now know the economy is weakening, so a 430k or 435k shouldn’t change many minds. But there is still disagreement about whether this period of weakness is a ripple or a wave, and every piece of weak data increases the odds that it is a wave.
The Beatings Will Continue Until Morale Improves
There was no new growth-related news today, but the markets continued to adjust to last week’s news. After getting smacked twice last week on the same news, markets seem to be shrinking from contact. Oil prices fell 1.5%, and other commodities besides metals (notably Softs and Grains, each down about 3%) were weak. Stocks dropped 1.1% and seem anxious to re-test the lows for the year which lie a mere 3% away and coincide with the 200-day moving average on the S&P.
Nominal and inflation-indexed bonds were both essentially unchanged, and volumes overall were light.
News off the Continent was also anti-climactic, but stocks in Peru dropped 12.5% on the victory of Hugo-Chavez-Facebook-Buddy (and former rebel) Ollanta Humala won a runoff election. This would seem like a one-off affecting only Peru, and perhaps it should be. Indeed other emerging markets ignored the first 9% or so but ended up closing lower. From a practical standpoint the vehicle for contagion is the fact that investors often participate in EM via funds and those funds will take a (small) hit because of Peruvian investments. To the extent that investors scale back EM positions as a result, it will affect many related (perhaps I should say “associated”) markets. Fortunately, Peru’s weight in the indices is pretty small, so even the 18% fall from the highs of last month will have only a small direct impact and the bigger effect is likely to be emotional. But this bears watching.
In a week with little in the way of scheduled economic news, it isn’t surprising to see previously-established trends following through. There is no economic data due tomorrow either, so I expect the beatings to continue.
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I read an article recently entitled “Inflation as a Redistribution Shock: Effects on Aggregates and Welfare” that is interesting because of the non-intuitive conclusions it draws. Although the paper is five years old, it comes from the respectable NBER and one of its authors was in the Federal Reserve System when the article was written.[1]
The paper concerns the effects of unanticipated inflation. We all know that unanticipated inflation transfers wealth from lenders to borrowers (although anticipated inflation does not – if the inflation is anticipated, it is reflected in the nominal interest rate), and that also implies that unanticipated inflation causes medium-wealth households – who tend to be borrowers – to gain at the expense of higher-wealth households, and for domestic households as a group to gain at the expense of foreign (nominal) bondholders. The authors also found several redistributive effects among age cohorts, and overall; for example, even though unanticipated inflation has a ‘persistent negative effect on output,’ it surprisingly improves the weighted welfare of domestic households. From the paper,
“Despite the fact that inflation-induced wealth changes sum to zero across agents, the responses of winners (net borrowers) and losers (net lenders) do not cancel out. Among households, the key asymmetry is that net borrowers tend to be younger than net lenders.”
This leads to various effects on the supply and demand of labor and of savings that flow from the fact that a windfall received by the young causes different behavior changes than the (opposite) effect of a negative wealth shock paid by the aged.
But the really interesting part of the result is that most of the losers in a period of unintended inflation can be compensated fairly easily from the windfall that the government experiences (since the government of course is a huge lender). Again, from the paper:
“Thus, while the poor as a group experience a negative direct redistribution effect, this loss turns out to be easy to compensate, precisely because it does not take much in terms of transfers to improve the well-being of the poor.
“From a political economy perspective, these findings lead us to conclude that the government can adopt simple fiscal policies in reaction to an inflation shock which imply that the shock benefits a majority. Thus, policymakers may be tempted to inflate the economy not just because they take some direct interest in the fiscal position of the government, but also because such a policy may actually have wide support if the losers from inflation receive some compensation. It is intriguing to observe that the U.S. inflation episode in the 1970s started right after Social Security was first indexed to inflation in 1972. While this policy change is unlikely to have been the main cause of the episode, it certainly lowered the political cost of inflation…” [emphasis added]
And in their conclusion:
“Our findings therefore lead to some doubts regarding the conventional wisdom that low inflation is always in the best interest of the domestic population. There is a sizeable fraction of the U.S. population which would stand to gain if another inflation episode such as the one in the 1970s were to occur…
“One of our key findings is that the cohort welfare effects are highly sensitive with respect to the fiscal policy regime followed by the government…If the windfall is used to raise pensions, …the poor as well as the old middle class are compensated for all their losses, and most groups, apart from the very rich, stand to gain from inflation.”
Well, oh my as my sainted aunt might have said. This is an interesting thought process, because the conventional wisdom (and what the Fed has said many times through many different mouthpieces) and research generally holds that aggregate social effects of an inflationary period are negative, at least partly because of economic frictions created by rapidly-changing prices. But these authors illustrate that isn’t necessarily true when one considers the different effects that inflation has on different economic actors, and the way government can respond.
It isn’t like the Fed needed any more ammunition to risk an inflationary debacle; they’re doing that already. But it is worth thinking about whether we might have it all wrong, and that all the talk is mainly meant to ensure that the inflation remains unanticipated. What if the Fed was actually trying to cause a general inflation? Especially if you’re one of the “very rich” who would be sacrificed in that situation, it is worth considering that possibility!
[1] Although in itself this isn’t particularly noteworthy. The Federal Reserve System is far and away the most popular single U.S. destination for economics PhDs.
Royally Skewed
Although commodities do occasionally crash, in general commodity prices are positively kurtotic (fat-tailed) and positively skewed. This is in contradistinction to equity prices, which are positively kurtotic but negatively skewed. In English, that means that both stock prices and commodity prices crash more than we would expect them to if price changes were random, but while stocks tend to crash down, commodities tend to crash up.
The reason for this is simple: commodity supply curves become very inelastic (steeper) when the level of actual, current inventory is fully allocated. There are only so many soybeans available right now. But at low levels of demand and lower prices, the supply curve gets more and more elastic (flatter), which means large declines in demand don’t drop prices as sharply as large increases in demand can increase them at the other end of the curve.
The practical import of this observation is this: one must be more careful shorting commodities than shorting stocks, because while a bull market in stocks can grind you to death, a bull move in commodities can rip you to suddenly to shreds (the fact that in a limit up market there is literally no price at which you are allowed to cover, while this situation rarely exists in equities, means that market infrastructure contributes to the danger).
Today, this lesson was made painfully when energy markets jumped about 6%. This was no ‘dead-cat bounce,’ which often follows a sharp move down. Last Thursday and Friday, NYMEX Unleaded dropped about 23 cents. Today, it rallied back 20 cents. The reason? Well, there was a rumor that NATO was bombing Libya, but that can hardly be surprising can it?
The bounce in Silver was more like 7%, but in the context of the 1/3 decline over the last week or so that really may be a ‘dead cat’ bounce. Silver really had gone too far too fast, and while I think at the current levels it is probably a reasonable wager I wouldn’t expect (or want) it to rally sharply back to the highs. As I said last week, commodities are generally in bull trends over the last year because of the oversupply of dollars in the market relative to “stuff.” But that is both a reason to rally and a speed limit. If the amount of money in circulation goes up 10%, commodity prices shouldn’t be doubling. I continue to be a commodity bull (although I invest through indices where there is some expectation of positive returns from rebalancing effects, rather than directly into specific commodities), but a patient one.
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Skewness and kurtosis, in addition to being great cocktail-party words, are also important concepts for investors to understand. More specifically, it is important for investors to think carefully about the difference of the “higher moments” (as skewness and kurtosis are sometimes collectively called) between asset classes and particular investments. Given a choice between two investments with the same expected return and variance, a long-only investor should always choose the one with ‘fat tails’ on the upside rather than the one with ‘fat tails’ on the downside. This is true for two reasons. First, the marginal pleasure of a gain, for most investors, is lower than the marginal pain of a loss, and this is increasingly true for large gains and losses. Second, a large gain increases the bankroll, but a large loss can be a portfolio-ending experience. All of the rules about long-term investing are based on the assumption that the long term can be reached – or, as Warren Buffett has said, one “-100%” really messes up any series of portfolio returns.
Recently, in a great customer letter called “Five fallacies about inflation (and why global policy rates are too low),” Markus Heider, Jerome Saragoussi, and Francis Yared of Deutsche Bank made some very adroit observations about the risks of inflation going forward. The quick summary is that they see inflation as the greater risk than deflation because 1. The output gap is smaller than suggested by the high unemployment rate; 2. A negative output gap does not imply declining inflation [frequent readers know I harp on this a lot]; 3. EM countries are exporting inflation rather than disinflation; 4. Commodity price inflation is becoming structural and is exacerbated by low global real policy rates; and 5. Central banks’ credibility is at risk of being eroded.
But the single best part of the report, in my opinion, is the chart they created to summarize the effect of their views on the distribution of possible inflation outcomes going forward. That chart is below (reprinted with permission):
Deutsche Bank's chart showing their assessment of how the distribution of inflation outcomes has probably changed. Used with permission.
In short, the higher expected value, flatter distribution, and fat upper tail combine to make long-inflation bets worthwhile even if they are somewhat expensive right now. This is one reason that TIPS are seemingly egregiously priced. It’s all about the skew. If we don’t get inflation, we probably bounce around between 1% and 3% inflation for a while. If we do get inflation, it could get ugly. Therefore, it makes sense to give up some current return to ‘buy the tail option.’ I agree, and think their picture is truly worth a thousand words. (I still think that TIPS are too expensive for my taste even with this fact, but it is the reason I was willing to be long them when 10-year real yields were as low as 1%. It’s just a harder call at 0.65%!).
I highly recommend you contact your Deutsche Bank contact to get a copy of this report (from April 1). Honestly, while the overall state of inflation research is clearly better now than it was, just a few years ago, these guys at DB seem to me to have some of the most consistently high-quality research in the space.
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The rally in equities (0.5%) and commodities comes with the caveat of occurring on low volume. I am clearly less sanguine about the former rally continuing than I am about the latter rally. Bonds also rallied slightly again today, with the 10-year yield falling to 3.14%. That is the rally that is a serious head-scratcher to me right now. I guess it is part and parcel with the current optimism that the Fed has engineered a recovery – at least, a modest one – without serious signs of widespread inflation in the sticky prices. But if I think about ways that optimistic assessment is likely to prove to be inaccurate, it seems to me that it is far more likely that the outcome is going to be much worse (in terms of the growth and inflation mix) than investors/economists currently expect, rather than much better.
In other words…I think we’re skewed.
