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The Phillips Curve is Still Working Just Fine
About five and a half years ago, I wrote a blog article entitled “The Phillips Curve is Working Just Fine, Thanks”, in response to the exhaustively-repeated nonsense that the ‘Phillips Curve is Broken.’ This nonsense never really goes away, but last week Fed Governor Waller delivered a speech on “The Unstable Phillips Curve,” derived from the same nonsense, and I felt duty-bound to resurrect my prior article and update it. The Phillips Curve has not been unstable at all, over the last quarter century at least. Here is my original article, linked here:
I must say that it is discouraging how often I have to write about the Phillips Curve.
The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.
Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).
Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.
And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).
But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.
The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?
I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.
So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.
Before I add to my rant, let me update the chart above with data since then, including the pandemic. The green dots in the chart below correspond to the dots in the chart above; the blue dots are for the period since then.
Amazingly, even during the pandemic and post-pandemic period, the Phillips Curve did a pretty decent job of describing the basic shape of this relationship. The dots overall are a bit higher; that’s attributable I think to the fact that inflation itself is higher and I’ve done this chart in nominal terms. There is some money illusion operating (or else the latest dots would be a lot higher), but it’s still a pretty nice fit, considering. I’ve preserved the prior regression line, but it doesn’t really shift very much.
In fact, the deviation prior to the pandemic – the little knot of blue dots to the left – are somewhat more surprising in a way, given the much lower economic volatility that there was when those points were laid down. But in any event, though, there is nothing obviously wrong with the Phillips Curve.
Now, it is true that the Unemployment Rate and the rate of consumer inflation have not been particularly well-behaved. But that isn’t a new phenomenon; that particular inconvenience has been that way for decades. The reason is pretty straightforward, and only confusing if you spent too much time getting a PhD and getting taught dumb things: the connection between wages and prices is not 1:1. It’s not constant. And there’s no particular reason that it should be, because labor is just one input into production costs, and the cost of production just affects the supply side of the supply/demand interplay which determines price. The really weird thing is that anyone ever thought that prices would be set by taking the current wage cost and adding a simple and stable markup.
A wage is just the price of labor, which is set in the market for labor, which involves the demand for labor and the supply of labor. The supply of labor changes very slowly. The demand for labor moves with the economic cycle. When the economic cycle is ebbing, the demand for labor falls – and that causes the quantity of labor demanded to decline (the unemployment rate goes up) as it also causes the price of labor to fall. That’s what happens when a demand curve shifts leftward on a mostly-static supply curve: Q down, P down. When the economic cycle is flowing, the demand for labor rises, which causes the quantity of labor demanded to increase (the unemployment rate declines) and the price of labor to rise. It isn’t that hard. In fact, you learn that in pretty much the first semester of economics.
It’s those later semesters that screw up economists, encouraging them to design complicated models that are very pretty but don’t necessarily relate to real-world dynamics. We should not be at all surprised when those models don’t work in the real world.
But don’t blame Phillips.
“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.
Tariffs and Subsidies…on Money
Many, many years ago (27, actually) I wrote a paper on how a tariff on oil actually has some beneficial effects which needed to be balanced against the beneficial effect that a lower oil price has on economic growth. But since the early 1990s until 2015 or so I can count on the fingers of one hand how many times the issue of tariffs came up in thoughts about the economy and markets. To the extent that anyone thought about them at all, it was to think about how lowering them has an unalloyed long-term positive effect. Which, for the most part, it does.
But the economics profession can sometimes be somewhat shamanistic on the topic of tariffs. Tariffs=bad; time for the next chapter in the book. There is much more complexity to the topic than that, as there is with almost any economic topic. Reducing economics to comic-book simplicity only works when there is one overwhelmingly correct idea, like “when demand for a good goes up, so does the equilibrium price.” The end: next chapter.
Tariffs have, though, both short-term and long-term effects. In the long-term, we all agree, the effects of raising tariffs are deleterious. For any given increase in money and velocity, we end up with lower growth and higher inflation, all else equal. It is important to realize that these are largely one-time effects although smeared out over a long period. That is, after equilibrium is reached if tariffs are not changed any longer, tariffs have no large incremental effect. It is the change in tariffs that matters, and the story of the success of the global economy in terms of having decent growth with low inflation for the last thirty years is largely a story of continuously opening trade. As I’ve written previously, this train was just about running out of track anyway so that we were likely to go back to a worse combo of growth and inflation, but reversing that trend would lead to significantly worse combinations of growth and inflation in the medium-to-long term.
In the short-term, however, tariffs can have a positive effect (if they are expected to remain) on the tariff-imposing country, assuming no retaliation (or even with retaliation, if the tariff-imposing country is a significant net importer). They raise employment, and they raise the wage of the employed. They even may raise the real wage of the employed if there is economic slack. The chart below shows the y/y change in manufacturing jobs, and ex-manufacturing jobs, for the last 40 years. Obviously, the manufacturing sector has been shrinking – a story of increased productivity, but also of trade liberalization as manufacturing was offshored. The Obama-era work programs (e.g. “Cash for Clunkers”) temporarily reversed some of that differential decline, but since 2016 – when we got a new President – manufacturing payrolls growth has caught up to non-manufacturing. That’s not a surprise – it’s the short-term effect of tariffs.
The point is that tariffs are a political winner in the short-term, which is one reason I think that people are overestimating the likelihood that “Tariff Man” is going to rapidly concede on trade and lower tariffs. If the Administration gets a clear “win” in trade negotiations, then I am sure the President is amenable to reversing tariffs. But otherwise, it doesn’t hurt him in the heavy manufacturing states. And those states turn out to be key.
(This is a relative observation; it doesn’t mean that total payrolls will rise. The economic cycle still has its own momentum, and while tariffs can help parts of the economy in the short term it doesn’t change the fact that this cycle was very long in the tooth with lots of imbalances that are overdue for correction. It is no real surprise that employment is softening, even though it is a lagging indicator. The signs of softening activity have been accumulating for a while.)
But in the long run, we all agree – de-liberalizing trade is a bad deal. It leads among other things to bloat and inefficiency in protected sectors (just as any decrease in competition tends to do). It leads to more domestic capacity than is necessary, and duplicated capacity in country A and country B. It promotes inefficiency and unbalanced growth.
So why, then, are investors and economists so convinced that putting tariffs or subsidies on money has good (or even neutral) long-term effects? When the Fed forces interest rates higher or lower, by arbitrarily setting short-term rates or by buying or selling long-term bonds – that’s a tariff or a subsidy. It is protecting interest-rate sensitive sectors from having interest rates set by competition for capital. And, as we have seen, it leads in the long run to inefficient building of capacity. The Fed evinces concern about the amount of leverage in the system. Whose fault is that? If you give away free ice cream, why are you surprised when people get fat?
The only way that tariffs, and interest rate manipulations, have a chance of being neutral to positive is if they are imposed as a temporary rebalancing (or negotiating) measure and then quickly removed. In the case of Federal Reserve policy, that means that after cutting rates to address a temporary market panic or bank run, the central bank quickly moves back to neutral. To be clear, “neutral” means floating, market-determined rates where the supply and demand for capital determines the market-clearing rate. If investors believed that the central bank would pursue such a course, then they could evaluate and plan based on long-term free market rates rather than basing their actions on the expectation that rates would remain controlled and protective.
It is no different than with tariffs. So for central bankers criticizing the trade policy of the Administration, I say: let those among you who are without sin cast the first stone.
Spinning Economic Stories
As economists[1] we do two sorts of things. We do quantitative work, and we tell stories.
One of the problems with economics is that we aren’t particularly regimented about how we convert data into stories and about how we look at stories to decide how to interrogate the data. So what tends to happen is that we have a phenomenon and then we look at what story we like and decide if that’s a reasonable way to explain the data…without asking if there isn’t a more reasonable way to explain the data, or at least another way that’s equally consistent with the data. I’m not saying that everyone does this, just that it’s disturbingly common especially among people being paid to be storytellers and for whom a good story is really important.
So for example, there is a well -known phenomenon that inflation tends to accelerate after the Fed begins raising interest rates.[2] Purporting to explain this phenomenon, here is a popular story that the Fed is just really smart, so they’re ahead of inflation, and when they seeing it moving up just a little bit they can jump on it real quick and get ahead of it and so inflation goes up…but the apparent causality is there because we just knew it was going to go up and acted before the observation of the higher inflation happened. This is basically Keynesian theory combined with “brilliant person” theory.
There is another theory that is consistent with this, of course: monetarism, which explains that increasing interest rates actually causes inflation to move higher, by causing velocity to increase. But, because this isn’t the popular story, this doesn’t get matched up to the data very frequently. In my mind it’s a better theory, because it doesn’t require us to believe that the Fed is super brilliant to make it work. (And, not to get snarky, but the countervailing evidence versus Fed staff economist genius is pretty mountainous). Of course, economists – and the Fed economists in particular – like theories that make them look like geniuses, so they prefer the prior explanation.
But again, as economists we don’t have a good and rigorous way to say that one way is the ‘preferred’ story or to look at other stories that are consistent with our data. We tend to look at what part of the data supports our story – in other words, confirmation bias.
Why this is relevant now is that the Fed is in fact tightening and inflation is in fact heading higher, and the story being pushed by the Fed and some economists is “good thing the Fed is tightening, because it looks like inflation was going up!” The story on the other hand that I have been telling for quite some time (and which I write about in my book) is that it’s partly because the Fed is tightening and interest rates are going up that that inflation is rising, in a feedback loop that is missed in our popular stories. The important part is the next chapter in the story. In the “Fed is getting ahead of it” story, inflation comes down and the Fed is able to stop tightening, achieving a soft landing. In the “rate increase is causing velocity to rise and inflation to rise” story, the Fed keeps chasing the dog which is only running because the Fed is chasing it.
There is another alternative, which really excites the stock market as evidenced by today’s massive – although disturbingly low-volume – rally. That story is that the Fed is going to become more “data dependent” (Chairman Powell suggested something along these lines today), which is great because the Fed has already won on inflation and growth is still okay. So the Fed can stop the autopilot rate hikes. This story unfortunately does require a little suspension of disbelief. For one thing, today’s strong Employment report (Payrolls 370k, including revisions, compared to 184k expectations) is unfortunately a December figure which means it has huge error bars. Moreover, the Unemployment Rate rose to 3.9% from 3.7%, and while a higher Unemployment Rate doesn’t mean the economy is definitely slowing (it could just be that more people are looking for jobs because the job market is so robust – another fun story), it is certainly more consistent with the notion that the economy is slowing at the margin. The fact that the Unemployment Rate went up, while Hourly Earnings rose more than expected and Jobs rose more than expected, should make you suspect that year-end quirkiness might have something to do with the figures. For the decades I’ve watched economic data, I always advise ignoring the January and February Employment Reports since the December/January changes in payroll are so large that the noise swamps the signal. But professional storytellers aren’t really content to say “this doesn’t really mean anything,” even if that’s the quantitative reality. They get paid to spin yarns, so spin yarns they do.
Yeah, about those wages: I’m not really sure why economists were expecting hourly earnings to decelerate this month. All of the anecdotal data, along with other wage measures, are suggesting that wages are rising apace (see chart, source Bloomberg, showing the Atlanta Fed Wage Tracker vs AHE). Not really a surprise, even given its compositional challenges, that AHE is also rising.
The thing about all of these stories is that while they can’t change the actual reality, they can change how reality is priced. This is one of the reasons that we get bubbles. The stories are so powerful that trading against them, with a ‘value’ mindset for example, is quixotic. Ultimately, in the long run, the value of the equity market is limited by fundamentals. But in the short run, it is virtually unlimited because of valuation multiples (price as a speculative multiple of fundamental earnings, e.g.) and those valuation multiples are driven by stories. And that’s a big reason that bullish stories are so popular.
But consider this bearish footnote on today’s 3.4% S&P rally: volume in the S&P constituents today was lower than the volume was on December 26! To be fair, the volume yesterday, when the S&P declined 2.5%, was even a bit lower than today’s volume. It’s typical thin and whippy first-week-of-the-year trading. Let’s see what next week brings.
[1] People occasionally ask me why I didn’t go on for my MA or PhD in Economics. I reply that it’s because I learned my Intermediate Microeconomics very well: I stopped going for a higher degree when the marginal costs outweighed the marginal benefits. When you look at it that way, it makes you wonder whether the PhD economists aren’t just the bad students who didn’t absorb that lesson.
[2] It’s referred to as the “price puzzle”; see Martin Eichenbaum, “Interpreting Macroeconomic Time Series Facts: The Effects of Monetary Policy: Comments.” European Economic Review, June 1992. And Michael Hanson, “The ‘Price Puzzle’ Reconsidered,” Journal of Monetary Economics, October 2004.
Developed Country Demographics are Inflationary, not Deflationary
I’m a relatively simple guy. I like simple models. I get suspicious with models that seem overly complicated. In my experience, the more components you add to a model the more likely it is that one of them ceases having explanatory power and messes up your model’s value. In this it is like (since tonight is Major League Baseball’s All-Star Game I thought I’d use a baseball analogy) bringing in relievers to a game. Every reliever you bring in has some chance that he just doesn’t have it tonight, so therefore you ought to bring in as few relievers as you can.
Baseball managers don’t seem to believe this, so they bring in as many relievers as they can. Similarly, economists don’t seem to believe the rule of parsimony. The more complexity in the model, the better (at least, for the economist’s job security).
Let’s talk about demographics and inflation.
Here’s how I think about how an aging population affects inflation:
- Fewer workers in the workforce implies a lower unemployment rate and higher wages, c.p.
- A higher retiree/active worker ratio implies lower saving, which will tend to send interest rates higher and equity prices lower, and tend to increase money velocity, c.p.
- A higher retiree/non-retiree ratio probably implies lower spending, c.p.
It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around #3, and the idea that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. But if there’s lower spending, that doesn’t necessarily indicate a wider output gap because of #1. The best you could say about the effect on the output gap of an aging population is that it is indeterminate: potential output growth should decline because of workforce decline (potential output growth » growth in the # of workers + growth in productivity per worker), while demand growth should also decline, leading to uncertain effects on the output gap.
I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.
The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MVºPQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.
So, my model is simple, and you don’t need to have a lot of extraneous dynamics if you simply say: slower potential growth implies higher potential inflation, and demographics implies lower potential future growth. Qed.
One other item I would point out about the three points above: all three are negative for stock markets. If you truly believe that the dominant effects are lower spending, less savings, and higher wages the you can’t possibly think that demographics are anything other than disastrous for equity valuations in the future.
The Phillips Curve is Working Just Fine, Thanks
I must say that it is discouraging how often I have to write about the Phillips Curve.
The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.
Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).
Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.
And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).
But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.
The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?
I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.
So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.
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Come see our new store at https://store.enduringip.com!
Inflation with Deflationary Overtones?
The Employment report was weak, with jobs coming in below consensus with a downward revision to prior months. It wasn’t abysmally weak, and not enough to change the a priori trajectory of the Fed. If the number had been 125k below expectations or 125k above it, then it may have had implications for the FOMC. But this is a number that has big swings and is revised multiple times. Getting 160k rather than 200k isn’t cause for celebration, but neither is it cause for panic. So whatever the Fed was getting ready to do didn’t change because of this number.
To be sure, no one knows what the Fed was planning to do, so this mainly has implications for the day’s volatility…which is to say that the market quickly went to sleep for the day.
Now, interestingly the Average Hourly Earnings number ticked higher to 2.5%, continuing the post-crisis upswing. At 2.5%, hourly earnings growth is slightly higher than median inflation and thus potentially “supportive of the inflation dynamic” from the standpoint of the Committee. Yes, wages follow inflation but not in the Fed models – so, while I don’t think this has any implications for future inflation it will eventually have implications for Fed policy. But this is a dovish Fed, and 2.5% earnings growth is not going to scare another tightening out of them…unless they were already planning to tighten.
Wages are actually a bit higher than that. Back in April I highlighted the Atlanta Fed’s Wage Growth Tracker and summarized how this measures is better than Hourly Earnings. I hadn’t been aware of this index previously but I follow it now. It stands at 3.2%. The difference between average hourly earnings and the Atlanta Fed Wage Tracker is summarized below (Source: Bloomberg). Again, though: I don’t think we have seen anything today which will change the Fed’s collective opinion about the need for different monetary policy.
Earlier this week, I promised that I would revisit the question of how we can have both deflation and inflation, and how these concepts are confused. I first posted an article summarizing this point in January 2014, and in re-reading it I think it is good enough to pretty much cut-and-paste with only mild edits. So here it is:
How Inflation and Deflation Can Peacefully Coexist
In the discussion about whether the economy is exhibiting “inflationary tendencies” or “deflationary tendencies,” I find that many, many observers grow confused by the fact that we measure prices in dollars, which are themselves subject to changes in relative value due to supply and demand.
It helps to forget about dollars as the unit of measure. Just because it says “One Dollar” does not mean that it is an ever-fixed mark. With apologies to Shakespeare, dollars are not the star to every wandering bark, whose worth’s unknown although its dollar price be taken.[1] There are two ways to look at the “inflation/deflation” debate. Depending on which one you are referring to, deflationary tendencies are not inconsistent with price inflation, and price inflation is not inconsistent with deflationary tendencies.
One is the question of dollar price; and here we are mainly concerned with the supply of dollars and the number of times they are spent, compared to the amount of stuff there is to buy. More dollars chasing the same goods and services imply higher prices. Of course, this is just another way of stating the monetarist equation: P ≡ MV/Q. This is an identity and true by definition. Moreover, it is true in practice: rapid money growth over some moderate length of time always corresponds with rapid deterioration in the purchasing power of the money unit – in other words, inflation. At least, we have no examples of (a) extremely high money growth without high inflation, or (b) extremely high inflation without high money growth.
But this is not the same discussion as saying that “the aging demographic [or debt implosion in a recession] means we will have deflation,” as many economists will have it. Deflation, in that sense, can still happen: if you have fewer workers making the same amount of GDP, then goods (and services) prices will fall relative to wages, which would be deflation the way we typically mean it if the overall price level was otherwise unchanged. However, if the money supply increases by a factor of 10, then nominal prices will increase no matter what else is going on. It may be, though, that in this case wages will increase slightly more than prices, so that there will be “deflation” in the unitless sense.
So, these are not inconsistent statements: (a) there will be increasing inflation next year, and (b) large amounts of private debt and demographic “waves” around the world are a deflationary force. The resolution to the seeming inconsistency is that (b) causes downward pressure on certain prices relative to other prices or, if you ignore the unit of exchange, it causes downward pressure in the ratio of one good that can be exchanged for another. Yet at the same time (a) implies that the overall increase in output in goods and services will be outstripped by the number of dollars spent on them, driving prices higher.
So you should cheer for the “good” sort of deflation. At least, you should cheer for it if you are still earning wages. But do not confuse that concept with the notion that prices in dollar terms will fall. That is wholly different, and unless central banks screw up pretty badly it is not going to happen. Indeed, despite all of the so-called “deflationary tendencies” – most of which I agree are important – I believe prices are going to rise in dollar terms and in fact they are going to rise at increasing rates (higher inflation) over the next few years.[2]
P.S. Don’t forget to buy my book! What’s Wrong with Money: The Biggest Bubble of All. Thanks!
[1] See Sonnet 116, in case you missed out on a liberal arts education and don’t get the reference!
[2] I kept this sentence…it was true in January 2014, as median inflation moved from 2.06% in Dec 2013 to 2.4% today, but I also believe this to be still true. Only the next leg will probably be faster.
The Sky is Not Falling…Yet
The Employment Report on Friday was bad – but it wasn’t the unmitigated disaster that the consensus seems to have spun it into. It is true that there were no bright spots. It is true that the net number of new jobs added was worse than consensus and indeed worse than some of the more pessimistic expectations. But 142k new jobs is not a recessionary collapse (yet). Let us remember that one or two months every year fall below that figure (see chart, source Bloomberg).
Folks, it’s just not a robust recovery and never has been. It has been slow and steady, and now it is probably petering out, but…let’s not jump off the buildings just yet. In fact, one of my favorite indicators during this period while the Unemployment Rate has been falling but the general perception of the employment picture has been poor has been the “Not in labor force, want a job now” series, which shows people who are discouraged enough to not be looking for work, but would take a job if it was offered. As the chart below shows, that number is far above the lows from the last couple of expansions, and so has been a good check on the improvement in the Unemployment Rate. Now, however, we must also recognize that it is near the recent lows.
So not all of the “job market internals” are flashing red. True, none of them are exactly flashing green, either! Nor have they really ever been, in this cycle.
At the same time, it is incredible to me that the ex-Chairman of the Fed is taking a victory lap, claiming in the Wall Street Journal today that his policies led to a non-inflationary decline in the unemployment rate. Surely a professional economist ought to know the difference between correlation and causality. It is absolute madness to claim that the Fed’s policies did nothing for the price level but had a huge effect on the real economy. That is almost exactly opposite of what generations of monetary policy experience teaches us: that monetary policy has almost no effect on real variables but only affects the price level. A more thorough retort will be given in “What’s Wrong with Money?”, which you can pre-order now! (If you prefer, send a note to WWWM@enduringinvestments.com and I will email you when it is published).
The unemployment rate declined for two reasons: the first is that just as no tree grows to the sky, no hole is bottomless. Eventually, even without any intervention at all, the business cycle takes over and recessions end. The second reason in this case is that the federal government ran (and continues to run) massive fiscal deficits, which demonstrably affect near-term growth. Yes, those deficits merely rearrange growth, stealing growth from the future to improve growth today, but if current growth is given by Y=C+I+G+(X-M) there is no way that the Fed can claim what is the biggest contribution over the last few years, percentage-wise. Madness, I say.
Is the economy headed for recession? In all likelihood, yes. But this employment number was not the first nor even the best sign of that possibility.
Which June Did You Mean, Charles?
Yesterday, Chicago Fed President Charles Evans gave a speech in which he said that he probably leaned towards making the first tightening early next year, as there is “no compelling reason for us to be in a hurry to tighten financial conditions.” The Fed, he said, probably shouldn’t raise rates until there’s a “greater confidence” that inflation one-to-two years ahead will be at or above 2%. This isn’t a surprising view, as Evans is the progenitor of the “Evans Rule” that says rates should stay near zero until unemployment has fallen below 6.5% (it has) or inflation has risen above 2.5%. Yes, those bounds have been walked about; in particular the 6.5% unemployment rate is obviously no longer binding (he sees the “natural rate” as being 5% again). But the very fact that he promoted a rule that set restraints on a mere return to normal policy means that he is a dove, through and through. So, it should not be surprising that he isn’t in a hurry to tighten.
What I found amusing is the sop he threw to the bears. Fed speakers often try to do the “on the one hand, on the other hand” maneuver, but in Evans’ case his heart clearly isn’t in it. He said that “you could imagine a case being made for a rate increase in June.” Notice that he doesn’t say he could imagine a case being made! I am also unclear about which June he means. Does he mean…
| (thru Apr) | (thru May) | |||
| Q1 GDP | Q2 GDP | Median CPI | M2 growth | |
| June 2012? | 2.3% | 1.6% | 2.4% | 9.2% |
| June 2013? | 2.7% | 1.8% | 2.0% | 6.6% |
| June 2014? | -2.1% | 4.6% | 2.2% | 7.3% |
| June 2015? | 0.2% | 1.0% (e) | 2.2% | 5.4% |
I am not sure exactly what he thinks those darn hawks are looking at, but it seems to me the case for tightening in June is getting worse every year.
Eagle-eyed readers will notice that I didn’t include the Unemployment Rate in the table above. That particular metric has been improving each year, but we know that the labor situation tends to lag the economic situation. The Unemployment Rate is a big political football, but it isn’t particularly useful for policy unless you believe in the concept of a “natural rate” with respect to accelerating unemployment in the overall economy. I don’t: low unemployment tends to increase wages, but has no discernible effect on consumer inflation. Moreover, it appears that the “natural rate” shifts quite a bit over time (6.5% down to 5% in Evans’ formulation, in only a few years’ time), making it look to me like a fairly useless concept.
Yes, of course it makes it more difficult politically to tighten when people are out of work, but since monetary policy is quite useful for affecting prices and not particularly useful for affecting growth, this should be a secondary effect at best. The Fed simply can’t help the unemployed worker, except by holding down inflation for him. In the real world, of course, the Fed Chair is not going to countenance an uptick in rates when unemployment is above 5% or so.
Let me be clear: I think the Fed ought to have tightened in 2012, 2013, or 2014, and they ought to tighten now. I don’t necessarily mean they should guide rates higher, but they should reduce the size of the mountain of reserves via any means a their disposal. But if you are going to argue one year over another year, I think it is hardest to argue that now is the time unless you are merely being guided by the old James Carville adage that the best time to plant a tree was twenty years ago, but the second-best time is right now.
One thing that Evans said that quickens my heart, as an inflation-watcher, is that the Fed “ought to allow” a chance that inflation overshoots 2% that is symmetrical to its chance of falling below it. While he is quintessentially unclear about how he would establish these probabilities – as I have just shown, he seems blissfully unaware that consumer price inflation is already above 2% – the mere fact of treating the costs of inflation misses as symmetrical is dangerous territory. The costs are not symmetrical. The costs of an inflation rate around 0% are very low; some frictions, perhaps, created by wage “stickiness” (even this possibility hasn’t been conclusively established until inflation gets convincingly below zero). The costs of an inflation rate of 4% are much higher, since inflation has historically had long “tails.” That is, once inflation goes up a little, it not infrequently rises a lot. Over the last 100 years, if you take the set of all year-on-year inflation rates above 4%, you find that about one-third of them are also above 10%. This means the costs of a loss of inflation vigilance is must greater than the costs of a loss of deflation vigilance.
Winter Is Coming
Sometimes being a value investor, amid overvalued (and ever more so) markets, feels a bit like being a Stark in Westeros. The analogy will be lost on you if you do not follow Game of Thrones, but the Starks hold the largest of the sub-kingdoms in Westeros. This kingdom also happens to be the coldest, and the sober Starks are always reminding people that “Winter is coming.”
I should observe that winter in Westeros is a much more serious affair than it is around here; it comes at odd intervals but can last for years. So being prepared for winter is really important. However, getting people to prepare for winter during the long “summer” is very difficult.
Sound familiar? The thing to keep in mind is that the Starks are always right, eventually, and they’re the ones who come through the winter in the best shape. Such is the case with value investors. (Some people might prefer calling value investors who are bearish on stocks right now “Chicken Littles” but I prefer being compared to Ned Stark, thanks. Although both of them have been known to lose their heads on occasion.)
Fortunately, it does not appear that winter is coming to the U.S. very soon. Friday’s Employment report was strong, despite the beginnings of downsizing in the oil and gas extraction businesses. The chart below shows the Baker Hughes oil and gas rig count, which is falling at a rate every bit as fast as it did in the credit crisis.
Yet, the U.S. economy as a whole generated 267,000 new jobs last month, which was above expectations. It is unlikely that this pace will continue, since the extraction (and related industry) jobs will be a drag. But in 2008, this happened when every other industry was being squeezed, and in the current case other industries are being squeezed by the strong dollar, but only mildly so. I think this will actually serve to increase the labor force participation rate, which has been in a downtrend for a long time – because laid-off oil workers will still be in the labor force looking for work, while other jobs will be getting filled by (sometimes) discouraged workers coming off the sidelines. So we may well see the Unemployment Rate rise even as jobs growth remains reasonable, even if less robust than the most recent figures.
Winter, though, is still coming.
In the near-term, winter is coming to Europe. Unusually, it is moving from the south to the north because Greece appears to be finally heading for the denouement that has been utterly unavoidable from the beginning. I wrote this in June 2012 (and I wasn’t the only one saying such things – the only real question has been how long it would take before the Greeks decided they’d had enough of sacrifice to hold together the Eurozone for the elites):
Greece will still leave the Euro. Government or no government, austerity or no austerity – the fiscal math simply doesn’t make sense unless Europe wants to pay for Greece forever. In principle, the Greeks can dig themselves out of trouble if they work harder, retire later, pay more taxes, and receive fewer government services. I do believe that people can change, and a society can change, under pressure of crisis. Remember Rosie the Riveter? But the question is whether they can change, whether they will change, do they even want to change, if the benefit of the change flows not to Greece’s people but to the behemoth European institutions that have lent money to Greece?
If a person declares bankruptcy, and the judge declares that he must pay all of his wages for the next thirty years, after deducting enough for food and shelter, to the creditors…do you think that person is going to go looking for a 60-hour workweek?
Am I sure that Greece is going to leave the Euro in a week, or a month, or a year? Not at all. The institutional self-preservation meme is very strong and I am always amazed at how long it takes obvious imperatives to actually happen.[1] But I am quite confident that Greece will eventually leave the Euro, and it does seem as if parties on all sides of the negotiating table are coming to that conclusion as well.
One question that authorities have had to come to peace with first was whether Grexit is really Armageddon. I have argued that default and an exit from the Euro is not bad for Greece, at least when compared to a multi-year depression.
And it’s probably not even horrible for Europe, or the world at large, at least compared to the credit crisis, despite all protestations that this would be “Lehman squared.” Again, this is old news and as I lay out the reasoning here there is no reason to repeat myself.
But it won’t be a positive thing. And it is likely to bring on “winter,” economically. Helpfully, the world’s central banks not only remain in easing mode but are increasing the dovishness of their stance, with the ECB foremost among the central banks that are priming the pumps again. M2 money growth in the Eurozone was up to 4.5% y/y in December (latest data available), with the highest quarter-over-quarter growth rate (8.3%, annualized) in money since the end of 2008! Meanwhile the Fed, while it is no longer adding to reserves, is still watching the money supply grow at 6% y/y with no good way to stop it. For all the talk about the FOMC hiking rates by mid-year, I think the probable rise in the Unemployment Rate discussed above, plus the weak inflation readings (with the notable exception of Median CPI), plus the fact that all other central banks are easing and likely to continue doing so, plus the probability of turbulence in Europe, makes it very unlikely that this Committee, with a very dovish makeup, will be tightening any time soon.
The likely onset of some winter will not help hold down inflation, however. Upward pressures remain, and the fact that the ECB is now running the pumps makes higher prices more likely. Yes, we care about money supply growth in Europe: the chart below shows the M2 growth of the US and Europe combined, against core CPI in the US. The fit is actually better than with US CPI alone.
Now, some markets are priced for winter and some are not. We think that real interest rates in Europe are far too low compared to real rates in the US, and stock prices in the US are too high compared to stock prices in Europe. The first chart below shows the spread of 10-year real rates in the US minus Europe (showing US yields are high compared to European yields); the second chart shows the ratio of the S&P 500 to the Eurostoxx 50.
You can see in the latter chart that the out-performance of the S&P has proceeded since 2009, while the under-performance of US inflation-linked bonds has only happened since 2012, so these are not simply two ways of looking at the same trade. In both cases, these deviations are quite extreme. But the European economy and the US economy are not completely independent of one another; weak European growth affects US corporate entities and vice-versa, and as I suggest above the growth of European money supply tends to affect US inflation as well. We think that (institutional) investors should buy TIPS and sell European linkers, and also buy European stocks against US stocks. By doing both of these things, the exposure to currency flows or general trends in global equity market pricing is lessened. (Institutional investors interested in how we would weight such a trade should contact us.)
[1] As another example, take the shrinking of Wall Street. It was obvious after 2008 that it had to happen; only recently, however, as banks and dealers have been forced to become more and more like utilities have we started to see layoffs while stocks are rising, which is very unusual. But Wall Street defended the bloated structures of the past for more than six years!
