Archive
Thanksgiving Memories: Re-Blog of Two Goodies
Since there aren’t a lot of folks out there trading today, that also means there probably aren’t a lot of folks reading articles about markets. I could just talk about the OpenAI guy going to Microsoft and then back again (I really couldn’t care less, but it seems everyone is breathless for new episodes of the Real Housewives of Artificial Intelligence), but I thought readers would be better served by a reprise of a couple of my old articles on inflation tails.
The first one is a lightly edited re-post of “Royally Skewed,” first posted May 9, 2011. (Wow, I’ve been doing this blog for a while!) Incidentally, feel free to go to the inflationguy.blog and search for topics of interest. Sometimes you can find a nugget among the 1100 or so articles!
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).
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):
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.
The second article dovetails with that one. In this article, from December 7, 2021, I provide a guess at the value of long inflation tails. This article is cleverly titled “A Guess at the Value of Long Inflation Tails,” because “Royally Skewed” was already taken.
A Guess at the Value of Long Inflation Tails
In my last post, “You Have Not Missed It,” I promised the following:
“There is one final point that I will explain in more detail in another post. Breakevens also should embed some premium because the tails to inflation are to the upside. When you estimate the value of that tail, it’s actually fairly large.”
So, as promised, here is that explanation.
Viewing the forward inflation curve as a forecast of expected inflation (whether using “breakevens” or, more accurately, inflation swaps) is biased in a particular way. Or, at least, it should be. The “breakeven” inflation rate is the rate at which a long-only investor over the ensuing period would be roughly as well off with a nominal bond (which pays a real rate plus a premium for expected inflation) and an inflation-indexed bond (which pays a real rate, plus actual inflation realized over the period). Obviously the inflation-indexed bond is safer in real space, so arguably nominal bonds should also offer a risk premium to induce a buyer to take inflation risk.[1] Ordinarily, though, we ignore this risk and just consider breakeven inflation to be the difference between real and nominal yields. Inflation swaps are cleaner, in that if inflation is higher than the stated fixed rate, the fixed-rate payer on the swap ‘wins’ and receives a cash flow at the end, whereas if inflation turns out to be lower than the stated fixed rate, it is the fixed-rate receiver who wins. So from here on, I will talk in terms of inflation swaps, which also abstract from various bond-financing issues of the breakeven…but the reader should understand that the concept applies to other measures of expected inflation as well.
Now, suppose that you expect 10-year inflation to come in at 2% per annum. Suppose that in the inflation swap market, the 10-year rate is 2% ‘choice’ – that is, you may either buy inflation at 2% or sell inflation at 2%. Since you expect inflation to be 2%, are you indifferent about whether you should buy or sell?
The answer is no. In this case you should be much more eager to buy 2% than to sell 2%, given that your point estimate is 2%. The reason why is that the distribution of inflation outcomes is not symmetrical: you are much more likely to observe a miss far above your expectation than to observe a miss far below your expectation. Therefore, the expected value of that miss is in your favor if you buy the inflation swap (pay fixed and receive inflation) at 2%. There is, in other words, an embedded option here that means the swap market should trade above where most people expect inflation to be.
We can roughly quantify at least the order of magnitude of this effect. Consider the distribution below. This chart (Source: Enduring Investments) shows the difference, from 1956 until 2011, of 10-year inflation expectations[2] compared with subsequent 10-year actual inflation results. The blue line is at 0% – at that point, actual inflation turned out to be right where a priori expectations had it. The chart obviously only covers until 2011 since that is the last year from which we have a completed 10-year period. Recognize that I am not charting the levels of inflation, but the level of inflation relative to the original expectation.
Notice that the chart has a cluster of outcomes (and in fact, the most-probable outcomes) just to the left of zero, where expectations exceeded the actual outcome by a little bit, but that there are very few long tails to the left. However, misses to the right, where the actual outcome was above the beginning-of-period expectations, were sometimes quite large. The median point (where half of the misses are to the left, and half are to the right) is 0.21%. But this is not a symmetric distribution, so if we randomly sample points from this distribution, we find that the average of that sample is 0.59%.
So, if you buy the inflation swap at 2% when your expectations are at 2%, on average you’ll win by 59bps, at least historically. Of course, past results are no indication of future returns, and a Fed economist would argue that we have much better control of inflation now than we ever have in the past (Ha ha. I crack myself up.). And inflation volatility markets, when they can be found, don’t trade at such high implied volatilities. Noted, although the wild swings in growth and the deficit and the money supply, not to mention recent realized outcomes, might make more cynical observers question whether we should be so confident in that view right at the moment.
Moreover, a counterargument is that at the present time an investor also has the advantage of investing when expectations are fairly low, so the downside tails are not as likely. The worst outcome of that whole 1956-2011 period was an 8.75% undershoot of inflation versus expectations. This happened in the 10 years following September 1981, when expectations were for 10-year inflation of 12.70% and actual inflation was 3.95%. But with expectations at 2.50%, is it really feasible to get a -6.25% compounded inflation rate? That would imply a 50% fall in the price level (and, I should note, it would mean that investors in TIPS would win hugely in real space since they get back no worse than nominal par. But that doesn’t help the swap buyer).
To be a little more fair, then, the following chart considers only the periods where inflation expectations were 5% per annum or less at the beginning of the period. That truncates only 10% of the distribution, but as you might expect the vast majority of the truncation is on the left-hand side. This is fair because it’s naturally harder to miss far below your expectations when your expectations are very low to begin with.[3]
The value of the expected miss in this contingent view is 1.13%. So, in order for the market to be priced fairly if general expectations are for 2.5% average CPI inflation the 10-year inflation swap would have to be around 3.63%. Again, even allowing for the “policymakers are smarter now” argument (an argument quite lacking, I would argue, in empirical evidence) I would feel comfortable saying that 10-year inflation swaps, and breakevens, should embed at least a 50bps or so ‘option premium’ relative to expectations.
I don’t believe that they do. Indeed, consider that the buyer of 10-year TIPS (with breakevens at 2.50%) not only wins if 10-year inflation is above 2.50% but the average win historically (conditioned on breakevens being below 5% to start, and by construction only considering wins) has been about 2.07% per annum – a massive outperformance. Not only that, but any losses are essentially guaranteed to be small because the tails on the left-hand side are truncated: if inflation is negative (that is, if the loss would have been greater than 2.50%) it is limited by the fact that the Treasury guarantees the nominal principal.
As an aside, we do consider this sort of option in other contexts. In the Eurodollar futures market, for example, we recognize that the person who is short the Eurodollar contract (and therefore gets a positive mark-to-market when interest rates rise) is in a better situation than the long (who gets the positive mark-to-market when interest rates fall), because the short gets to invest wins at higher interest rates and borrow losses at lower interest rates, while the long must borrow to cover losses when interest rates are higher, and but gets to invest wins when interest rates are lower. As a result, Eurodollar futures trade lower than the forwards implied from the swap curve, since the buyer needs to be induced by a better-than-expected price. And there are other such examples. But I am pretty sure I have never seen an example of an embedded option like this that is priced so differently relative to history than the embedded options in the inflation market!
[1] However, since this risk is symmetric – the seller of the bond also has risk in real space, but in the opposite direction – it isn’t immediately obvious why one side should get an inducement over the other. So I will leave the ‘risk premium’ aside.
[2] For long-term inflation expectations back before the advent of TIPS, I used the Enduring model relating real yields to nominal yields, about which I’ve written previously. You can find a brief discussion of this and an illustration of the model at this link: https://inflationguy.blog/2016/12/23/a-very-long-history-of-real-interest-rates/
[3] The author’s wife has been known to make something like this observation from time to time.
Where Inflation Stands in the Cycle
It’s important, I think, that I occasionally remind readers of a fact that is supported by overwhelming quantitative evidence, and yet virtually ignored by a wide majority of economists (and central bankers): inflation is a consequence of the stock of money growing faster than real economic growth. Period.
MV=PQ
That doesn’t mean that forecasting inflation is easy if we remember that fact, but at least we can make good directional predictions when, say, the stock of money rises 25% in a year, instead of mouthing some nonsense about inflation in such a case being “transitory.”
However, I realize that when someone mentions that equation a lot of people tune out, thinking this has become a religious argument between monetarists and Keynesians. So let me toss out some data. Keep in mind, there is measurement error in statistics for the money supply, real GDP (especially), and prices. And, as I’ve written before, sharp changes in M can cause a short-term impact on velocity until Q and P can catch up – my ‘trailer attached by a spring’ analogy. But over time, a shock move in velocity becomes less important (and reverses, which is what we are in the middle of), and so we would expect by simple algebra to see that a good prediction of the change in the price level is given by M/Q. Is it?
First let me share one of my favorite charts from a Federal Reserve Economic Review.[1] I’ve been using this for years.
This is over 5-year periods, and you can see that there’s a pretty good correlation – especially for large changes – in the change in the ratio of money/income and the change in prices. (By the way, the original article is still worth reading).
Here is another chart from that note, updated by me through the end of 2022.
The fact that the price level has gone up a little bit less than the ratio of money to GDP over time is a reflection of the fact that money velocity has gone down slightly, and then more quickly, over the last 110 years. If you think velocity will fully revert, then the blue line will eventually converge with the red line – but in my mind there’s no reason to believe that velocity is stable or entirely mean-reverting over time…only that it doesn’t permanently trend higher or lower like money, prices, and GDP do.
Obviously, this leads us to the question of where we are now. Here is a chart of the change in headline prices (CPI) as a function of the change in M/Q for five countries/regions.
The chart basically says that the UK and EU have seen prices move almost exactly what you would have predicted, if you could have known in advance what M and Q were going to do. Naturally, none of us knew that. Japan, the US, and Canada haven’t seen prices rise as much as you would have expected, yet. Some of the reason why not is the effect I mentioned earlier: the dump of money into accounts during COVID was so fast that there was no time for prices to adjust. Actually, it’s only this close because food and energy adjust more rapidly…if you look at the picture with just core inflation, it appears there’s still some lifting to do to get back to the 45-degree line. As energy prices and food prices mean-revert some, core inflation should stay a little bubbly for a while.
Now, there’s three ways to get back to the line. We can see prices rise. We can see GDP rise. Or we can see the money supply fall. The latter two effects are better for consumers. The “GDP rises” is the best for everyone, although that’s the slowest-moving of the pieces. The “money supply fall” option is the best for consumers, but the worst for investors. Presently, we’re seeing a little bit of all three. But here is where I should take a moment to highlight how important the Fed’s balance sheet reduction has been in this process. Here is a chart from 2019Q4 to the present, just for the US, showing how this relationship developed over time.
Initially, of course, there was a massive increase in money with no change in prices, as COVID hit in 2020. The point at (30%, 0%) is what the Fed had to work with as the lockdowns began to be lifted in late summer 2020. The sharp single-quarter reversal there was the result of the massive GDP spike in 2020Q3.
At that point, we would have anticipated that if nothing else happened, we would see a gradual 23% or so increase in the price level. If the Fed had immediately pulled back on the money printing, probably a lot less. Instead, the money printing continued for quite a while until by the middle of 2022 we were looking at a change in M/Q of about 37% since the end of 2019. Right about that time, the Fed got alarmed and began to shrink the balance sheet (and hike rates, although you will notice that the price of money does not show up on this chart but only its quantity!) That, combined with some decent growth, has decreased the pent-up pressure on prices. As of the end of 2023Q3, the aggregate M/Q change was 26.2%, while core prices had risen 16.4% (headline prices, including a 33% increase in energy and a 25% increase in food prices, are up 19.5% since the end of 2019).
If the money supply grows only at the rate of GDP from here, then this line will turn vertical and we have about a 10% increase in core inflation to ‘make up’ before we are back on the line. The good news is that the Fed currently is still reducing its balance sheet; the bad news is that M2 since April has stopped declining. More bad news is that GDP is likely to be soft or even negative here over the next few quarters, judging from payrolls, delinquencies, and other data. We could also hold out hope that velocity won’t fully rebound to pre-COVID levels, but there’s no reason other than “it sure would be nice if that happened” to expect that. Ergo, I think we’re still looking at higher-for-longer not just in the interest rate structure, but in the trajectory of inflation.
The most astonishing point on the charts above, in my mind, is the Japan point especially on the first chart. The amazing part isn’t that Japan’s inflation rate is lower than that of other countries here. They’ve added less money, so as a first pass you’d expect less inflation. But what’s amazing is that the Yen is also an absolute basket case, which means that imports – like, say, oil or gasoline – have gone up a lot more in price than for other countries. Crude oil in USD has risen about 22% in USD terms since the end of 2019. It’s up 66% in Yen terms! And yet, even with that Japanese inflation has stayed relatively low. So far. These charts tell me that I’d want to buy Japanese inflation and sell EU and UK inflation, where prices are closer to already reflecting the effect of the money geyser than they are in Japan.
[1] “Are Money Growth and Inflation Still Related?”, Economic Review, Federal Reserve Board of Atlanta, 2nd Quarter, 1999. https://www.atlantafed.org/-/media/documents/research/publications/economic-review/1999/q2/vol84no2_dwyer-hafer.pdf
Money Velocity Update!
Now that we have our first estimate of GDP for Q3, we also have our first estimate of M2 velocity for the third quarter. Because there is an amazing amount of uninformed hypothesis out there, I figured it was worth a quick review of where we are and where we’re going, and why it matters.
Why it matters: without the rebound in velocity, the slow-but-steady decline in M2 that we have experienced since mid-2022 would be outright deflationary. The money decline and the velocity re-acceleration are part and parcel of the same event, and that is the geyser of money that was squirted into the economy during COVID. Velocity collapsed for mostly mechanical reasons: it is a plug number in MVºPQ, and since prices do not instantly adjust to the new money supply float, velocity must decline to balance the equation. Another way of looking at it is that if you add money to people’s accounts faster than they can spend it then velocity will decline. I have previously presented an analogy that in this unique circumstance money velocity behaves as if it were a spring connecting a car, speeding away suddenly, with a trailer that has some inertia. Initially the spring absorbs the potential energy, and later provides it to the trailer as it catches up. Ultimately, the spring returns to its original length, when the car has stopped accelerating and the trailer is going at the same speed.
As M2 has declined in an unprecedented way, after surging in an unprecedented way, velocity has rebounded in an unprecedented way after plunging in an unprecedented way. All of these things are connected, episodically (but we will look at the underlying, lasting dynamics in a bit). With this latest GDP update, M2 velocity rose 1.9%, the 9th largest quarterly jump since 1970. Over the last four quarters, it has risen 10.4%, the largest on record, and 16% over eight quarters, also the largest on record.
https://fred.stlouisfed.org/series/M2V
To return to the level M2 Velocity was at, at the end of 2020Q1, it needs to rise another 4.8%. For M2 to return to the level it was at, at the end of 2020Q1, it needs to fall another 23%. One of these is likely to happen; the other one is not. The net difference, after subtracting cumulative growth (8.8% since then, so far), is a permanent increase in the price level. If M2 continues to come down, the net effect is a higher level of inflation over this period but not calamitous.
Note that there is no way we get the price level back to where it was, unless M2 declines considerably farther for considerably longer, or unless money velocity inexplicably turns around and dives again. I know that some well-known bond bull portfolio managers have been calling for that, but they were wrong the whole way along so why would you listen to them now?
I’ve been pretty clear that (a) I have been surprised that the Fed was successful in decreasing the money supply, since I thought the elasticity of loan supply would be more than the elasticity of loan demand (I was wrong), (b) I think the Fed deserves credit for shrinking the balance sheet, which they have long said doesn’t matter (it matters far more than interest rates, for inflation), (c) Powell deserves credit for turning into a hawk and pushing the institution of the Federal Reserve to become hawkish after decades under Greenspan, Bernanke, and Yellen where the only question being asked was ‘do we wait for the stock market to drop 10%, or only 5%, before we flood the system with money?’ Chairman Powell deservedly will go down in history as the guy who recognized the ‘spring effect’ that kept long-term upward pressure on inflation even as so many people were chirping about supply constraints and ‘transitory inflation’ (including, to be fair, Powell himself. But whatever he said, what he did was pretty reasonable).
However, the next bit is going to be challenging.
Velocity, being the inverse of the demand for real cash balances, is primarily affected by two main forces – one of them durable and one of them ephemeral. The ephemeral effect, which is rarely super-important, is that people tend to want to hold more cash when they are uncertain. Indeed, our model for velocity actually captured accidentally some of the ‘spring effect’ because for us it showed up as extreme uncertainty. Put another way, even if the Fed hadn’t flushed tons of money into the system, velocity would have had something of a sharp decline because of the high degree of economic uncertainty. Ergo, it was crucial that they flush in at least some money because otherwise we would have had outright deflation. They didn’t get the magnitude right, but they got the sign right. Anyway, the ‘uncertainty’ effect doesn’t last forever. The measure of uncertainty I use is a news-based index of economic policy uncertainty; it has retraced about 85% of its spike although it has been persistently high since political divisiveness became the main fact of US political life back in 2009 or so.
The more durable effect on the desire to hold cash is the presence of better-yielding alternatives to cash. When interest rates are uniformly zero and the stock market is on the moon, there’s very little reason to not hold cash. But when non-cash rates are high, and stocks and other investments more reasonably priced, cash is a wasting asset that people want to ‘put to work.’ The easiest way to see that is with interest rates, which for the last couple of decades have tracked the decline in money velocity closely as both declined.
And here is the problem. If interest rates are back at 2007 levels, then naïvely we would expect velocity to be back in the vicinity of 2007 levels also. But that is massively higher than the current level. In 2007, money velocity was around 1.98 or so: about 49% higher than the current level!
Needless to say, there’s no way the money supply is contracting that much. If velocity rose even, say, 30% then we would have a serious and long-lasting inflation problem. Fortunately, because of the economic policy uncertainty and other non-interest rate effects (I did say that “naïvely” we would be looking for 1.98, right?), the eventual rise in velocity beyond the snap-back level is much less than that. It actually only adds about 6% to the snap-back level. That still means 2% more inflation than would otherwise be expected, for three years, or 3% more for two years.
Of course, interest rates could fall again and ‘fix’ that problem. But it’s hard to see that happening while the money supply continues to contract, isn’t it? And that’s where it gets difficult. If you continue to decrease the balance sheet – which you need to do – and money continues to contract, then you probably get more velocity and inflation stays higher than you expect. Or, if you drop interest rates then you don’t get velocity much over the pre-COVID level, but you also get more money growth and inflation stays higher than you expect.
All of which adds up to one reason why I continue to think that inflation will stay sticky and higher than we want it, for a while. Powell has surprised me before, though, and this would be a good time to do it again.
Enough with Interest Rates Already
One of the things which alternately frustrates me and fascinates me is the mythology surrounding the idea that the central bank can address inflation by manipulating the price of money, even if it ignores the quantity of money.
I say “mythology” because there is virtually no empirical support for this notion, and the theoretical support for it depends on a model of flows in the economy that seem contrary to how the economy actually works. The idea, coarsely, is that by making money more dear the central bank will make it harder for businesses to borrow and invest, and for consumers to borrow and spend; therefore growth will slow. This seems to be a reasonable description of how the world works. But this then gets tied into inflation by appealing to the idea that lower aggregate demand should lower price pressures, leading to lower inflation. The models are very clear on this point: lower growth causes less inflation and more growth causes more inflation. The fact that this doesn’t appear to be the case in practice seems not to have lessened the fervor of policymakers for this framework. This is the frustrating part – especially since there is a viable alternative framework which seems to actually describe how the world works in practice, and that is monetarism.
The fascinating part are the incredibly short memories that policymakers enjoy when it comes to pursuing new policy using their preferred framework. Here’s the simplest of examples: from December 2008 until December 2019, the Fed Funds target rate spent 65% of the time pinned at 0.25%. The average Fed funds rate over that period was 0.69%. During that period, core inflation ranged from a low of 0.6% in 2010 to a high of 2.4%, hitting either 2.3% or 2.4% in 2012, 2016, 2017, 2018, and 2019. That 0.6% was an aberration – fully 86% of the time over that 11 years, core inflation was between 1.5% and 2.4%. Ergo, it seems reasonable to point out that ultra–low interest rates did not seem to cause higher inflation. If that is our most-recent experience, then why would the Fed now be aggressively pursuing a theory that depends on the idea that high interest rates will cause lower inflation? The most-recent evidence we have is that interest rates do not seem to affect inflation.
This isn’t just a recent phenomenon. But the nice thing about the post-GFC period is that for a good part of it, the Fed was ignoring bank reserves and the money supply and effecting policy entirely through interest rates (well, occasionally squirting some QE around, but if anything that should have increased inflation – it certainly didn’t dampen the effect of low interest rates). This became explicit in 2014 when Joseph Gagnon and Brian Sack, shortly after leaving the Fed themselves, published “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve.” In this piece, they argued that the Fed should ignore the quantity of reserves in the system, and simply change interest rates that it pays on reserves generated by its open market operations. The fundamental idea is that interest rates matter, and money does not, and the Fed dutifully has followed that framework ever since. As I just noted, though, the results of that experiment would seem to indicate that low interest rates, anyway, don’t seem to have the effect that would be predicted (and which effect is necessary if the policy is to be meaningful).
And really, this shouldn’t be a surprise because for the prior three decades, the level of the real policy rate (adjusting the nominal rate here by core CPI, not headline) has been completely unrelated to the subsequent change in core inflation.
So, to sum up: for at least 40 years, the level of real policy rates has had no discernable effect on changes in the level of inflation. And yet, current central bank dogma is that rates are the only thing that matters.
I stopped the chart in 2014 because that’s when the Gagnon/Sack experiment began, but it doesn’t really change anything to extend it to the current day. Actually, all you get is a massive acceleration and deceleration in core inflation that all happened before any interest rate changes affected growth (seeing as how we have not yet had a recession). So it’s a result-within-a-result, in fact.
Any observation about how the Fed manages the price of money rather than its quantity would not be complete without pointing out that the St. Louis Federal Reserve’s economist emeritus Daniel L Thorton, one of the last known monetarists at the Fed until his retirement, wrote a paper in 2012 entitled “Monetary Policy: Why Money Matters and Interest Rates Don’t” [emphasis in the original title]. In this well-argued, landmark, iconic, and totally ignored paper Dr. Thornton argued that the central bank should focus almost entirely on the quantity of money, and not its price. Naturally, this is concordant with my own view, plus more than a century of evidence around the world that the price level is closely tied to the quantity of money.
To be fair, the connection of changes in M2 to changes in the price level has also been weak since the mid-1990s, for reasons I’ve discussed at length elsewhere. But at least money has a history of being related to inflation, whereas interest rates do not (except as a result of inflation, rather than as a cause of them); moreover, we can rehabilitate money by separately modeling money velocity.
There does not appear to be any way to rehabilitate interest rate policy as a tool for addressing inflation. It hasn’t worked, it isn’t working, and it won’t work.
No Need to Rob Peter to Pay Paul
So, I suppose the good news is that policymakers have stopped pretending that prices will go back down to the pre-pandemic levels. My friend Andy Fately (@fx_poet) in his daily note today called to my attention these dark remarks from Bank of England Chief “Economist” Huw Pill:
“If the cost of what you’re buying has gone up compared to what you’re selling, you’re going to be worse off…So somehow in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether higher wages or passing the energy costs through on to customers…And what we’re facing now is that reluctance to accept that, yes, we’re all worse off, and we all have to take our share.”
I think it’s worth stopping to re-read those words again. There are two implications that immediately leap out to me.
The first is that this is scary-full-Socialist. “We all have to take our share” is so anti-capitalist, anti-freedom, anti-individualist that it reeks of something that came from the pages of Atlas Shrugged. No, thank you, I don’t care to take my share of your screw-up. I would like to defend my money, and my real spending power, and my real lifestyle. If that comes at the cost of your lifestyle, Mr. Pill, then I’m sorry.
But the second point is that…it doesn’t come at the cost of someone else’s lifestyle. This is why I put “economist” in quotation marks above. There is still a lot of confusion out there between the price level and inflation, and what a change in the price level means, but if you’re an economist there shouldn’t be.
You see statements like this everywhere…”food prices are up 18%. If people are spending 18% more on food, it means they’re spending less elsewhere.” “Rents are up 17%. If people are spending 17% more on rent, it means they’re spending less elsewhere.” “Pet food is up 21%. If people are spending 21% more on pet food, it means they’re spending less elsewhere.” “New vehicle prices are up 22%. If people are spending 22% more on new vehicles, it means they’re spending less elsewhere.” “Price of appliances are up 19%. If people are spending 19% more on new appliances, it means they’re spending less elsewhere.”
You get my point. All of those, incidentally, are actual aggregate price changes since the end of 2019.
This is where an actual economist should step in and say “if the amount of money in circulation is up 37%, why does spending 18% more on good or service A mean that we have to spend less on good or service B?” In fact, this is only true if the growth in the aggregate amount of money is distributed highly unevenly. In ‘normal’ times, that might be a defensible assumption but during the pandemic money was distributed remarkably evenly.
Okay…the amount of money in circulation is a ‘stock’ number and the prices of stuff changing over time is a ‘flow’ number, which is why money velocity also matters. M*V is up about 24% since the end of 2019. So a 20% rise in prices shouldn’t be surprising, and since there’s lots more money out there a 20% rise in the price of one good does not imply you need to spend less on another good. That’s only true in a non-inflationary environment. The world has changed. You need to learn to think in real terms, especially if you are a “Chief Economist.”
(N.b. to be sure, this is somewhat definitional since we define V as PQ/M, but the overarching point is that with 40% more money in the system, it should be not the slightest bit surprising to see prices up 20%. And, if velocity really does act like a spring storing potential energy, then we should eventually expect to see prices up more like 30-40%.)
Here’s a little bonus thought.
Rents are +17%, which is roughly in line with a general rise in the prices of goods and services. Home prices are up about 36% (using Shiller 20-City Home Price Index), which is roughly in line with the raw increase in M2.
Proposition: since the price of unproductive real assets is essentially an exchange rate of dollars:asset – which means that an increase in a real asset’s price is the inverse of the dollar’s decrease – then the price of a real asset should reflect the stock of money since price is dictated by the relative scarcity of the quantity of dollars versus the real asset. But the price of a consumer good or service should reflect the flow of money, so something more like the MV/Q concept.
Implication:
Discuss.
Who’s Afraid of De-Dollarization?
Do we need to worry about the end of dollar dominance in international trade – the de-dollarization of global finance?
I am hoping to do a podcast on this topic in a few weeks, featuring a guest who is actually an expert on foreign exchange and who can push back on my thought processes (or, less likely, echo them) – but the topic seems timely now. There is widespread discussion and concern in some quarters, as China and Russia push forward efforts to establish the Chinese Yuan as an alternative currency for international trade settlement, that this could spell the sunset of the dollar’s dominance. Some of the more animated commentators declare that de-dollarization will dramatically and immediately eviscerate the standard of living in the United States and condemn the nation to be an also-ran third-rate economy as its citizens descend into unspeakable squalor.
Obviously, such ghoulish prognostications are ridiculously overdone for the purpose of generating clicks. But how much of it is true, at least on some level? What would happen if, tomorrow, the US dollar lost its status as the world’s primary reserve currency?
One thing that wouldn’t change at all is the quantity of dollars in circulation. That’s a number that the Federal Reserve exerts some control over (they used to have almost total control, when banks were reserve-constrained; now that banks have far more reserves than they need, they can lend as much as they like, creating as many floating dollars as they like, constrained only by their balance sheet). The holders of dollars have absolutely no control over the amount of them in circulation! If Party A doesn’t like owning dollars, they can sell their dollars – but they have to sell it to some Party B, who then holds the dollars.
What also wouldn’t change immediately is how many dollar reserves every country holds. From time to time, people get concerned that “China is going to sell all of its dollars.” But China got those dollars because they sell us more stuff than we sell them, which causes them to accumulate dollars over time. How can China get rid of their dollars? Their options are fairly limited:
- They can start buying more from us than they sell to us. We’ve been trying to get them to do this for years! Seems unlikely.
- They can buy from us, stuff priced in dollars, but only sell goods to us that are priced in Yuan. To get Yuan, a US purchaser would have to sell dollars to buy Yuan. Since China doesn’t want to be the other side of that trade (which would leave them with the same amount of dollars), the US purchaser would have to go elsewhere to buy Yuan. This would strengthen the Yuan. This is also something we’ve been trying to get them to do for years! The Bank of China stops the Yuan from strengthening against the dollar by…selling Yuan and buying dollars. Hmmm.
- They can just hit the bid and sell dollars against all sorts of other currencies. This would greatly weaken the dollar, and is perhaps the biggest fear of many of the people worried about de-dollarization.
Supposing that China decided on #3, they would be making US industry much more competitive around the world against all of the currencies that China was buying. Foreign buyers of US products would now be able to buy US goods much more cheaply. It would cause more inflation in the US, but it would take a large dollar decline to drastically increase US inflation since foreign trade is a smaller part of the US economy than it is for many other countries.
A much lower dollar, making US prices look lower to non-US customers, would help balance the US trade deficit. Yay!
A tendency towards balance of the trade deficit would have ancillary impacts. When the US government runs a fiscal deficit, it borrows from essentially two places: domestic savers and foreign savers. Foreigners, having a surplus of dollars (since they have trade surpluses with us), buy Treasuries among other things. If the trade deficit went down drastically, so would foreign demand for US Treasuries. That in turn would (unless the government started to balance its fiscal deficit) cause higher interest rates, which would be necessary to induce domestic savers to buy more Treasuries. Or, if domestic savers were not up to the task, the buyer of last resort would be…the Federal Reserve, which could buy those bonds with printed money. And that’s a really bad outcome.
Now, does any of this cause a collapse of the American system or spell an end to US hegemony? No. If policymakers respond to such an event by refusing to get the fiscal house in order, then things could get ugly. But it would be hard to blame that outcome on the end of the dollar as the medium of international trade – blame would more appropriately be directed at the failure of domestic policymakers to adjust in response.
In the end, it is hard to escape the idea that good or bad economic and inflation outcomes in the United States track mainly, one way or the other, back to domestic policy decisions. Whether the US economic system remains a dominant one is…fortunately or unfortunately…in our hands, not in the hands of foreign state actors.
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.
Summary of My Post-CPI Tweets (February 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup! To be sure, the importance of this data point in the short run is much less than it was a week ago, but it would be a mistake to lose sight of inflation now that the Fed is likely moving from QT to QE again.
- A reminder to subscribers of the tweet schedule: At 8:30ET, when the data drops, I will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
- Afterwards (recently it’s been 9:30ish) I will have a private conference call for subscribers where I’ll quickly summarize the numbers.
- After my comments on the number, I will post a partial summary at https://inflationguy.blog and later will podcast a summary at inflationguy.podbean.com .
- I am also going to try and record the conference call for later. I think I’ve figured out how to do that. If I’m successful, I’ll tweet that later also.
- Thanks again for subscribing! And now for the walkup.
- This picture of the last month has changed quite a bit over the last few days! Suddenly, rates have reversed and the nominal curve is steepening. The inflation market readings are…of sketchy quality at the moment.
- Now, the swap market has also re-priced the inflation trough: instead of 2.65% in June (was in low 2s not long ago), the infl swap market now has y/y bottoming at 3.34% b/c of base effects before bouncing to 3.7% & then down to 3.15% by year-end. I think that’s pretty unlikely.
- Let’s remember that Median CPI reached a new high JUST LAST MONTH, contrary to expectations (including mine). The disturbing inflation trend is what had persuaded investors…until late last week…that the Fed might abruptly lurch back to a 50bp hike.
- These are real trends…so I’m not sure why economists are acting as if they are still certain that inflation is decelerating. The evidence that it is, so far at least, is sparse.
- Also, this month not only did the Manheim used car index rise again, but Black Book (historically a better fit although BLS has changed their sampling source so we’re not sure) also did. I have that adding 0.04%-0.05% to core.
- But maybe this is a good time to step back a bit, because of the diminished importance of this report (to be sure, if we get a clean 0.5%, it’s going to be very problematic for the Fed which means it should also be problematic for equity investors).
- Over the last few days we’ve read a lot about how banks are seeing deposits leave for higher-yielding opportunities. This is completely expected: as interest rates rise, the demand for real cash balances declines.
- You may have heard me say that before. But it’s really Friedman who said that first: velocity is the inverse of the demand for real cash balances. DEPOSITS LEAVING FOR HIGHER YIELDS IS EXACTLY WHAT HIGHER VELOCITY MEANS.
- And it is the reason for the very high correlation of velocity with interest rates.
- So the backdrop is this: money may be declining slightly but velocity is rebounding hard. Exactly as we should expect. Our model is shown here – it’s heavily influenced by interest rates (but not only interest rates).
- And if the Fed is going to move from its modest QT to QE, especially if they don’t ALSO slash rates back towards zero, then the inflationary impulse has little reason to fade.
- You know, I said back when the Fed started hiking that they would stop once the market forced them to. What has been amazing is that there were no accidents until now, so the market let them go for it. And in the long run this is good news – rates nearer neutral.
- But we have now had some bumps (and to be fair, I said no accidents until now but of course if the FDIC and Fed had been doing their job and monitoring duration gaps…this accident started many many months ago).
- With respect to how the Fed responds to this number: it is important to remember that the IMPACT ON INFLATION of an incremental 25bps or 50bps is almost zero. Especially in the short run. It might even be precisely zero.
- But the impact of 25bps or 50bps on attitudes, on deposit flight, and on liquidity hoarding could be severe, in the short run. On the other hand, if the Fed stands pat and does nothing but end QT, it might smack of panic.
- If I were at the Fed, I’d be deciding between 25bps and 0bps. And the only decent argument for 25bps is that it evinces a “business as usual” air. It won’t affect 2023 inflation at all (even using the Fed’s models which assume rates affect inflation).
- Here are the forecasts I have for the number – I tweeted this yesterday too. I’m a full 0.1% higher on core than the Street economists, market, and Kalshi. But I’m in-line on headline. So obviously as noted above I see the risks as higher.
- Market reactions? If we get my number or higher, it creates an obvious dilemma for the Fed and that means bad things for the market no matter how the Fed resolves that. Do they ignore inflation or ignore market stability?
- If we get lower than the economists’ expectation (on core), then it’s good news for the market because MAYBE it means the Fed isn’t in quite such a bad box and can do more to support liquidity (read: support the mo mo stock guys).
- So – maybe this report is important after all! Good luck today. I will be back live at 8:31ET.
- Well, headline was below core!
- Waiting for database to update but on a glance this doesn’t look good. Core was an upside surprise slightly and that was with used cars a DRAG.
- m/m CPI: 0.37% m/m Core CPI: 0.452%
- Last 12 core CPI figures
- So this to me looks like bad news. I don’t see the deceleration that everyone was looking for. We will look at some of the breakdown in a minute.
- M/M, Y/Y, and prior Y/Y for 8 major subgroups
- Standing out a couple of things: Apparel (small weight) jumps again…surprising. And Medical Care is back to a drag…some of that is insurance adjustment (-4.07% m/m, pretty normal) and some is Doctors Services (-0.52% m/m), while Pharma (0.14%) only a small add.
- Core Goods: 1.03% y/y Core Services: 7.26% y/y
- We start to see the problem here: any drag continues to be in core goods. Core goods does not have unlimited downside especially with the USD on the back foot. Core services…no sign of slowing.
- Primary Rents: 8.76% y/y OER: 8.01% y/y
- And rents…still accelerating y/y.
- Further: Primary Rents 0.76% M/M, 8.76% Y/Y (8.56% last) OER 0.7% M/M, 8.01% Y/Y (7.76% last) Lodging Away From Home 2.3% M/M, 6.7% Y/Y (7.7% last)
- Last month, OER and Primary Rents had slipped a bit and econs assumed that was the start of the deceleration. Maybe, but they re-accelerated a bit this month. Lodging away from home a decent m/m jump, but actually declined y/y so you can see that’s seasonal.
- Some ‘COVID’ Categories: Airfares 6.38% M/M (-2.15% Last) Lodging Away from Home 2.26% M/M (1.2% Last) Used Cars/Trucks -2.77% M/M (-1.94% Last) New Cars/Trucks 0.18% M/M (0.23% Last)
- FINALLY we see the rise in airfares that has been long overdue. I expected this to add 0.01% to core; it actually added 0.05%. Those who want to say this is a good number will screech “outlier!” but really it’s just catching up. The outlier is used cars.
- Both the Manheim and Black Book surveys clearly showed an increase in used car prices. But the BLS has recently changed methodologies on autos. Not clear what they’re using. Maybe it’s just timing and used will add back next month. We will see.
- Here is my early and automated guess at Median CPI for this month: 0.634%
- Now, the caveat to this chart is that I was off last month (the actual figure reported is shown), but that was January. I think I’ll be better on February. I have the median category as Food Away from Home. This chart is bad news for the deceleration crowd, and for the Fed.
- Piece 1: Food & Energy: 7.97% y/y
- OK, Food and Energy is decelerating, but both still contributed high rates of change. Energy will oscillate. It is uncomfortable that Food is still adding.
- Piece 2: Core Commodities: 1.03% y/y
- This is the reason headline was lower than expected. Core goods – in this case largely Used Cars, which I thought would add 0.05% and instead subtracted 0.09% from core. That’s a -14bps swing. +5bps from airfares, but health insurance was a drag…and we were still >consensus.
- Piece 3: Core Services less Rent of Shelter: 5.96% y/y
- …and this is the engine that NEEDS to be heading sharply lower if we’re going to get to 3.15% by end of year. It’s drooping, but not hard.
- Piece 4: Rent of Shelter: 8.18% y/y
- …and I already talked about this. No deceleration evident. As an aside, it’s not clear why we would see one with rising landlord costs, a shortage of housing, and robust wage gains, but…it’s an article of faith out there.
- Core inflation ex-shelter decelerated from 3.94% y/y to 3.74% y/y. That’s good news, although mainly it serves to amplify Used Cars…but look, even if you take out the big add from sticky shelter, we’re still not anywhere near target.
- Equity investors seem to love this figure. Be kind. They’re not thinking clearly these days. It’s a bad number that makes the Fed’s job really difficult.
- Note that Nick Timiraos didn’t signal anything yesterday…that means the Fed hasn’t decided yet. Which means they cared about this number. Which means to me that we’re likely getting 25bps, not 0bps. Now, maybe they just wanted to watch banking for another few days, but…
- …the inflation news isn’t good. As I said up top, 25bps doesn’t mean anything to inflation, but if they skip then it means we are back in QE and hold onto your hats because inflation is going to be a problem for a while.
- Even if they hike, they will probably arrest QT – and that was the only part of policy that was helping. Higher rates was just accelerating velocity. But I digress. Point is, this is a bad print for a Fed hoping for an all-clear hint.
- The only core categories with annualized monthly changes lower than -10% was Used Cars and Trucks (-29%). Core categories ABOVE +10% annualized monthly: Public Transport (+46%), Lodging AFH (+31%), Jewelry/Watches (+20%), Misc Personal Svcs (+17.7%), Footwear (+18%), >>>
- Women’s/Girls’ Apparel (+15%), Tobacco and Smoking Products (+13%), Recreation (+11%), Motor Vehicle Insurance (+11%), Infants’/Toddlers’ Apparel (+11%), and Misc Personal Goods (+10%). Although I also have South Urban OER at +10%, using my seasonality estimate.
- On the Medical Care piece, we really should keep in mind this steady drag from the crazy Health Insurance plug estimate for this year. It’ll almost certainly be an add next year. Imagine where we’d be on core if that was merely flat rather than in unprecedented deflation.
- Let’s go back to median for a bit. The m/m Median was 0.63% (my estimate), which is right in line with last month. The caveat is that the median category was Food Away from Home but that was surrounded by a couple of OER categories which are the ones I have to estimate. [Corrected from original tweet, which cited 0.55% as my median estimate]
- I can’t re-emphasize this enough. Inflation still hasn’t PEAKED, much less started to decline.
- One place we had seen some improvement was in narrowing BREADTH of inflation. Still broad, but narrower. However, this month it broadened again just a bit and the EIIDI ticked higher. Higher median, broader inflation…and that’s with Used Cars a strange drag.
- Stocks still don’t get it, but breakevens do. The 10y BEI is +7bps today. ESH3 is +49 points though!
- We’ll stop it there for now. Conference call will be at 9:30ET (10 minutes). (518) [redacted] Access Code [redacted]. I will be trying to record this one for playback for subscribers who can’t tune in then.
- The conference call recording seemed to go well. If you want to listen to it, you can call the playback number at (757) 841-1077, access code 736735. The recording is about 12 minutes long.
In retrospect, my forecast of 0.4% on seasonally-adjusted headline and 0.5% on core looks pretty good…but that’s only because we got significant downward one-offs, notably from Used Cars. If Used Cars had come in where I was expecting (+1.4%) instead of where it actually came in (-2.8%), and the rest of the report had been the same, then core inflation would have been 0.6% and we would be having a very different discussion right now.
As it is, this is not the number that the Fed needed. Inflation has not yet peaked, and that’s with Health Insurance providing a 4-5bps drag every month. That’s with Used Cars showing a drag instead of the contribution I expected. The “transitory” folks will be pointing to rents and saying that it seems ridiculous, and ‘clearly must decline,’ but that’s not as clear to me. Landlords are facing increased costs for maintenance, financing, energy, taxes; there is a shortage of housing so there is a line of tenants waiting to rent, and wage growth remains robust so these tenants can pay. Why should rents decelerate or even (as some people have been declaring) decline?
Apparel was also a surprising add. Its weight is low but the strength is surprising. A chart of the apparel index is below. Clothing prices now are higher than they’ve been since 2000. The USA imports almost all of its apparel. This is a picture of the effect of deglobalization, perhaps.
So all of this isn’t what the Fed wanted to see. A nice, soft inflation report would have allowed the Fed to gracefully turn to supporting markets and banks, and put the inflation fight on hold at least temporarily. But the water is still boiling and the pot needs to be attended. I think it would be difficult for the Fed to eschew any rate hike at all, given this context. However, I do believe they’ll stop QT – selling bonds will only make the mark-to-market of bank securities holdings worse.
But in the bigger picture, the FOMC at some point needs to address the question of why nearly 500bps of rate hikes have had no measurable effect on inflation. Are the lags just much longer than they thought, and longer than in the past? That seems a difficult argument. But it may be more palatable to them than considering whether increasing interest rates by fiat while maintaining huge quantities of excess reserves is a strategy that – as monetarists would say and have been saying – should not have a significant effect on inflation. The Fed models of monetary policy transmission have been terribly inaccurate. The right thing to do is to go back to first principles and ask whether the models are wrong, especially since there is a cogent alternative theory that could be considered.
Back when I wrote What’s Wrong With Money?, my prescription for unwinding the extraordinary largesse of the global financial crisis – never mind the orders-of-magnitude larger QE of COVID policy response – was exactly the opposite. I said the Fed should decrease the money supply, while holding interest rates down (since, if interest rates rise, velocity should be expected to rise as well and this will exacerbate the problem in the short-term). The Fed has done the opposite, and seem so far to be getting the exact opposite result than they want.
Just sayin’.
The Powell of Positive Thinking
Yes: Federal Reserve Chairman Powell was very hawkish at his Congressional testimony on Tuesday and Wednesday. He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. He additionally signaled that the peak probably will be higher than previously signaled (I’ve been saying and thinking 5% for a while, but it’s going to be higher), and even signaled the increasing likelihood of a return to 50bp hikes after the recent deceleration to 25bps.
This latter point, in my view, is the least likely since all of the reasons for the step down to 25bps remain valid: whether the peak is 5% or 6%, it is relatively nearby and the confidence that we should have that rates have not risen enough should therefore be decreasing rapidly. Moreover, since monetary policy works with a lag and there has been very little lag since the aggressive tightening campaign began, it would be reasonable to slow down or stop to assess the effect that prior hikes have had.
But here is the bigger point, and one that Powell did not broach. There is really not much evidence at all that the Fed’s hikes to date have affected inflation. It is completely an article of faith that they surely will, but this is not the same as saying that they have. Consider for a moment: in what way could we plausibly argue that rate hikes so far have been responsible for the decline in inflation? The decline in inflation has been entirely from the goods sector, and a good portion of that has been from used cars returning to a normal level (meaning, in line with the growth in money) after having overshot. How exactly has monetary policy driven down the prices of goods?
This is not to say that higher interest rates have not affected economic activity, and this (to me) is the real surprise: given the amount of leverage extant in the corporate world, it amazes me that we haven’t seen a more-serious retrenchment. Some of this is pent-up demand that still needs to be satisfied, for example in housing where significant rate hikes would normally dampen housing demand substantially and seems to have. However, there is a severe shortage of housing in the country and so construction continues (and home prices, while they have fallen slightly, show no signs of the collapse that so many have forecast). Higher rates are also rippling through the commercial MBS market, as many commercial landlords have inexplicably financed their projects with floating rate debt and where the cost of leverage can make or break the project.
Higher interest rates, on the other hand, tend to support residential rents, at least until unemployment eventually rises appreciably. I think perhaps that not many economists are landlords, but higher costs tend to not result in a desire to charge lower rents. On the commercial side, leases are for longer and turnover is more costly, but the average residential landlord these days is not facing a shortage of demand.
So where have rate hikes caused inflation to decline? Judging from the fact that Median CPI just set a new high, I think the answer is pretty plain: they haven’t. And yet, the Fed believes that if they keep hiking, inflation will fall into place. Where else can we more plainly see at work the maxim that “if a piece doesn’t fit, you’re not using a big enough hammer?” Or maybe, this is just a reflection of the notion that if you want something bad enough, the wanting itself will cause the thing to happen. [N.B. this is really more in line with the prescription from Napoleon Hill’s classic book “Think and Grow Rich”, but the title of Peale’s equally-classic “The Power of Positive Thinking” suggested a catchier title for this article. Consider it poetic license.]
Moreover, what we have seen is that higher interest rates have had the predicted effect on money velocity. Although I have elsewhere noted that part of the rebound in money velocity so far is due to the ‘spring force’ effect, there is substantial evidence that one of the main drivers of money velocity is the interest rate earned on non-cash balances. Enough so, in fact, that I wrote about the connection in June 2022 in a piece entitled “The Coming Rise in Money Velocity,” before the recent surge in velocity began. [I’d also call your attention to a recently-published article by Samuel Reynard of the Swiss National Bank, “Central bank balance sheet, money, and inflation,” where he incorporates money velocity into his adjusted money supply growth figure. Reynard is one of the last monetarists extant in central banking circles.]
Now, nothing that I have just written is going to deter Powell & Co from continuing to hike rates until demand is finally crushed and, according to their faith but in the absence of evidence to date, inflation will decelerate back to where they want it. But with long-term inflation breakevens priced at levels mirroring that faith, it is worth questioning whether there is some value in being apostate.
Is Inflation Mean-Reverting?
Over the last couple of decades, the assumption that inflation is mean-reverting to something approximating the Fed’s target level (or to where inflation expectations are supposedly – without any evidence advanced to support the notion – ‘anchored’) has become a key component of most economists’ models. I’ve pointed out a number of times in podcasts (including my own Inflation Guy Podcast as well as numerous others) and in articles that after a quarter-century of having low and stable inflation any model which did not assume mean-reversion has been discarded because it made bad predictions over that period compared to one which did.
A critical follow-up question is whether a model should assume mean reversion in inflation. My observation implicitly says that it should not. If I’m wrong, and inflation in fact is mean-reverting, then the right models won and there’s no real problem.
So, did the right models win?
There are many sophisticated ways to test for mean reversion, but an intuitive one is this: for a given current level of inflation, which is a better guess: (a) inflation will be closer to the ‘mean’ in the next period; (b) inflation will be about the same distance from the mean (homeostasis), neither pulling towards the mean nor pushing away from the mean; or (c) inflation will be further away from the mean, such that deviations from mean get amplified over time. In case (b) we would say that inflation itself has momentum; in case (c) we would say the acceleration of inflation has momentum. The latter case seems an unlikely case of extreme instability: it says that once prices move away from equilibrium, the economy either enters into an inflationary spiral or a deflationary spiral with no clear end. While this clearly can eventually happen in the hyperinflation case, those cases seem to have other causes that tend to amplify the swings (notably, an accelerating loss of faith in the currency itself).
Let’s consider case (a) and (b), and look at some historical data.
The chart below shows the period 1957-2022. The x-axis indicates the current level of inflation, (I collapse the range from -0.5% to +0.5% and call it 0%, +0.5% to +1.5% and call it 1%, etc), and the y-axis shows the average inflation over the subsequent one year. So, the point that is at [2%, 2.3%] shows that between 1957 and 2022, if inflation was between 1.5% and 2.5% then the average inflation over the ensuing 12 months was 2.3%.
I’ve drawn a line that indicates inflation at the same level at the point of observation and subsequently (x=y). Notice that for any number below x=2%, y tends towards 2%. This shows that when the current reading is very low inflation or deflation, the subsequent year we tend to get something close to 2%. Notice that at higher rates of inflation, the dots are below the line – meaning that if inflation is high, the following year tends to see inflation closer to the target. So, this is what we would think mean reversion would look like (and FWIW, it is more pronounced if you choose a longer historical period but because the next chart I am showing is core CPI and we only have data to 1957, I wanted to use the same range).
Case closed! Inflation mean reverts!
Well, not exactly. This is headline inflation. We already know that food and energy tend to mean-revert; that is, after all, why economists exclude food and energy – because we know that high energy readings lead to high inflation prints, and we don’t want monetary policy to overreact to inflation that isn’t really persistent. So, let’s look at core instead.
This chart looks different in key aspects. Except for very high core readings (with comparatively few observations that happen to coincide with when Volcker was aggressively tightening policy), the best estimate for core inflation over the next 12 months is not something closer to the assumed mean; the best estimate is the same level as what we have right now.
What that means – and it is super important – is that inflation has momentum. Keep in mind that during most of the period shown here, the Federal Reserve was actively trying to make inflation mean-revert. And they didn’t succeed, at least on a one-year basis.
Well, monetary policy works with long and variable lags, right? How about core inflation over the period 12-24 months from now? Surely then we should see some mean reversion?
The answer, at least for core inflation, is decidedly no…except for very high current readings of inflation.
Two takeaways:
- Inflation has momentum. This means that forecasting core inflation to return to the target level, just because we think it should, is a bad forecasting approach.
- Monetary policy seems to have had, at least over this period, very little effect. Generously, it didn’t have effect on average…so perhaps sometimes the Fed overshot and other times it didn’t do enough. There is indeed a range. For example: starting from 5% y/y core inflation (between 4.5% and 5.5%), the 10th percentile of the 1y CPI outcomes after that was 3.5% and the 90th percentile was 6.0%. Starting from 7%, the 10th percentile was 3.1% and the 90th was 9.6%. So the average includes some times when inflation kept going up and some times when it was going back down.
The corollary to the second takeaway…call it takeaway 2a…is this: by the same token, there’s not a lot of reason for the Fed to be super aggressive raising rates to rein in inflation. We know that they can do harm. It’s less clear that they can do a whole lot of good!
