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The Coming Rise in Money Velocity

June 28, 2022 2 comments

As M2 money growth soared throughout the COVID and post-COVID period of direct stimulus check-writing funded by massive quantitative easing (QE), monetarism novices thought that this would not result in inflation because money velocity simultaneously collapsed. Consequently, they argued, M*V was not growing at an outrageous rate.

There was precedence for such optimism. In the Global Financial Crisis of 2008-09, money supply grew rapidly with the onset of QE and money velocity declined, never to recover. The chart below shows in a normalized fashion the rise in M, the decline in V, and the relative quiescence of MV/Q, which is of course P by definition as long as you choose your Ms, Vs, and Qs right.

A similar thing happened in this episode, so why would this be any different?

There are many reasons why these episodes are different. To name a few:

  • The absolute scale of the rise in M2 was 2.5x the rise in 2007-2010, and that’s being generous since that measures the growth in 2007-2010 starting almost 2 years before the first QE in November 2008 compared to only 15 months in the second case.
  • As I’ve written previously, QE in the first case was directed at banks; at the same time that the Federal Reserve was adding reserves it was also paying banks interest on reserves – because the point was to strengthen banks, not consumers.
  • 5y interest rates came into 2008 at 3.44%; they came into 2020 at 1.69%. Since velocity is most highly correlated to interest rates, there was less room for this factor to be a lasting downward influence on velocity (after the crisis began in 2008, 5y Treasury rates never exceeded 3% again except for a few days in 2018).
  • Bank credit growth never stopped in the 2020 crisis, while it contracted at a 5% rate in the 2008 crisis (see chart, source Board of Governors of the Fed).

The monetarist novices (you can tell they’re novices because they say things like “Friedman said velocity was constant,” which is false, or “velocity is just a plug number [true] and has no independent meaning of its own [false]”) insisted that velocity was in a permanently declining state and that there was no reason at all to expect it to ever “bounce.” After all, it bounced only slightly after the GFC; why should it do so now?

But after 2008, as I noted, interest rates bounced only briefly before declining again…with the added phenomenon that some global debt came to bear negative yields, calling into fair question whether there was in fact any natural “bottom” to velocity if interest rates are the main driver! And velocity, obediently, dripped lower as well.

There is at least one other big driver to money velocity, although it is rarely important and almost never for very long. And that is economic uncertainty, which creates a demand to carry excess cash balances (implying lower money velocity). A model driven (mainly) by rates and a measure of uncertainty has done a pretty good job at explaining velocity over time (see chart, source Enduring Investments), including explaining the collapse in velocity during the COVID crisis out-of-sample.

Now, explaining velocity is a helluva lot easier than predicting it, because it isn’t easy to predict interest rates. Nor is it easy to predict the precautionary demand for money – but at least we can count on that being somewhat mean-reverting. The latest point from the model shown above uses current data, and suggests (largely because of the rise in interest rates, but also because precautionary balances are declining) that money velocity should bounce. Not that the model predicts it will happen this week, but it should not be surprising when it does.

A rise in velocity would be a really bad thing, because the money supply is very unlikely to decline very far especially while bank credit growth continues to grow. The only reason we have been able to sustain 6% or 8% money growth for a very long time has been because we could count on velocity to keep declining with interest rates. If money growth ticks up at, say, a mere 6% while money velocity rises 5%, then nominal GDP is going to rise 11%…and most of that will be in prices.

Now, this is a very slow-moving story. I mention it now for one specific reason, and that is that we are almost certain to see a rise in velocity in Q2 when the GDP figures come out in late July. That’s because money growth for the quarter has been very slow so far. So far, the Q2 average M2 is 0.06% higher than the Q1 average. My best wild guess is that we will end up with an 0.5% annualized q/q growth rate. The Atlanta Fed GDPNow model estimates 0.25% GDP growth in Q2 (the Blue Chip Consensus is still at 3%). And if the inflation market is right, Q/Q inflation in Q2 will be about 11.7%. That’s CPI, so let’s be generous and say 9%. We don’t know all of these numbers, but we know 2/3 of all of them. Let’s use the Blue Chip consensus for GDP and assume M2 doesn’t spike next month and the price level doesn’t collapse. Then:

If that happened, the increase would be the largest quarterly jump in money velocity – absent the reactionary bounce in 2020Q3 after the 20% plunge in 2020Q2 – since 1981. And here’s the rub: because of the mathematics of declines and recoveries, that would still leave us with velocity that prior to 2020 would have been an all-time record low.

Does this matter? Not if you believe the monetarism dabblers, who will say this is a mechanical adjustment that will soon be reversed as velocity continues its long slide to oblivion. Nor will it matter to the Fed, who at best will take executive notice of the fact before ignoring it since they aren’t monetarists any longer. But for those who think that inflation comes from too much money chasing too few goods? It’s scary.

Why Roughly 2.25% is an Equilibrium Real Rate

Recently, Fed officials have taken to discussing “long-term equilibrium” interest rates as a way of indicating to the market where interest rates might ultimately be heading. It is not exactly a terrifying prospect. The Fed seems to collectively believe that the “neutral” short-term nominal interest rate is in the 2.50%-2.75% range; some fear that the Fed funds target right may have to be lifted “modestly” above this level for a time. This seems hard to believe, with inflation running with an 8% handle – such an overnight rate would equate to an annual 5-6% incineration of purchasing power. The only way this could be considered “neutral” is if one begs the question by asserting contrary to evidence that the long-run equilibrium inflation rate is around 2%-2.25%.

I have noted repeatedly over the last year or so why it is unlikely in my opinion that the current equilibrium for inflation is in the 2% range; I feel it is closer to 4%-5% in the medium-term. But if an observer has a model which has been ‘trained’ on data from the last thirty years, the model will assuredly tell you that any time inflation deviates from 2%, it comes back to 2%. In fact, any model which did not produce that prediction would not have been considered a good model: it would have made predictions which, for 30 years, would have been noticeably incorrect from time to time. Ergo, all surviving models will view something like 2% as an attracting level for inflation, and we know the Fed continues to believe this. So, evidently, do many other economists. I keep showing this following chart because I think it’s delicious. Take today’s level; take the level your model says is a self-enforcing equilibrium, and draw a straight line. That’s your forecast. You too can be a million-dollar Wall Street economist.

Faced with awful predictions from this cadre of models, one solution is to consider why they had bad predictions, and attempt to develop models that would perform on data from the 1970s and 1980s as well. A more attractive solution, from an institutional perspective, is to blame model-exogenous events. That is, “the model is fine; who could have foreseen that supply chain issues would have triggered such a large inflation?” And so, we preserve the FOMCs ability to continue making terrible forecasts.

Similarly, Minneapolis Fed President Neel Kashkari stated not too long ago that the Fed may have to “push long-term real rates into restrictive territory.”[1] This continues the Fed’s error of obsessing on the price of liquidity rather than its quantity, but that isn’t the point I am making here. Kashkari made a different error, in an essay posted on the Minneapolis Fed website on May 6th.[2] He claimed that the neutral long-term real interest rate is around 0.25%, which conveniently is where long-term real rates are now.

However, we can demonstrate that logic, reinforced by history, indicates that long-term real rates ought to be in the neighborhood of the economy’s long-term real growth rate potential.

I will use the classic economist’s expedient of a desert-island economy. Consider such an island, which has two coconut-milk producers and for mathematical convenience no inflation, so that real and nominal quantities are the same. These producers are able to expand production and profits by about 2% per year by deploying new machinery to extract the milk from the coconuts. Now, let’s suppose that one of the producers offers to sell his company to the other, and to finance the purchase by lending money at 5%. The proposal will fall on deaf ears, since paying 5% to expand production and profits by 2% makes no sense. At that interest rate, either producer would rather be a banker. Conversely, suppose one producer offers to sell his company to the other and to finance the purchase at a 0% rate of interest – the buyer can pay off the loan over time with no interest charged. Now the buyer will jump at the chance, because he can pay off the loan with the increased production and keep more money in the bargain. The leverage granted him by this loan is very attractive. In this circumstance, the only way the deal is struck is if the lender is not good at math. Clearly, the lender could increase his wealth by 2% per year by producing coconut milk, but is choosing instead to maintain his current level of wealth. Perhaps he likes playing golf more than cracking coconuts.

In this economy, a lender cannot charge more than the natural growth in production since a borrower will not intentionally reduce his real wealth by borrowing to buy an asset that returns less than the loan costs. And a lender will not intentionally reduce his real wealth by lending at a rate lower than he could expand his wealth by producing. Thus, the natural real rate of interest will tend to be in equilibrium at the natural real rate of economic growth. Lower real interest rates will induce leveraging of productive activities; higher real interest rates will result in deleveraging.

This isn’t only true of the coconut economy, although I would strongly caution that this isn’t exactly a trading model and only a natural tendency with a long history. The chart below shows (1) a naïve real 10-year yield created by taking the 10-year nominal Treasury yield and subtracting trailing 1-year inflation, in purple; (2) a real yield series derived from a research paper by Shanken & Kothari, in red; (3) the Enduring Investments real yield series, in green, and (4) 10y TIPS, in black.

The long-term averages for these four series are as follows:

  • Naïve real: 2.34%
  • Shanken/Kothari: 3.13%
  • Enduring Investments: 2.34%
  • 10y TIPS: 1.39%
  • Shanken/Kothari thru 2007; 10y TIPS from 2007-present: 2.50%

It isn’t just a coincidence that calculating a long-term average of long-term real interest rates, no matter how you do it, ends up being about 2.3%-2.5%. That is also close to the long-term real growth rate of the economy. Using Commerce Department data, the compounded annual US growth rate from 1954-2021 was 2.95%.

It is generally conceded that the economy’s sustainable growth rate has fallen over the last 50 years, although some people place great stock (no pun intended) on the productivity enhancements which power the fantasies of tech sector investors. I believe that something like 2.25%-2.50% is the long-term growth rate that the US economy can sustain, although global demographic trends may be dampening that further. Which in turn implies that something like 2.00%-2.25% is where long-term real interest rates should be, in equilibrium.[3] Kashkari says “We do know that neutral rates have been falling in advanced economies around the world due to factors outside the influence of monetary policy, such as demographics, technology developments and trade.” Except that we don’t know anything of the sort, since there is a strong argument against each of these totems. Abbreviating, those counterarguments are (a) aging demographics is a supply shock which should decrease output and raise prices with the singular counterargument of Japan also happening to be the country with the lowest growth rate in money in the last three decades; (b) productivity has been improving since the Middle Ages, and there is no evidence that it is improving noticeably faster today – and if it did, that would raise the expected real growth rate and the demand for money; and (c) while trade certainly was a following wind for the last quarter century, every indication is that it is going to be the opposite sign for the next decade. It is time to retire these shibboleths. Real interest rates have been kept artificially too low for far too long, inducing excessive financial leverage. They will eventually return to equilibrium…but it will be a long and painful process.


[1] https://www.reuters.com/business/finance/feds-kashkari-we-may-have-push-long-term-real-rates-into-restrictive-territory-2022-05-06/

[2] https://www.minneapolisfed.org/article/2022/policy-has-tightened-a-lot-is-it-enough

[3] The reason that real interest rates will be slightly lower than real growth rates is that real interest rates are typically computed using the Consumer Price Index, which is generally slightly higher than the GDP Deflator.

Categories: Economics, Economy, Theory Tags:

Shortages are Unmeasured Inflation

October 24, 2021 5 comments

Recently, I’ve been saying occasionally that “shortages are unmeasured inflation.” In some conversations I have had, it became apparent to me that people were taking this statement as being a throwaway line: “inflation is bad, shortages are bad, therefore they’re kinda the same.” But what I mean is actually more profound than that, and so I figured I would explain and illustrate, and hopefully thereby to convince.

Let’s use some charts.

What has happened since the large increase in federal spending and transfer payments were implemented in several waves since the shutdown began is that demand in many product markets has shifted outward. This implies that output “Q” moves from c to d while the price level “P” moves from a to b. [1]

So a strong increase in demand causes an increase in the quantity exchanged at the new equilibrium, and an increase in the price of the good or service at that equilibrium. This is the nice, smooth, continuous markets, instantaneous-adjustment picture from Econ 101. It’s also not the way the real world works, especially with large shifts in demand.

If price only adjusts partially, maybe if “anchored inflation expectations” or a fear of being accused of gouging restrained vendors from raising prices enough to ration the available supply, then a shortage results. This is the same thing which occurs classically if a price cap is instituted from the outside. Now price moves up from a only to b’, but the quantity demanded at that price is at d’. Thus, the bracket on the chart below shows the size of the shortage at that price, where consumers want d’ but suppliers can’t/won’t provide that much.

Note that this shortage is a direct substitute for the increase in price that would otherwise happen if prices could instantly and fully adjust. Moreover, the picture is somewhat worse in the short-term because the supply curve – in the short-term – is much more inelastic at some point (because, for example, no matter how high the price gets we can’t deliver more used cars in the short run). So, in the picture below the short-run supply curve in blue implies that the large increase in demand pushes prices to b’ with output only at d’, until supply eventually adjusts to the long-run supply curve S(lr), when we end up in the new market-clearing equilibrium.

In this case, the difference between b and b’ is “transitory” inflation, caused by temporary supply constraints. But note that in this picture, there is no perceived shortage. The market clears at b’ and d’. In other words, the conditions leading to the “transitory” increase inflation are not the same ones leading to the shortages.

We can combine these; if in the last picture above vendors also constrain prices to b, then there is a shortage as the quantity demanded stays up at d rather than at the market-clearing level d’. But, again, in that instance the shortage reflects the fact that prices should have adjusted to b’ but did not. Also in that case, it would be inaccurate to claim that the inflation was transitory, since prices should remain at b even when the supply eventually adjusts to the long-run equilibrium. It would be the shortage that was transitory.

In theory, if we knew the shapes of the curves of supply and demand for each product market, we could estimate how much higher prices would be at equilibrium and therefore how much additional inflation the shortage implies. We could directly translate the shortages to an “equilibrium” price level and therefore inflation. It strikes me as plausible that we could develop a rough estimate of such a number, but I leave that to the PhD candidates looking for dissertation topics. In the meantime, just remember that with inflation over 5% presently and shortly headed above 6%…the inflation rate is understated, and we know that because there are lots of shortages.


[1] If the deficits, funded by Fed purchases of Treasuries, had just offset the loss in incomes due to the shutdown – perfectly, across all individual markets – then there would have been no demand shift and no net change in output or prices. And if the deficits had not been accompanied by an increase in the Fed balance sheet, then it would have been individuals buying the bonds and so the only effect would have been because the marginal propensity to consume of the people receiving transfer payments is higher than the marginal propensity to consumer of the people buying the bond issuance. But in this column I’m trying not to muddy the discussion with the argument of whether we need both fiscal and monetary stimulus to cause inflation. I’m just focused on the narrow question of what it means when I say “shortages are unmeasured inflation.”

Why We’re Wrong About Restaurants

Figuring out the macro impact of the virus, while not easy, is in some ways easier than figuring out a lot of the micro. In some cases the impact seems pretty obvious, and probably is: airlines are likely to carry fewer passengers, and more of them will be business travelers, for a while (resulting, by the way, in higher airfares in CPI). But some of the effects are much harder to figure out than we think, and a lot of it comes down to the fact that people who are idly speculating about these things tend to be pretty poor about defining what the substitutes are for any product or service.

Actually, the question of ‘what is a substitute’ turns out to be hugely important in economic modeling, because it directly impacts the question of demand elasticity. If I am the only person who sells widgets, and you need a widget, then I probably have a lot of control over what you pay. But if someone else sells something that works about as well as a widget (but isn’t a Widget™), then I as the supplier likely have a lot less flexibility and I face a more elastic demand curve. This is one reason that salespeople are taught to remember that the customer doesn’t want a quarter-inch drill bit; they want a quarter-inch hole. In a more formal setting: it is enormously important in antitrust economics that the market is defined clearly when considering if a firm is monopolizing or attempting to monopolize[1], so much so that there is an index called the Herfindahl-Hirschman Index with which industry concentration can be expressed. But I digress.

We read that many restaurants will fail as a result of the COVID-19 crisis, because quite aside from the question of the financial damage done to the restaurant owner from a two-month hiatus in revenues there is the question of “will people even come back?” And, if people do come back, but the restaurant-owner can only fit half as many people in the restaurant due to social distancing, then many restaurants can’t survive. Right?

So we are told, but there are a ton of assumptions there and some of them don’t hold. One of the biggest assumption is the question of what consumers use as a substitute for restaurant meals. With airlines, there is a clear substitute for the vacation traveler and that’s the automobile. Moreover, a vacation is not a necessity per se. But everyone needs to eat, so we can say with some confidence that if the average American ate 2.5 meals per day before the crisis they will probably eat 2.5 meals per day after the crisis. Somehow, they need to get those meals. If they are not going to restaurants for some of those meals, what are the alternatives? The argument that restaurants will fail hinges partly on the idea that these alternatives are convenient enough and enough competition for restaurant meals that consumers will eschew eating out and so restaurants won’t be able to sell their product. But will they? The alternatives to a restaurant meal are (a) a meal cooked at home or (b) a meal delivered. Many restaurants might fail for financial reasons, but that happens all the time in the food preparation biz. The question is whether the total number of restaurants in the country will be dramatically lower in the post-virus world. If so, it means that people are choosing en masse to make a significantly higher percentage of their meals at home. Anyone reading this who is doing a lot of their own cooking these days will realize why that’s probably not a tenable outcome as long as we continue to need two incomes in most families! Some, surely, will cook more. But when this is over, I suspect that meals not prepared at home will be a similar portion of our diets as it was before.

“Meals not prepared at home” includes both restaurant meals and delivery meals. Since the total number of meals consumed will be roughly the same, I think we’ll see a bit more home-cookin’ and a lot more delivery. It will be the restaurants, even those that did not previously deliver, cooking those meals. Maybe more delivery-only restaurants will start up. But I really think that we will see almost as many restaurants a year from now as we do now.

A separate question is what happens to the price of a meal-not-cooked-at-home, and it seems to me that the answer must be that it goes a lot higher. A delivered meal requires more manpower (for delivery), especially if delivery is going to be efficient at all. And in-restaurant meals (for those dinners, like your anniversary dinner, for which there are no good substitutes) are going to be higher-priced both because the demand curve will be more inelastic in the same way that the demand curve for business air passengers is more inelastic, and because the supply will be constrained. But my point is that if the restaurant used to plate 100 meals per hour, they’ll still plate pretty close to 100 meals per hour. It’s just that 50 of those meals will be going out the door.

Is there a substitute for movie theaters? Absolutely, and it was already winning. Good-bye movie theaters (although I have seen something about drive-ins making a comeback). A substitute for sports venues? Not so much, so I think we’ll see some innovation about how we safely attend such events but we haven’t seen the last of major league baseball at Citi Field or rugby at Twickenham. I think that international visitors to Disney World will probably decline, but domestic visitors will probably increase, as Disney for the latter is a substitute for an island vacation. But those islands that depend on tourism – there will be some pain there as there aren’t many convenient ways to get to Martinique that don’t involve flying.

But while I’m sure some restaurants will close because they cannot figure out delivery or because their product doesn’t translate well to delivery (see this story about a high-end restaurant that is facing this dilemma), I think consumption of meals-not-cooked-at-home will ensure that we will have a similar number of restaurants in the future. The broader point is this: be careful when you’re thinking about the damage that certain businesses will experience. Be sure to think about what the market for the good or service is, and what the relevant competitors are. Again, this doesn’t mean that existing companies will always survive, but if you know that the market for (for example) automobiles is still going to be there then there will be companies that serve that market. If they are different companies than today’s companies, that’s just creative destruction and it isn’t a bad thing for the consumer. (And, personal pitch: if you or your company needs help navigating these waters, visit our new website at https://www.enduringinvestments.com and drop me a line.)


[1] See Tasty Baking Company and Tastykake, Inc. v. Ralston Purina, Inc. and Continental Banking Co. (1987) in which the plaintiffs argued that the relevant market was premium snack cakes and pies and defendants argued that their products competed in the market for ‘all sweet snacks,’ because obviously their combination was less dominant if there were lots of substitutes.

Categories: Economics, Economy, Virus

COVID-19 in China is a Supply Shock to the World

February 25, 2020 3 comments

The reaction of much of the financial media to the virtual shutdown of large swaths of Chinese production has been interesting. The initial reaction, not terribly surprising, was to shrug and say that the COVID-19 virus epidemic would probably not amount to much in the big scheme of things, and therefore no threat to economic growth (or, Heaven forbid, the markets. The mere suggestion that stocks might decline positively gives me the vapors!) Then this chart made the rounds on Friday…

…and suddenly, it seemed that maybe there was something worth being concerned about. Equity markets had a serious slump yesterday, but I’m not here to talk about whether this means it is time to buy TSLA (after all, isn’t it always time to buy Tesla? Or so they say), but to talk about the other common belief and that is that having China shuttered for the better part of a quarter is deflationary. My tweet on the subject was, surprisingly, one of my most-engaging posts in a very long time.

The reason this distinction between “supply shock” and “demand shock” is important is that the effects on prices are very different. The first stylistic depiction below shows a demand shock; the second shows a supply shock. In the first case, demand moves from D to D’ against a stable supply curve S; in the latter case, supply moves from S to S’ against a stable demand curve D.

Note that in both cases, the quantity demanded (Q axis) declines from c to d. Both (negative) demand and supply shocks are negative for growth. However, in the case of a negative demand shock, prices fall from a to b; in the case of a negative supply shock prices rise from a to b.

Of course, in this case there are both demand and supply shocks going on. China is, after all, a huge consumption engine (although a fraction of US consumption). So the growth picture is unambiguous: Chinese growth is going to be seriously impacted by the virtual shutdown of Wuhan and the surrounding province, as well as some ports and lots of other ancillary things that outsiders are not privy to. But what about the price picture? The demand shock is pushing prices down, and the supply shock is pushing them up. Which matters more?

The answer is not so neat and clean, but it is neater and cleaner than you think. Is China’s importance to the global economy more because of its consumption, as a destination for goods and services? Or is it more because of its production, as a source of goods and services? Well, in 2018 (source: Worldbank.org) China’s exports amounted to about $2.5trillion in USD, versus imports of $2.1trillion. So, as a first cut – if China completely vanished from global trade, it would amount to a net $400bln in lost supply. It is a supply shock.

When you look deeper, there is of course more complexity. Of China’s imports, about $239bln is petroleum. So if China vanished from global trade, it would be a demand shock in petroleum of $240bln (about 13mbpd, so huge), but a bigger supply shock on everything else, of $639bln. Again, it is a supply shock, at least ex-energy.

And even deeper, the picture is really interesting and really clear. From the same Worldbank source:

China is a huge net importer of raw goods (a large part of that is energy), roughly flat on intermediate goods, and a huge net exporter of consumer and capital goods. China Inc is an apt name – as a country, she takes in raw goods, processes them, and sells them. So, if China were to suddenly vanish, we would expect to see a major demand shock in raw materials and a major supply shock in finished goods.

The effects naturally vary with the specific product. Some places we might expect to see significant price pressures are in pharmaceuticals, for example, where China is a critical source of active pharmaceutical ingredients and many drugs including about 80% of the US consumption of antibiotics. On the other hand, energy prices are under downward price pressure as are many industrial materials. Since these prices are most immediately visible (they are commodities, after all), it is natural for the knee-jerk reaction of investors to be “this is a demand shock.” Plus, as I said in the tweet, it has been a long time since we have seen a serious supply shock. But after the demand shock in raw goods (and possibly showing in PPI?), do not be surprised to see an impact on the prices of consumer goods especially if China remains shuttered for a long time. Interestingly, the inflation markets are semi-efficiently pricing this. The chart below is the 1-year inflation swap rate, after stripping out the energy effect (source: Enduring Investments). Overall it is too low – core inflation is already well above this level and likely to remain so – but the recent move has been to higher implied core inflation, not lower.

Now, if COVID-19 blossoms into a true global contagion that collapses demand in developed countries – especially in the US – then the answer is different and much more along the lines of a demand shock. But I also think that, even if this global health threat retreats, real damage has been done to the status of China as the world’s supplier. Although it is less sexy, less scary, and slower, de-globalization of trade (for example, the US repatriating pharmaceuticals production to the US, or other manufacturers pulling back supply chains to produce more in the NAFTA bloc) is also a supply shock.

A Generous Fed Isn’t Really the Good News it Sounds Like

October 31, 2019 14 comments

I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).

Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.

I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.

So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.

I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.

In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:

GDP = C + I + G + (X-M),

or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?

But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).

The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.

An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.


[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.

How Not to Do Income-Disparity Statistics

June 10, 2019 4 comments

I am a statistics snob. It unfortunately means that I end up sounding like a cynic most of the time, because I am naturally skeptical about every statistic I hear. One gets used to the fact that most stats you see are poorly measured, poorly presented, poorly collected, or poorly contexted. I actually play a game with my kids (because I want them to be shunned as sad, cynical people as well) that I call “what could be wrong with that statistic.” In this game, they have to come up with reasons that the claimed implication of some statistic is misleading because of some detail that the person showing the chart hasn’t mentioned (not necessarily nefariously; most users of statistics simply don’t understand).

But mostly, bad statistics are harmless. I have it on good authority that 85% of all statistics are made up, including that one, and another 12.223% are presented with false precision, including that one. As a result, the only statistic that anyone believes completely is the one they are citing themselves. So, normally, I just roll my eyes and move on.

Some statistics, though, because they are widely distributed or widely re-distributed and have dramatic implications and are associated with a draconian prescription for action, deserve special scrutiny. I saw one of these recently, and it is reproduced below (original source is Ray Dalio, who really ought to know better, although I got it from John Mauldin’s Thoughts from the Frontline).

Now, Mr. Dalio is not the first person to lament how the rich are getting richer and the poor are getting poorer, or some version of the socialist lament. Thomas Piketty wrote an entire book based on bad statistics and baseless assertions, after all. I don’t have time to tackle an entire book, and anyway such a work automatically attracts its own swarm of critics. But Mr. Dalio is widely respected/feared, and as such a simple chart from him carries the anti-capitalist message a lot further.[1]

I quickly identified at least four problems with this chart. One of them is just persnickety: the axis obviously should be in log scale, since we care about the percentage deviation and not the dollar deviation. But that is relatively minor. Here are three others:

  1. I suspect that over the time frame covered by this chart, the average age of the people in the top group has increased relative to the average age of the people in the bottom group. In any income distribution, the top end tends to be more populated with older people than the bottom end, since younger people tend to start out being lower-paid. Ergo, the bottom rung consists of both young people, and of older people who haven’t advanced, while the top rung is mostly older people who have Since society as a whole is older now than it was in the 1970s, it is likely that the average age of the top earners has risen by more than the average age of the bottom earners. But that means the comparison has changed since the people at the top now have more time to earn, relative to the bottom rung, than they did before. Dalio lessens this effect a little bit by choosing 35-to-64-year-olds, so new graduates are not in the mix, but the point is valid.
  2. If your point is that the super-wealthy are even more super-wealthier than they were before, that the CEO makes a bigger multiple of the line worker’s salary than before, then the 40th percentile versus 60th percentile would be a bad way to measure it. So I assume that is not Dalio’s point but rather than there is generally greater dispersion to real earnings than there was before. If that is the argument, then you don’t really want the 40th versus the 60th percentile either. You want the bottom 40% versus the top 40 percent except for the top 1%. That’s because the bottom of the distribution is bounded by zero (actually by something above zero since this chart only shows “earners”) and the top of the chart has no bound. As a result, the upper end can be significantly impacted by the length of the upper tail. So if the top 1%, which used to be centi-millionaires, are now centi-billionaires, that will make the entire top 40% line move higher…which isn’t fair if the argument is that the top group (but not the tippy-top group, which we all agree are in a category by themselves) is improving its lot more than the bottom group. As with point 1., this will tend to exaggerate the spread. I don’t know how much, but I know the direction.
  3. This one is the most insidious because it will occur to almost nobody except for an inflation geek. The chart shows “real household income,” which is nominal income (in current dollars) deflated by a price index (presumably CPI). Here is the issue: is it fair to use the same price index to deflate the incomes of the top 40% as we use to deflate the income of the bottom 40%? I would argue that it isn’t, because they have different consumption baskets (and more and more different, as you go higher and higher up the income ladder). If the folks at the top are making more money, but their cost of living is also going up faster, then using the average cost of living increase to deflate both baskets will exaggerate how much better the high-earners are doing than the low-earners. This is potentially a very large effect over this long a time frame. Consider just two categories: food, and shelter. The weights in the CPI tell us that on average, Americans spend about 13% of their income on food and 33% on shelter (these percentages of course shift over time; these are current weights). I suspect that very low earners spend a higher proportion of their budget on food than 13%…probably also more than 33% on shelter, but I suspect that their expenditures are more heavily-weighted towards food than 1:3. But food prices in real terms (deflated by the CPI) are basically unchanged over the last 50 years, while real shelter prices are up about 37%. So, if I am right about the relative expenditure weights of low-earners compared to high-earners, the ‘high-earner’ food/shelter consumption basket has risen by more than the ‘low-earner’ food/shelter consumption basket. Moreover, I think that there are a lot of categories that low-earners essentially consume zero of, or very small amounts of, which have risen in price substantially. Tuition springs to mind. Below I show a chart of CPI-Food, CPI-Shelter, and CPI-College Tuition and Fees, deflated by the general CPI in each case.

The point being that if you look only at incomes, then you are getting an impression from Dalio’s chart – even if my objection #1 and #2 are unimportant – that the lifestyles of the top 40% are improving by lots more than the lifestyles of the bottom 40%. But there is an implicit assumption that these two groups consume the same things, or that the prices of their relative lifestyles are changing similarly. I think that would be a hard argument. What should happen to this chart, then, is that each of these lines should be deflated by a price index appropriate to that group. We would find that the lines, again, would be closer together.

None of these objections means that there isn’t a growing disparity between the haves and the have-nots in our country. My point is simply that the disparity, and moreover the change in the disparity, is almost certainly less than it is generally purported to be with the weakly-assembled statistics we are presented with.


[1] Mr. Mauldin gamely tried to object, but the best he could do was say that capitalists aren’t good at figuring out how to share the wealth. Of course, this isn’t a function of capitalists. The people who decide how to distribute the wealth in capitalism are the consumers, who vote with their dollars. Bill Gates is not uber-rich because he decided to keep hundreds of billions of dollars away from the huddling masses; he is uber-rich because consumers decided to pay hundreds of billions of dollars for what he provided.

Categories: Economics, Politics, Rant, Theory

Spinning Economic Stories

January 4, 2019 5 comments

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.

The Important Trade Effects Are Longer-Term

The question about the impact of trade wars is really two questions, and I suppose they get conflated a lot these days. First, there’s the near-term market impact; second is the longer-term price/growth impact.

The near-term market impact is interesting. When the market is in a bad mood (forgive the anthropomorphization), then trade frictions are simply an excuse to sell – both stocks and bonds, but mostly stocks. When the market is feeling cheerful, and especially around earnings season, trade wars get interpreted as having very narrow effects on certain companies and consequently there is no large market impact. That is what seems to have happened over the last few weeks – although trade conflicts are escalating and having very concentrated effects in some cases (including on markets, such as in commodities, where they really oughtn’t), it hasn’t dampened the mood of the overall market.

In fact, the risk in these circumstances is that a “happy” market will take any sign of a reduction in these tensions as broadly bullish. So you get concentrated selloffs in single names that don’t affect the market as a whole, and when there’s any sign of thawing you see a sharp market rally. We saw a bit of that in the last day or so as Mexico’s President-elect and US President Trump both expressed optimism about a ‘quick’ NAFTA deal. Honestly, the broad market risk to trade in the near-term is probably upwards, since any increase in tensions will have a minor and concentrated effect while any thawing (especially with China) at all will cause a rally.

But beware in case the mood changes!

As an inflation guy, I’m far more interested in the longer-term impact. And there, the impact is unambiguous and bad. I’ve written about this in the past, in detail (see this article, which is probably my best on the subject and first appeared in our private quarterly), but the salient point is that you don’t need a trade war to get worse inflation outcomes than we have seen in the last 20 years. You only need for progress on advancing global trade to stop. And it seems as though it has.

Not all of the forces pressing on inflation right now are bullish, although most are. Apartment rents have slowed their ascent, and the delayed effect of the dollar’s rally will have a dampening effect next year (arrayed against that, however, are the specific effects of tariffs on particular goods) although globally, FX movements are roughly zero-sum in terms of global inflation. Money growth has slowed, to levels that would tend to contain inflation if velocity were also to remain stable at all-time lows. But velocity recently started to uptick (we will find out on Friday if this uptick continued in Q2) and as interest rates gradually increase around the globe money velocity should also quicken. The chart below (source: Enduring Investments) shows our proprietary model for money velocity.

At this point, trade is pushing inflation higher in two ways. The first is that arresting the multi-decade trend towards more-open markets and more-numerous trade agreements fundamentally changes the inflation/growth tradeoff that central banks globally will face. Rather than having a following wind that made monetary policy relatively simple (although policymakers still found a way to louse it up, potentially beyond repair, largely as a result of believing their own fables about the powerful role that central banks played in saving the world first from inflation, and then from deflation), there will be a headwind that will make monetary much more difficult – more like the 1960s and 1970s than the 1980s, 1990s, and 2000s. The second way that trade conflict is pushing inflation higher is mechanical, by causing higher prices of recorded goods as a direct result of tariff implementation.

But this second way, while it gets all the ink and causes near-term knee-jerk effects in markets, is much less important in the long run.

Tariffs Do Not Cause Price Declines

July 5, 2018 7 comments

Adding to a good’s price does not make its price decline.

It’s worth repeating that a couple of times, because it seems to be getting lost in the discussion about tariffs – in particular, in the discussion about tariffs levied on US commodities. Grains prices have been plummeting, as the chart below showing front corn and soybean prices (source: Bloomberg) illustrates.

There are many reasons that grains prices may be declining, but if “tariffs have been levied on US production” is one of them then there is some really weird economics happening. Corn and soybeans are commodities. Specifically, this means that they are essentially fungible – corn from site “A” is essentially the same as corn from site “B.” So what does this mean for the results of a tariff?

If China stops buying soybeans from the US altogether, it means that unless they’re going to stop eating soybeans they will buy soybeans from Brazil. But if Brazil sells all of their soybeans to China, it means that Germany can no longer soybeans from Brazil. So where does Germany buy its soybeans from? Well, it seems that the US has beans that are not spoken for in this scenario…in other words, when we are talking about commodities a tariff mostly just reorganizes the list of who is buying from whom. If soybean prices are falling because China isn’t buying our soybeans, it means a great deal for Russia or Germany or whoever else is going to buy beans from us instead of from China’s new supplier. More than that, if global soybeans prices are falling because of tariffs then it means that everyone is getting cheaper soybeans because China is changing who they’re buying from. If that’s the case, then we really need to slap tariffs on everything and watch prices decline!

Let’s go back to elementary microeconomics. Adding a tariff is reflected in our product market supply and demand curves as a shift in the supply curve to the left: the quantity that producers are willing to supply at any price declines, because the price to the producer declines. Put a different way, the market price required to induce any particular quantity supplied rises by the amount of the tariff. Now, whether that causes market prices to rise a lot or a little, or quantity supplied to fall by a lot or a little, depends on the elasticities of supply and demand. If demand if fairly inelastic (which seems reasonable – you may be able to substitute for “beans” but it’s hard to substitute for “grains”), then you will see more of a price response than a quantity response, at least in the short run where the supply of beans is fairly inelastic. But that price response is up, not down.

By the way, this gets a little hard to illustrate with supply and demand curves, because with a tariff what you have are now two separate markets and separate prices for the same good. This is what confuses some people – if China is no longer buying from the US, doesn’t that mean that demand for US beans has declined, and therefore prices should decline? The crucial point is that we are talking here about commodity goods, and supplies are fairly interchangeable. If we are talking about Harley Davidson motorcycles, the answer is different because if Europe stops buying Harleys, they have to buy a different product altogether. In that case, the global price of “motorcycles” might be relatively unaffected, but the price of Harleys will rise (and the output decline) relative to other motorcycles. So, a tariff on Harley-Davidson motorcycles definitely hurts the US, but a tariff on soybeans – or even “US soybeans” since that is not a universal distinction – should have virtually no effect on US producers. And certainly, no effect on the global price of soybeans.

There are other reasons that grains prices may be declining. Since Brazil is a major producer of beans, the sharp decline in the Brazilian Real has pushed the US dollar price of beans lower (see chart, source Bloomberg). In the chart below, the currency is shown in Reals per dollar, and inverted. This is a much more important factor explaining the decline in grains prices, as well as one that could easily get worse before it gets better.

I think the discussion of the effects of tariffs has gotten a bit polluted since the decline in grains seems to coincide with the announcement of tariffs from China. I think the price decline here has fed that story, but it’s bad economics. Piecemeal tariffs on commodity products are not likely to appreciably change the supply and demand outcome, although it will result in rearranging the sources of product for different countries. Tariffs on non-commodity product, especially branded products with few close substitutes, can have much larger effects – although we ought to remember that from the consumer’s perspective (and in the measurement of consumer inflation), tariffs never lower prices faced by consumers although they can lower prices received by producers. This is why tariffs are bad – they cause higher prices and lower output, and the best case is no real change.


DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have both long and short positions in grains, and in particular long positions in Beans and Corn, this month.

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