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Three Pertinent Inflation Observations
I have three items to discuss in this week’s post.
The first item is an announcement made by the BLS on Tuesday regarding upcoming changes to how the CPI for Health Insurance will be computed.
The backdrop for this change is that the CPI for Health Insurance is an imputed cost for the CPI. When a consumer buys health insurance, he/she is actually buying medical care, plus a suite of insurance products related to the actuarial benefits of pooling risks (that is, it’s much cheaper for people to buy a share of an option on the tail experience of a group of people, than it is for each person to buy a tail on their own experience – which is the main benefit/function of insurance). If all of the cost of health insurance was actually for health insurance, the weight of medical care itself (doctors’ services, e.g.) would be quite low because most of us pay for that care through the insurance company.
So the BLS needs to disentangle the cost of the medical care that we are buying indirectly from the cost of the embedded insurance products. The link above goes into more detail on all of this, but the bottom line is that once per year the BLS figures out what consumers paid for health insurance, how much of that was actually used by the insurance company to purchase health care, and therefore how much is attributable to the cost of the insurance product. Because they do this only once per year, and smear the answer over 12 months, you get step-wise discontinuities in the monthly figures. For many years this was not a big problem, but since 2018 there have been several fairly significant swings. The chart below shows the m/m percent change in health insurance CPI. You can see it went from stable, to +1.5% per month or so in 2018-2020, to -1% for 2020-2021, to +2% for 2021-2022, to -4% in the most-recent year.
That latest period has been a significant and measurable drag on the overall and core CPIs, and it was due to reverse starting with the October 2023 CPI released in November. Estimates were that it was going to be something like 2% per month, roughly. The change announced above introduces some smoothing so that these swings should be significantly dampened. The basic method doesn’t change, but it should be smoother and more-timely since the corrections will be every 6 months instead of every year. In order to make the new calculation method match endpoints, though, this means that starting in October, the +2%ish impact will bedoubled because the BLS will make the ‘normal’ adjustment but smear it over 6 months instead of 12, then transition to the new method.
The implication is that Health Insurance, which will have decreased y/y core CPI by about 0.5% once we get to October, will add 0.25% back over the 6 months ending April. So, we already know about a significant swing higher in core inflation that is coming soon. Take note.
The second item I want to note is M2. It’s a minor thing at this point, but after three months it is worth noticing that M2 is no longer declining. It isn’t a lot, as the chart below shows, but the three months ended April showed a contraction at a 9.6% annualized pace and the most-recent three months saw an increase at a 3.7% pace.
In the long run, 3.7% would certainly be acceptable but remember we still have some M2 velocity rebound to complete. What is interesting is that this is happening despite the fact that the Fed is continuing to reduce its balance sheet and loan officers are saying that lending standards are tightening. It may simply be a return to normal lending behaviors, with a gradual increase in loans that naturally accompany the rising working capital needs of a growing economy. Remember, banks are not reserve-constrained at this point, so they’ll keep lending. Anyway, I don’t want to make too much of 3-month change in the M2 trend, just as I was reluctant to make too much of those early M2 contractions…but this is what I expected to happen. I just expected it earlier. We will see if it continues. If it does, then that in concert with the natural rebound in M2 velocity means that further declines in inflation are going to be difficult, and we might even see some reacceleration.
Finally, the third item for today. In my podcast on Tuesday, I asked the question whether China’s recent sluggish growth, caused partly by its property bubble and overextended banks, meant that we should be looking at recession and disinflation in the US – which is the current meme being promulgated by many economists. I discussed the 1997-1998 “Asian Contagion” episode, and explained that a recession in a “producer” (net exporting) country hits the rest of the world very differently from a recession in a “consumer” (net importing) country like the US. A recession in consumer countries causes recession in producer economies, because the consumer economies are ‘downstream.’ On the other hand, a recession in producer countries can have the opposite effect on its customers – because, when an economy like China is in recession, that means it is providing less competition in the commodity markets that we also use. In turn, that means we can actually grow faster, all else equal.
This is what happened in the Asian Contagion episode, and I wanted to put some charts around that. The Thai baht was the first domino, and it collapsed in August 1997. It wasn’t until fears that the Hong Kong Dollar would de-peg from the USD, in October of that year – precipitating a 7% one-day drop in the Dow – that people in the West started getting very concerned and the Fed started citing troubles in the former Asian Tigers as a downside risk. Here are charts of the period. The first one shows quarterly GDP, which never increased less than 3.5% annualized; the second is median CPI, which was continuing a long period of deceleration from the 1980s prior to the crisis…but which began to accelerate in mid-1998.
The bottom line is that as long as our export sector is relatively small and as long we remain a developed consumer economy, weakness in producing economies is not a dampening effect for us but rather, if anything, a stimulating effect.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
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 Re-Onshoring Trend and the Long-Term Impact on Core Goods
I know that today, and probably for a little while, investors are focused on Ukraine and Russia. I am gratified that for what seems the first time in many years, notes about the conflict tend to include some form of the addendum “and its effect on domestic inflation,” albeit in many cases this is from the perspective of how this engagement will damage or burnish President Biden’s poll numbers at home and the prospects for his party in the midterm elections. How self-absorbed we Americans are! To be fair, in my opinion the importance of the US policy-response operetta was always less about Ukraine than about Taiwan. I hope that doesn’t turn out to be right.
However, today I want to talk about the re-onshoring trend in manufacturing, and the significance of this for inflation going forward.
One of my 2022 themes so far is that the conventional expectation for inflation to peak soon and ebb to a gentle 2% over the next 12-18 months is mostly predicated on the idea that the extraordinary spikes we have seen in certain categories (see: motor vehicles) will eventually pass, and inflation will return to the underlying trend. The simpler observers see it as 12 months since (mechanically) the spikes will all be out of the y/y number in 12 months. Some forecasters are giving themselves a little wiggle-room by saying it will take 18 months as the ports unclog and ‘other knock-on effects’ wash through. But in my opinion, the evidence is strong that the underlying trend is no longer 2%, but more likely 3-4% or higher. Part of that evidence is the great breadth that we have seen in the recent inflation numbers, which suggests either a riot of unfortunate coincidental events all in the same direction, or else a common cause…say, the rapid growth rate of the money supply, which as of the latest report is still growing more than 12% annualized over the last quarter, half-year, and year.
The forecasts of sharply decelerating inflation expect the parade of “one off” causes to end – and, crucially, to be replaced by unbiased random events that are equally likely to be up or down. This is ‘assuming a can-opener,’ and is economist malpractice in my opinion. Because of the continued rapid growth of money, and until that rapid growth slows drastically or reverses, the surprises are mostly going to be on the high side. That’s why I expect inflation to be lower at the end of the year than it is right now, but not lots lower.
All of this, though, obfuscates a trend that had started prior to COVID but has gained great momentum since. When President Trump was first elected, we’d suggested in our customer Quarterly Inflation Outlook that one of the following winds which had kept inflation low despite loose monetary policy throughout the 1990s and 2000s was in the process of stopping and potentially reversing. That following wind was globalization. I eventually ended up talking a lot about de-globalization. Here’s one article from four years ago. I really love the Deutsche Bank chart in it.
In a nutshell, the argument was that domestic goods prices had been kept abnormally low despite strong economic growth and loose monetary policy through the prior quarter-century because businesses had gradually over time offshored production and extended raw materials and intermediate-goods supply chains to cheaper manufacturing locations outside of our borders. But that’s a trick that can only be turned once. When most production is overseas and most intermediate goods imported from the Pacific Rim, costs will resume rising at the rate of inflation in the source country, adjusted for FX changes. For decades, we’d seen core goods inflation near zero despite services inflation in the 2-4% range, as this dynamic played out, but there was no reason that goods inflation should permanently be zero.
So I thought that in 2016 we were already coming slowly to a point where similar monetary policy going forward was going to result in less growth and more inflation because that trick had been used up. The election of President Trump merely accelerated that timeline and increased the probability that the trend wouldn’t only stop but could reverse, causing the division of growth and inflation for a given monetary policy to be distinctly bad and requiring much tighter policy.
COVID-19, and the global response to COVID-19, has more or less totally reversed the arrow of global trade. Businesses are pulling manufacturing back to the US and pulling supply chains back to the Western Hemisphere as much as possible. Geopolitical tensions between the US and Russia, and the US and China, combined with the increased appreciation of the optionality of inventories and the cost imposed by long and variable lead times, which is partly reflected in the need to hold more inventory. And that, in turn, drastically decreases the attractiveness of a long supply chain, especially with global tensions, the rise of democratic populism (“we want what’s ours, not some global citizenship award!”), and the persistent rise in energy and other costs of transportation (driver shortages, etc).
All of which arguments I’ve made before. But I’m not sure I’ve drawn the line clearly enough that the net effect of this changing dynamic – which results in manufacturers choosing higher costs rather than lower costs – is that goods inflation is unlikely in my view to return to being centered around zero. While core services are a bigger chunk of the consumption basket than are core goods, that’s mostly because of shelter services. Core goods is 22% of the consumption basket; core services (less rent of shelter) is 25%. So this is not something that can be idly dismissed. If the mean of the distribution moves from 0% to just 3%, that moves the “normal” level of inflation up ~0.66%. Obviously, I think in the medium-term the number is a lot larger than that, but the key is whether the effect is going to be persistent over a long period of time (think years or decades, not months). I believe it will far outlast COVID, because the causes go far beyond COVID.
When Over-Ordering is More Than Hoarding
It is a lament I have heard recently from the manufacturing/supply side, but also an excuse I’ve heard from some of the economist ranks for why “this supply chain issue will all get sorted out; people are just going crazy.” In this column I want to explain why “overordering” is not only perfectly rational but actually demanded by some typical operational procedures.
The complaint is “our customers are not only ordering what they used to order, but they’re ordering far more than they used to. Basically, they’re hoarding and we have had to ration our product and only partially fill orders/only fill them for our top customers.” Now, hoarding is a real thing, but moreso for consumers than in B2B. There are, though, some serious reasons (by which I mean, ‘reasons that are held by serious people’) why it makes sense to increase orders at a time like this. And it’s not because you are assuming you’ll get 50% fill rates on your orders, so you order double in the hopes that you’ll get the actual amount you want. That’s an “unserious” reason.
One of the reasons I have written about before. Back in January, I wrote an article called “The Optionality of Inventories,” in which I predicted the companies would move away from lean inventory models because inventory serves as an option against bad things happening: if bad things don’t happen, you’ve paid a little more for your inventory; if bad things happen, you have a large gain (loss averted) because you had a cushion. That article is worth a quick read. I also point out that, as inflation increases, there is a financial incentive to hold larger inventories because the inventories themselves are increasing in value. To the extent that more firms are recognizing the option value of inventory, it makes total sense that the demand gets fiercer the closer to raw materials you get. The entire supply chain needs to hold more inventories.
But there’s another “serious” reason that is related to the length of the supply chain itself. “Fred, last year you only ordered 1,000 units. This year you ordered 2,000 units! I know your business hasn’t doubled. Why are you doing that?” Fred might well be doing this because lead times are increasing, and that mathematically increases his reorder point and quantity.
Reorder quantity mathematics, at the simplest level, is just “number of days of lead time” times “average use per day,” and you reorder when inventory declines below that number plus some “safety stock” which is essentially a fudge factor. So, if we are using one ton of flour per day, and it takes us a week to get flour, then we need to reorder whenever we get down to seven tons of flour (call it 8, just in case. That extra one is the ‘safety stock.’) And, when we reorder, we reorder at least seven tons of flour since by the time that order arrives, we’ll be down to one ton of flour. But if the lead time now stretches to two weeks, we are suddenly ordering 14 tons of flour even if our usage didn’t change.
That simple model works for very regular inventory usage patterns, but in many applications the quantity used (or demanded, if we are talking about holding finished goods inventories) is variable. In that case, the reorder point and quantity also depends on the variance in the order flow. Again, inventories are like options, and so the sophisticated way to think about the safety stock is the option value where the stock-out (you run out of inventory) is the strike price. If you want to never lose on that bet, you have to have a high option price (safety stock); moreover, the higher is volatility, the higher is the level of inventory required to maintain a given ‘acceptable’ level of stock outs.[1]
How does 2021 compare to 2019, the last time manufacturers faced “normal” order patterns that they are now seeing customers exceed? Well, there have been substantial increase in lead times, and substantial increases in every kind of volatility you can imagine. Lead times across the globe have increased probably 30-50% at least, and that means that required inventory needs to increase 30-50% at a minimum, plus more because volatility has increased.
So that customer who is ordering a lot more right now than they historically have is not doing it to “hoard.” They’re probably doing it just to manage inventory properly. Of course, that puts more pressure on the supply chain, and increases lead times further. It represents a one-time increase in GDP, as intended inventory accumulation adds to output in the period it is accumulated, and that pressure also boosts price pressure. And ‘round and ‘round we go.
And all of this, we should take pains to remember, started when governments decided to use cardiac paddles to resuscitate a patient they’d actively tried to kill, and central banks made sure they were hooked up to a strong current to do so. The fact that the body economic is convulsing should not be a surprise to anyone. The question is whether we can sue for malpractice.
[1] The only way to guarantee that you’ll never run out of inventory, if there’s any variance in the demand for the inventory, is to hold massive amounts of inventory. So in practice you have to pick an acceptable stock-out frequency, which enters into the calculation.
Drug Prices and Most-Favored-Nation Clauses: Considerations
A potentially important development in the market for pharmaceuticals – and in the pricing of the 1.6% of the Consumer Price Index that Medicinal Drugs represents – is the President’s move towards a “most-favored-nation” clause in the pricing of pharmaceuticals. The concept of a favored-nations clause is not new, although this is the first time it has been applied broadly to the pharmaceutical industry. In the investment management industry, it is not uncommon for very large investors (state pension funds, for example) to demand such a clause in their investment management agreements. Essentially, what such a clause does is guarantee to the customer that no other customer will get better pricing.[1] In the context of pharmaceuticals, the “problem” that the President is addressing is the fact that Americans buying a drug will often pay many times what a customer in another country will pay the pharmaceutical company for that same drug.
The optics are terrific for the President, but the economics not as much so. The argument is that demanding such a clause will force pharmaceutical companies to lower prices for American consumers drastically, to something approximating the price of those same products purchased abroad. The reality, though, is not so clear.
This is a story about price elasticity of demand. As I do often, I pause here and give thanks that I studied economics at a university that had a fantastic econ faculty. Economics is a great field of study, because done right it teaches a person to ask the right questions rather than jumping to what seems to be the apparent answer. (Incidentally, I feel the same way about Street research: done right, the value of that research is in guiding the questions, rather than handing us the answers.)
So let’s start at the ‘free market’ version of the pharmaceutical company’s profit-maximization problem. Let’s start by assuming that the marginal cost of production of a little pill is close to zero, or at least that it’s no different for the pill sold in one country versus the pill sold in another country. Then, the firm’s profit-maximizing linear programming problem is to maximize, independently for each country, the price where the marginal revenue is essentially zero – where in order to sell additional units, the price must be lowered enough that selling those additional units costs more in lost profit on the other units than it does on the incremental units. (If I sell 10 units at $10, and in order to sell the 11th unit I have to lower the price to $9, then I go from $100 in revenue to $99 in revenue and so if I am a profit-maximizer I won’t do this).
This point will be different in each country, and depends on the demand elasticity for that drug in that country. If the demand for a drug is very elastic, then that market will tend to clear at a lower price since each incremental decline in price will produce a relatively large increase in incremental quantity demanded. On the other hand, if the demand for the drug is very inelastic, then that market will tend to clear at a higher price since each additional increase in price will result in the loss of relatively few units of quantity sold. Now, every country and every drug will have different price elasticities. A lifestyle drug like the little blue pill will face fairly elastic demand in a Third World country, while a malarial drug probably does not.[2]
As an aside, one of the things which creates a more-elastic demand curve is the availability of substitutes. So, if the FDA makes it more difficult for a new statin drug to be approved than does the equivalent agency in Italy, then demand for a particular statin drug (all else equal) will be more elastic in Italy, where it faces more competition, than in the US. If you want lower prices, promote competition. But back to our story:
Now the Trump Administration adds a constraint to the drug company’s linear programming problem, such that the maximization is now joint; the problems are no longer independent maximization problems but the company must find the price that maximizes revenue across all markets collectively. If the free market has found a perfect and efficient equilibrium, then any such constraint must lower the value of the revenue stream to the drug company because if it did not, then it implies the company would already have be operating at that single-price solution. Constrained solutions can never be more valuable than unconstrained solutions, if both are in equilibrium.
What the drug company most assuredly will not do, though, is immediately lower the price to the American consumer to the lowest price charged to any other country. What it will do instead is take the highest price, and then add the incremental market that has the most inelastic demand, and see how much total revenue will increase if they have to lower the universal price to induce demand in that market. Note that this outcome may lower the price in the high-priced country, but it will also raise the price in the low-priced country. Since the lower-priced countries probably have more-elastic demand than the high-priced country…which is suggested by the fact that they had lower prices when they were being separately optimized…it is easy to imagine a scenario where the drug company ends up only supplying the high-priced country because the large increases in price for other countries essentially eliminate that demand. And that outcome, or indeed as I said any constrained outcome, is likely to be bad for the drug company. But what it will almost certainly not do is cause drug prices in the USA to drop 70%, or a massive decline in the Medicinal Drugs portion of CPI.
It may cause a decline in US drug prices, but that is not as certain as it appears. If the optimal strategy is to supply the drug only in the United States, then prices need not change at all (the US would then be the Most Favored Nation because it’s the only customer). In fact, the drug company might need to increase prices in the US. That happens because when you allow price discrimination, any customer who pays more than the variable cost of the product (which we assume here is close to zero) contributes something to the fixed overhead of the company;[3] therefore, a company that understands cost accounting will sometimes sell a product below the total cost per unit as long as it is above the variable cost per unit. When a US company, then, sells a pill to Norway at a really low price but above the cost of production, it defrays some of its overhead. If a most-favored-nation clause prevents a company from doing this, it will need to raise the price of the product in its remaining markets in order to cover the overhead that is not being covered any longer by those customers.
OK, so that’s just one iteration. I suspect that most pharmaceutical companies will end up lowering prices a little bit in the US and in other countries where prices are similar, and only selling them in countries that now pay a very low price to the extent that those foreign countries and/or international charities subsidize those purchases. But then we get into the financial and legal engineering part of this: what happens if Pfizer now licenses the formula for a particular drug to an Indian company that is legally distinct and doesn’t sell to the United States? Does the licensing agreement also fall under the MFN clause? What if Pfizer spins off its South American operations, sharing the intellectual property with its spinoff? For that matter, it might be the case that for some drugs, it is optimal to sell it everywhere in the world except the US, because the value of the unconstrained-non-US portion of the business is greater than the constrained-US portion of the business.
Now wouldn’t that be a kick in the head, to see pharmaceutical companies leave the US and refuse to sell to the US consumer because it makes them subject to the MFN clause? In the end, it seems to me that this is a great political gesture but it will be very difficult to get the results the President and his team wants.
[1] As an aside, in investment management this has caused the universe of strategies available to institutions demanding this clause to be reduced, hurting their investors. There are many circumstances in which an investment manager will offer outstanding, and sometimes outlandish, terms to investors who are the first in a new strategy, or who are low-touch easy/sophisticated customers, etc; a later entry by a large, high-maintenance customer may not be economic under the same terms.
[2] I am not at all an expert on how drug price elasticity behaves in this riot of market/product combinations, so readers who are should give me a break! I’m just illustrating a point.
[3] Cleverly called “variable contribution.”
COVID-19 in China is a Supply Shock to the World
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.
It has been so long since we have seen a supply shock that we have forgotten what they look like. China Inc shutting down is a supply shock. Supply shocks are inflationary, not disinflationary. Carry on.
— Michael Ashton (@inflation_guy) February 24, 2020
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
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.
Tariffs Don’t Hurt Domestic Growth
I really wish that economics was an educational requirement in high school. It doesn’t have to be advanced economics – just a class covering the basics of micro- and macroeconomics so that everyone has at least a basic understanding of how an economy works.
If we had that, perhaps the pernicious confusion about the impact of tariffs wouldn’t be so widespread. It has really gotten ridiculous: on virtually any news program today, as well as quite a few opinion programs (and sometimes, it is hard to tell the difference), one can hear about how “the trade war is hurting the economy and could cause a recession.” But that’s ridiculous, and betrays a fundamental misunderstanding about what tariffs and trade barriers do, and what they don’t do.
Because to the extent that people remember anything they were taught about tariffs (and here perhaps we run into the main problem – not that we weren’t taught economics, but that people didn’t think it was important enough to remember the fine points), they remember “tariffs = bad.” Therefore, when tariffs are implemented or raised, and something bad happens, the unsophisticated observer concludes “that must be because of the tariffs, because tariffs are bad.” In the category of “unsophisticated observer” here I unfortunately have to include almost all journalists, most politicians, and most alarmingly a fair number of economists and members of the Fed. Although, to be fair, I don’t think the latter two groups are making the same error as the former groups; they’re probably just confusing the short-term and the long-term or thinking globally rather than locally.
In any event, this reached a high enough level of annoyance for me that I felt the need to write this short column about the effects of tariffs. I actually wrote some of this back in June but needed to let it out again.
The effect of free trade, per Ricardo, is to enlarge the global economic pie. (Ricardo didn’t speak in terms of pie, but if he did then maybe people would understand this better.) However, in choosing free trade to enlarge the pie, each participating country surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off.
However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the US went through a period of truly sucking at automobile manufacturing, we still have the big three automakers. On the other hand, the US no longer produces any apparel to speak of. In fact, I would suggest that the only way that free trade works at all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself. Many would argue that (b) is what happened, as the US was willing to let its manufacturing be ‘hollowed out’ in order to make the world a happier place on average. Enter President Trump, who suggested that as US President, it was sort of his job to look out for US interests. And so we have tariffs and a trade war.
What is the effect of tariffs?
- Tariffs are good for the domestic growth of the country imposing them. There is no question about it in a static equilibrium world: if you raise the price of the overseas competitor, then your domestic product will be relatively more attractive and you will be asked to make more of it. If other countries respond, then the question of whether it is good or bad for growth depends on whether you are a net importer or exporter, and on the relative size of the Ex-Im sector of your economy. The US is a net importer, which means that even if other countries respond equally it is still a gain…but in any event, the US economy is relatively closed so retaliatory tariffs have a comparatively small effect. The effect is clearly uneven, as some industries benefit and some lose, but tariffs are a net gain to growth for the US in the short term (at least).
- Tariffs therefore are good for US employment. In terms of both growth and employment, recent weakness has been blamed on tariffs and the trade war. But this is nonsense. The US economy and the global economy have cycles whether or not there is a trade war, and we were long overdue for a slowdown. The fact that growth is slowing at roughly the same time tariffs have been imposed is a correlation without causality. The tariffs are supporting growth in the US, which is why Germany is in a recession and the US is not (yet). Anyone who is involved with a manufacturing enterprise is aware of this. (I work with one manufacturer which has suddenly started winning back business that had previously been lost to China in a big way).
- Tariffs are bad for global growth. The US-led trade war produces a shrinkage of the global pie (well, at least a slowing of its growth) even as the US slice gets relatively larger. But for countries with big export-import sectors, and for our trade partners who are net exporters to the US and have tariffs applied to their goods, this is an unalloyed negative. And as I said, more-fractious trade relationships reduce the Ricardian comparative advantage gain for the system as a whole. It’s just really important to remember that the gains accrue to the system as a whole. The question of whether a country imposing tariffs has a gain or a loss on net comes down to whether the growth of the relative slice outweighs the shrinkage of the overall pie. In the US case, it most certainly does.
- Trade wars are bad for inflation, everywhere. I’ve written about this at length since Trump was elected (see here for one example), and I’d speculated on the effect of slowing trade liberalization even before that. In short, the explosion of free trade agreements in the early 1990s is what allowed us to have strong growth and low inflation, even with a fairly profligate monetary policy, as a one-off that lasted for as long as trade continued to open up. That train was already slowing – partly because of the populism that helped elect Mr. Trump, and partly because the 100th free trade agreement is harder than the 10th free trade agreement – and it has gone into reverse. Going forward, the advent of the trade war era means we will have a worse tradeoff of growth and inflation for any given monetary policy. This was true anyway as the free-trade-agreement spigot slowed, but it is much more true with a hot trade war.
- Trade wars are bad for equity markets, including in the US. A smaller pie means smaller profits, and a worse growth/inflation tradeoff means lower growth assumptions need to be baked into equity prices going forward. Trade wars are of course especially bad for multinationals, whose exported products are the ones subject to retaliation.
In the long run, trade wars mean worse growth/inflation tradeoffs for everyone – but that doesn’t mean that every country is a net loser from tariffs. In the short run, the effect on the US of the imposition of tariffs on goods imported to the US is clearly positive. Moreover, because the pain of the trade war is asymmetric – a country that relies on exports, such as China, is hurt much more when the US imposes tariffs than the US is hurt when China does – it is not at all crazy to think that trade wars in fact are winnable in the sense of one country enlarging its slice at the expense of another country or countries’ slices. To the extent that the trade war is “won,” and the tariffs are not permanent, then they are even beneficial (to the US) in the long run! If the trade war becomes a permanent feature, it is less clear since slower global growth probably constrains the growth of the US economy too. Permanent trade frictions would also produce a higher inflation equilibrium globally.
In this context, you can see that the challenge for monetary policy is quite large. If the US economy were not weakening anyway, for reasons exogenous to trade, then the response to a trade war should be to tighten policy since tariffs lead to higher prices and stronger domestic growth. However, the US economy is weakening, and so looser policy may be called for. My worry is that the when the Federal Reserve refers to the uncertainty around trade as a reason for easing, they either misapprehend the problem or they are acting as a global central bank trying to soften the global impact of a trade war. I think a decent case can be made for looser monetary policy – but it doesn’t involve trade. (As an aside: if central bankers really think that “anchored inflation expectations” are the reason we haven’t had higher inflation, then why are they being so alarmist about the inflationary effects of tariffs? Shouldn’t they be downplaying that effect, since as long as expectations remain anchored there’s no real threat? I wonder if even they believe the malarkey about anchoring inflation expectations.)
Do I like tariffs? Well, I don’t hate them. I don’t think the real economy is the clean, frictionless world of the economic theorists; since it is not, we need to consider how real people, real industries, real companies, and real regimes behave – and play the game with an understanding that it may be partially and occasionally adversarial, rather than treating it like one big cooperative game. There are valid reasons for tariffs (I actually first enumerated one of these in 1992). I won’t make any claims about the particular skill of the Trump Administration at playing this game, but I will say that I hope they’re good at it. Because if they are, it is an unalloyed positive for my home country…whatever the pundits on TV think about the big bad tariffs.
Tariffs and Subsidies…on Money
Many, many years ago (27, actually) I wrote a paper on how a tariff on oil actually has some beneficial effects which needed to be balanced against the beneficial effect that a lower oil price has on economic growth. But since the early 1990s until 2015 or so I can count on the fingers of one hand how many times the issue of tariffs came up in thoughts about the economy and markets. To the extent that anyone thought about them at all, it was to think about how lowering them has an unalloyed long-term positive effect. Which, for the most part, it does.
But the economics profession can sometimes be somewhat shamanistic on the topic of tariffs. Tariffs=bad; time for the next chapter in the book. There is much more complexity to the topic than that, as there is with almost any economic topic. Reducing economics to comic-book simplicity only works when there is one overwhelmingly correct idea, like “when demand for a good goes up, so does the equilibrium price.” The end: next chapter.
Tariffs have, though, both short-term and long-term effects. In the long-term, we all agree, the effects of raising tariffs are deleterious. For any given increase in money and velocity, we end up with lower growth and higher inflation, all else equal. It is important to realize that these are largely one-time effects although smeared out over a long period. That is, after equilibrium is reached if tariffs are not changed any longer, tariffs have no large incremental effect. It is the change in tariffs that matters, and the story of the success of the global economy in terms of having decent growth with low inflation for the last thirty years is largely a story of continuously opening trade. As I’ve written previously, this train was just about running out of track anyway so that we were likely to go back to a worse combo of growth and inflation, but reversing that trend would lead to significantly worse combinations of growth and inflation in the medium-to-long term.
In the short-term, however, tariffs can have a positive effect (if they are expected to remain) on the tariff-imposing country, assuming no retaliation (or even with retaliation, if the tariff-imposing country is a significant net importer). They raise employment, and they raise the wage of the employed. They even may raise the real wage of the employed if there is economic slack. The chart below shows the y/y change in manufacturing jobs, and ex-manufacturing jobs, for the last 40 years. Obviously, the manufacturing sector has been shrinking – a story of increased productivity, but also of trade liberalization as manufacturing was offshored. The Obama-era work programs (e.g. “Cash for Clunkers”) temporarily reversed some of that differential decline, but since 2016 – when we got a new President – manufacturing payrolls growth has caught up to non-manufacturing. That’s not a surprise – it’s the short-term effect of tariffs.
The point is that tariffs are a political winner in the short-term, which is one reason I think that people are overestimating the likelihood that “Tariff Man” is going to rapidly concede on trade and lower tariffs. If the Administration gets a clear “win” in trade negotiations, then I am sure the President is amenable to reversing tariffs. But otherwise, it doesn’t hurt him in the heavy manufacturing states. And those states turn out to be key.
(This is a relative observation; it doesn’t mean that total payrolls will rise. The economic cycle still has its own momentum, and while tariffs can help parts of the economy in the short term it doesn’t change the fact that this cycle was very long in the tooth with lots of imbalances that are overdue for correction. It is no real surprise that employment is softening, even though it is a lagging indicator. The signs of softening activity have been accumulating for a while.)
But in the long run, we all agree – de-liberalizing trade is a bad deal. It leads among other things to bloat and inefficiency in protected sectors (just as any decrease in competition tends to do). It leads to more domestic capacity than is necessary, and duplicated capacity in country A and country B. It promotes inefficiency and unbalanced growth.
So why, then, are investors and economists so convinced that putting tariffs or subsidies on money has good (or even neutral) long-term effects? When the Fed forces interest rates higher or lower, by arbitrarily setting short-term rates or by buying or selling long-term bonds – that’s a tariff or a subsidy. It is protecting interest-rate sensitive sectors from having interest rates set by competition for capital. And, as we have seen, it leads in the long run to inefficient building of capacity. The Fed evinces concern about the amount of leverage in the system. Whose fault is that? If you give away free ice cream, why are you surprised when people get fat?
The only way that tariffs, and interest rate manipulations, have a chance of being neutral to positive is if they are imposed as a temporary rebalancing (or negotiating) measure and then quickly removed. In the case of Federal Reserve policy, that means that after cutting rates to address a temporary market panic or bank run, the central bank quickly moves back to neutral. To be clear, “neutral” means floating, market-determined rates where the supply and demand for capital determines the market-clearing rate. If investors believed that the central bank would pursue such a course, then they could evaluate and plan based on long-term free market rates rather than basing their actions on the expectation that rates would remain controlled and protective.
It is no different than with tariffs. So for central bankers criticizing the trade policy of the Administration, I say: let those among you who are without sin cast the first stone.
