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Fed Gearing Up to Stand Down
I guess it’s something about strong growth numbers and a tightening central bank that bonds just don’t like so much. Ten-year Treasury yields rose about 9bps today, under pressure from the realization that higher growth and higher inflation, which is historically a pretty bad cocktail for bonds, is being offset less and less by extraordinary Federal Reserve bond buying. Yields recently had fallen as the Q1 numbers doused the idea that the economic recovery will continue without incident, and as the global political and security situation deteriorated (maybe we will just say it became “less tranquil”). Nominal 10 year yields had dipped below 2.50%, and TIPS yields had reached 0.20% again. It didn’t hurt that so many were leaning on the bear case for bonds and were tortured the further bonds rallied.
Stocks, evidently, didn’t get the message that higher interest rates are more likely, going forward, than lower interest rates. They didn’t get the message that the Fed is going to be less accommodative. They didn’t even get the message that the Fed sees the “likelihood of inflation running persistently below 2 percent has diminished somewhat.” The equity markets ended flat. Sure, it has not been another banner month for the stock jockeys, but with earnings up a tepid 6% or so year/year the market is up nearly 17% so…yes, you did the math right: P/E multiples keep expanding!
My personal theory is that stocks are doing so well because Greenspan thinks they’re expensive. In an interview today on Bloomberg Television, Greenspan said that “somewhere along the line we will get a significant correction.” Historically speaking, the former Chairman’s ability to call a top has been something less than spectacular. After he questioned whether the market might be under the influence of ‘irrational exuberance,’ the market continued to rally for quite some time. Now, he wasn’t alone in being surprised by that, but he also threw in the towel on that view and was full-throatedly bullish through the latter stages of the 1990s equity bubble. So, perhaps, investors are just fading his view. Although to be fair, he did say that he didn’t think equities are “grossly overpriced,” lest anyone think that the guy who could never see a bubble might have actually seen one.
Make no mistake, there is no question that stocks are overvalued by every meaningful metric that has historical support for its predictive power. That does not mean (as we have all learned over the past few years) that the market will decline tomorrow, but it does ensure that future real returns will be punk over a reasonably-long investment horizon.
It will certainly be interesting to see how long markets can remain levitated when the Fed’s buying ceases completely. Frankly, I am a bit surprised that these valuation levels have persisted even this long, especially in the face of rising global tensions and rising inflation. I am a little less surprised that commodities have corrected so much this month after what was a steady but uninspiring move higher over the first 1-2 quarters of 2014. Commodities are simply a reviled asset class at the moment (which makes me love them all the more).
Do not mistake the Fed’s statement (that at the margin the chance of inflation less than 2% is slightly less likely) for hawkishness. And don’t read hawkishness into the mild dissent by Plosser, who merely wanted to remove the reference to time in the description of when raising rates will be appropriate. Chicago Fed President Evans was the guy who originally wanted to “parameterize” the decision to tighten by putting numbers on the unemployment rate and inflation levels that would be tolerable to the Fed (the “Evans Rule”)…levels which the economy subsequently blasted through without any indication that the Fed cared. But Evans himself recently said that “it’s not a catastrophe to overshoot inflation by some amount.” Fed officials are walking back the standards for what constitutes worrisome inflation, in the same way that they walked back the standards for what constitutes too-low an unemployment rate.
This is a good point at which to recall the “Wesbury Map,” which laid out the excuses the Fed can be expected to make when inflation starts being problematic. Wesbury had this list:
- Higher inflation is due to commodities, and core inflation remains tame.
- Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that’s temporary.
- It’s not actual inflation that matters, but what the Fed projects it to be.
- It’s okay for inflation to run a little above 2% for a while because it was under that level for so long.
- Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
- Well, 3-4% inflation isn’t that bad for the economy, anyway.
I think the order of these excuses can change, but they’re all excuses we can expect to hear trotted out. Charles Evans should have just shouted “FOUR!” Instead, what he actually said was
“Even a 2.4 percent inflation rate, if it’s reasonably well controlled, and the rest of the economy is doing ok, and then policy is being adjusted in order to keep that within a, under a 2.5 percent range — I think that can work out.”
That makes sense. 2.4% is okay, as long as they limit it to 2.5%. That’s awfully fine control, considering that they don’t normally even have the direction right.
Now, although the Evans speech was a couple of weeks ago I want to point out something else that he said, because it is a dangerous error in the making. He argued that inflation isn’t worrisome unless it is tied to wage inflation. I have pointed out before that wages don’t lead inflation; this is a pernicious myth. It is difficult to demonstrate that with econometrics because the data is very noisy, but it is easy to demonstrate another way. If wages led inflation, then we would surely all love inflation, because our buying power would be expanding when inflation increased (since our wages would have already increased prior to inflation increasing). We know, viscerally, that this is not true.
But economists, evidently, do not. The question below is from a great paper by Bob Shiller called “Why Do People Dislike Inflation” (Shiller, Robert, “Why Do People Dislike Inflation?”, NBER Working Paper #5539, April 1996. ©1996 by Robert J. Shiller. Available at http://www.nber.org/papers/w5539). This is a survey question and response, with the economist-given answer separated out from the answer given by real people.
Economists go with the classic answer that inflation is bad mainly because of “menu costs” and other frictions. But almost everyone else knows that inflation makes us poorer, and that very fact implies that wages follow inflation rather than lead.
Put another way: if Evans is going to be calm about inflation until wage inflation is above 3.5%, then we can expect CPI inflation to be streaking towards 4% before he gets antsy about tightening. Maybe this is why the stock market is so exuberant: although the Fed has tightened by removing the extra QE3, a further tightening is evidently a very long way off.
Is Inflation of 2% Enough for You?
In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”
At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.
To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.
I am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!
It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.
Ten-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.
Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.
None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?
