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Money, Commodities, Balls, and How Much Deflation is Enough?
Money: How Much Deflation is Enough?
Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.
That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.
The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).
Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.
Commodities: How Much Deflation is Enough?
Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).
The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.
The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.
Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.
As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.
Balls: How Much Deflation is Enough?
Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”
The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.
Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.
Inflation Consequences of QE – per Reynard
Before getting into today’s column, let me first describe my plan of attack for the month of December. I plan to have several comments this week and next week, culminating in my annual “Portfolio Projections” piece at the end of next week. Then, for the last two weeks of the month, I plan to ‘re-blog’ some of my best articles from the last four years (editing out the current events, which will no longer be topical of course). Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these posts.
With that housekeeping complete, I want to turn today to a scholarly article I recently stumbled on which is worth a read even once you have read my synopsis and comments. The article, written one year ago by Samuel Reynard of the Swiss National Bank, is entitled “Assessing Potential Inflation Consequences of QE after Financial Crises.” It appears to be unpublished except as a working paper, which perhaps shouldn’t be surprising since it is so decidedly clear-eyed and takes the consensus view of QE to task.
What I love about this article is that Reynard’s view is remarkably consonant with my own – the only example I can come up with of a reasonably-placed central banker espousing such commonsensical views (Daniel Thornton at the St. Louis Fed gets an honorable mention though), backed with quantitative data and clear reasoning. Here is the paper’s abstract:
“Financial crises have been followed by different inflation paths which are related to monetary policy and money creation by the banking sector during those crises. Accounting for equilibrium changes and non-linearity issues, the empirical relationship between money and subsequent inflation developments has remained stable and similar in crisis and normal times. This analysis can explain why the financial crisis in Argentina in the early 2000s was followed by increasing inflation, whereas Japan experienced deflation in the 1990s and 2000s despite quantitative easing. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.”
In the introduction, the author directly tackles current central bank orthodoxy: “It is usually argued that it is sufficient to monitor inflation expectations, and that central banks can avoid accelerating inflation by quickly withdrawing reserves (or by increasing the interest rate payed on reserves) once inflation expectations start rising. The monetary analysis of this paper however shows that there has never been a situation of excess broad money (created by the banking system) which has not been followed by increasing inflation, and that the increase in inflation occurs after several years lags.”
Reynard starts with the quantity theory of money (MV≡PQ), which I have discussed at length in this column. Regular readers will know that I am careful to distinguish transactional money from base money – as does Reynard – and that the sole reason inflation has not accelerated is that money velocity has declined. This decline is not due to the financial crisis directly, but as I have shown before it is due to the decline in interest rates. This makes monetary policy problematic, since an increase in interest rates which in ordinary times (that is, when there isn’t a couple trillion of excess reserves) would cause M2 to decelerate and dampen inflation will also cause money velocity to rise – offsetting to some extent the effects of the rising interest rates on the money supply. (Among other things, this effect tends to help cause monetary policy to overshoot on both sides). Reynard’s insightful way around this problem is to “model equilibrium velocity as a function of interest rate to reflect changes in inflation environments.” That is, the monetary equation substitutes an interest rate variable, based on a long-run equilibrium relationship with velocity, for velocity itself. In Reynard’s words,
“Thus the observed money level is adjusted…by the interest rate times the estimated semi-elasticity of money demand to account for the fact that, for example in a long-lasting disinflationary environment when inflation and interest rate decrease, the corresponding increase in money demand reflecting the decline in opportunity cost is not inflationary: the price level does not increase with the money level given that equilibrium velocity decreases.”
This is exactly right, and it is exceedingly rare that a central banker has that sort of insight – which is one of the reasons we are in this mess with no obvious way out. Reynard then uses his model to examine several historical cases of post-crisis monetary and inflationary history: Switzerland, Japan, Argentina and the 1930s U.S. He finds that there are downward rigidities to the price level that cause inflation to resist turning negative (or to fall below about 1.5% in the U.S.), but that when there is excess liquidity the link between liquidity and inflation is very tight with a lag of a couple of years. Reynard’s opinion is that it is this non-linearity around price stability that has caused prior studies to conclude there is no important link between money and inflation. As Fama observed back in the early 1980s, and I observe pretty much daily to the point that it is now a prohibited topic at the dinner table, when inflation is very low there is a lot of noise in the money-inflation relationship that makes it difficult to find the signal. But the money-inflation connection at higher levels of inflation and money, and over longer periods of time, is irrefutable.
In the last section of the paper, the author assesses the effects of current QE (through November 2012) on future inflation in the U.S. His conclusion is that “Excess liquidity has always been followed by persistent increases in inflation. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.” The chart accompanying this statement is reproduced below.
As you can see, the model suggests inflation of 3-4% in 2013 and 5% in late 2014. While clearly inflation in 2013 has been lower than suggested by the chart, this isn’t supposed to be a trading model. I suspect that if get 3-4% in 2014 and 5%+ in 2015 (our forecast is for 3.0%-3.6% on core inflation in 2014 and 3.3%-4.8% in 2015), the issue of whether Reynard was essentially correct will not be in question!
Inflation, Deflation, and Putting
Since there is no data of note for a little while, there are some other topics I suppose I have time to remark upon.
I recently read a piece by Morgan Stanley called “Of Dogs, Deflation and Inflation.” In it, the authors essentially argue that the relative stasis of inflation recently is “best interpreted as a balance between inflation and deflation rather than concluding that neither is a material risk. While bold central bank action has been successful in stabilising inflation over the past five years, it has also increased the two-way risk to the future price level – both longer-term inflation and deflation risks have increased.”
If I see a photograph of a golf ball sitting on the rim of the cup, I might conceive of several reasons for that configuration. One is that there are no important forces acting on the ball, so it is sitting still on the edge of the cup. Another is that there are massive forces that are all canceling out: say, a strong wind blowing from right to left, and the golfer using a huge club rather than a putter to put the ball from left to right. Which of these two is inherently more likely? Is it possible that inflation has been relatively stable around the Fed’s target (using Median CPI) because massive quantitative easing just happened to exactly cancel the deflationary forces of the credit collapse? Well, of course it is possible. It is also possible that a derivatives book with two hundred trades in it just happens to have no risk at all. But when you are talking large numbers, it takes extreme precision to balance a system.
So it is more likely that neither force was very strong. However, there is yet a third explanation for that photograph, and that is that the ball was actually in motion and the picture just happens to capture a moment in time. The ball, in fact, proceeded to fall into the cup, but we don’t know that because the picture doesn’t tell us what came after.
This is the situation I believe we are in with inflation in the aftermath of the great recession. There is no doubt that the Fed’s aggressive easing helped ameliorate the deflationary pressures, although I think they were never as great as we thought at the time since the main deflationary pressure came from the decline in money velocity…which was caused mainly by a Fed-induced decline in interest rates. But these two forces, Fed easing and the deflationary impulses from a credit crunch, don’t act simultaneously. The Fed’s action takes longer to materialize in inflationary outcomes…especially when, as in this case, most of the easing from QE was sequestered in sterile bank reserves. We have, though, seen what is happening in the housing market, and it is foolishness to think that this has anything to do with strong household incomes or Congressional support for housing. It is plainly the result of a higher float of money, which has manifested in higher prices for real assets. And that putt was set in motion not this year, but with the earliest QEs that pushed money growth over 10% at times over the years since 2008.
Don’t look at the current state of the ball, that is core inflation, as being a deterministic snapshot. There is a delay between monetary policy and inflation outcomes (the old rule of thumb was 9-12 months, but it was pretty flexible), and that delay is even longer this time around because of the excess-reserves issue. The ball is in motion, and my guess is that the Fed struck the putt too hard.
