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 It appears to be unpublished except as a working paper, which perhaps shouldn’t be surprising since it is so decidedly clear-eyed and takes the consensus view of QE to task.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!
There’s a bright golden haze on the meadow,
There’s a bright golden haze on the meadow.
The Dow is as high as an elephant’s eye,
An’ it looks like it’s climbin’ clear up to the sky.
Oh what a beautiful morning!
Oh what a beautiful day.
It’s far too pretty for trading,
So why don’t we play golf today.
With apologies to Rodgers and Hammerstein, it appeared as if the lovely spring day in the Northeast took its toll on market activity today. It has always been the case that good weather tended to cause trading to slow, but as trader bonuses have gradually disconnected from performance over the last few years it seems as if the pattern has been accentuated. True, there wasn’t much to trade on today…but in the past that didn’t seem to matter quite so much.
That said, I won’t stop at merely butchering show tunes as there are one or two recent stories I’d like to address from yesterday that I didn’t broach in that somewhat-lengthy article. The first is the news that President Obama’s latest tax plan includes a provision to cap IRAs at $3 million. To most of us, that’s a lot of money, although the article points out rightly that if you are a business owner who has contributed to a retirement plan as long as it has been available, it is fairly easy to get numbers above that level without needing extraordinary returns. Thrift, and compound returns, are two of the only three investing miracles that can produce great wealth with little effort (the third is rebalancing – look for my book “Only Three Miracles,” due out in roughly 2023).
But more disturbing is the fact that the White House has not said whether this $3mm level would be indexed for inflation (or, for that matter, whether it would affect defined benefit plans or Roth IRAs on which you’ve already paid taxes). If it is not indexed for inflation, then any readers of this column could be ‘capped out’ of tax-advantaged structures with sufficient inflation. And, since there is no reason that inflation could not reach scary levels, given the right circumstances, this is something that every investor should be aware of.
It is also disturbing to me, personally, that according to the story:
“The White House said in an April 5 statement that under current law ‘some wealthy individuals’ can accumulate ‘substantially more than is needed to fund reasonable levels of retirement saving.’”
Maybe I am the only person who is concerned about the use of the word “reasonable” here, as if my decision for what amount of savings I want to accumulate, rather than spend, is open to someone else’s validation of whether my savings is “reasonable.” But I suspect not. This statement isn’t part of the law, but it is part of the context under which laws are being proposed, and I think this means that we investors (including unreasonable ones, who should be spending much more and saving less, darn it) ought to be paying attention.
The other topic I want to include concerns the remarks of Chairman Bernanke yesterday at a conference in Georgia. I’ve previously pointed out in this space that selling assets from SOMA or letting those bonds run off are not feasible approaches for the Fed to take when it comes time to tighten. Apparently, the Fed now agrees, after having previously discussed (publicly) these options. Bernanke remarked in his response to audience questions that “asset sales are late in the process and not meant to be the principal tool of policy normalization” and that rather the Fed prefers to adjust the interest rate paid on excess reserves (IOER) as its main policy tool.
My main complaint about the IOER tool is that we have no idea how it is calibrated, and whether a small adjustment can cause important amounts of liquidity to be pulled back from the market. Moreover, I think this is a defensive tool – the Fed needs to keep the Excess Reserves from becoming Required Reserves by having banks expand lending too quickly. But consider the difficulty: if a bank has $1bln in excess reserves and $50mm in required reserves (for example), and increases lending by 50% so that required reserves rise to $75mm and excess reserves fall to $975mm, then by how much does the Fed need to raise IOER, currently at 25bps, to induce the bank to hold $1bln rather than $975mm in excess reserves? This is the problem – the Fed isn’t operating on the variable that they actually want to control.
The picture below is a slide from the presentation I will be delivering this month at the Inside Indexing event in Boston. Notice the relative sizes of the excess and required reserves slices. The Fed needs to take big swipes at the excess reserves piece without damaging the required reserves piece too much. This strikes me as being somewhat more challenging than the Federal Reserve currently seems to believe.
I continue to think that the best solution for the Fed, and also the one least likely to be deployed, is to raise reserve requirements to make official the unofficial policy of de-leveraging banks. By doing that, they will with one wave of the magic monetary wand cause excess reserves to vanish and they can operate again on required reserves.
Do you want to discuss any of this with me directly? Long-time readers know that I value the interaction with readers, as that feedback is the main compensation I get for writing this column. Well, I am introducing today a new way to interact with me, (and more importantly, for me to interact with you). I am offering (free) “office hours” to anyone who wants to sign up, to talk about pretty much anything in a free-form give-and-take. I’m starting with four 15-minute sessions per week, and we’ll see how it goes (of course, anyone who wants a deeper dive on an inflation topic is welcome to contact me about consulting through Enduring Investments). To sign up for my free office hours, click here and pick a date and time.
I’d noted in mid-December on this list that I was a guest on Bloomberg Radio on the “Bloomberg on the Economy” program with Carol Massar.
I promised to post a recording of the interview once I got it. Well, I’ve got it! Here it is, about 10 minutes. (It would be 8 minutes without my stammering. I’ll work on that.)
Thanks to the people at Bloomberg for chasing down a copy of this for me.
I will have another comment out over this long weekend, and it may well mention the S&P ratings downgrades of most of Europe, which just hit the tape. However, I just learned that the Society of Actuaries finally published a paper of mine in their “Retirement Mongraph,” available here, and I figured I would mention it to followers of this blog.
Here’s my abstract:
To date, the financial literature has focused on very simple algorithms designed to improve the solution to the two-part challenge of determining the optimal portfolio asset-allocation strategy and determining the maximum sustainable withdrawal rate for retirees. Most research, for example the well-known “Trinity Study” of Cooley, Hubbard, and Walz, pursues the asset-allocation problem by maximizing long-run asset growth subject to a withdrawal rule and a given acceptable probability of remorse (a.k.a. shortfall). However, the Liability-Driven Investing (LDI) thought process improves the approach by seeking instead to maximize return for a given level of volatility of the portfolio surplus, rather than optimizing on the basis of the volatility of the assets themselves; by more closely matching assets and liabilities, the sensitivity of the strategy to unexpected returns, risks, and correlations is greatly decreased. I updated the Trinity Study to incorporate inflation-indexed bonds and then illustrate how the LDI thought process may be applied to individual investors.
Please let me know if you have any questions or comments!