With heavy travel over the last week and looming over the next couple of weeks, I figured that I really ought to get an article out before everyone forgets that I write a blog.
It isn’t that there is a dearth of topics. I have so much to talk about that I am brimming over; however, between the usual press of our Quarterly Inflation Outlook (which comes out after the CPI number this month) and the press of business-seeking activity, it has been difficult to put virtual pen to virtual paper.
Here is a great example. The New York Fed blog routinely gives me great material, both positive and negative. They’ve just published an article entitled “Inflation in the Great Recession and New Keynesian Models” with a followup article called “Why Didn’t Inflation Collapse in the Great Recession?” The pair of articles could just as easily be entitled, “When Your Model Doesn’t Work, Add a Parameter.”
I have said on a number of occasions that the credit crisis was a great test of the fundamental Keynesian hypothesis that inflation is caused by growth relative to potential output. And, in the event, that hypothesis was shown to be as bankrupt as Countrywide. I have always liked the way I summed up the state of the argument in 2012:
“The upshot is that we’ve just come off the biggest recession in 80 years, and inflation barely slowed. In fact, if you remove the effects of the bubble unwind in housing, it didn’t slow at all. If growth causes inflation, and if recessions are by definition deflationary, then we should have seen a decline in core prices.”
Here is the chart that accompanies that assertion:
Now, this doesn’t mean that the monetarists are right, but it assuredly means that the Keynesians are wrong. It is far too much, though, to ask for the peaceful surrender of this view. Instead, the Keynesians (or “New Keynesians” if you prefer) first recalibrated their models, like Goldman did in 2012. (Note, incidentally, that their re-calibrated model called for sharply declining core inflation starting from the moment they published that prediction, converging on 1.4% or so in 2013. In actuality, Median CPI basically went sideways from 2011 until recently. Core inflation declined, but only because of the one-off effect of the sequester, which I don’t imagine is what Goldman was forecasting).
What the NY Fed authors have done is to postulate that the real problem with New Keynesian models is that slack isn’t measured right, but rather that “the present value of expected future marginal costs is the more meaningful way of measuring slack.” It is a wonderful thing to be able to live in a world of models populated with unobservable variables that just happen to take on the right values to make the theory work. Even if, from time to time, one needs to re-calibrate when the model’s predictions don’t work out.
For the rest of us, the fact that monetarist models predicted that inflation would not plunge in the crisis, and have consistently given predictions wholly consistent with subsequent outcomes – without requiring re-parameterization – is a pretty strong argument that it’s likely to be closer to the right way to look at the world…even if it doesn’t give us as much to do.
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.
So, the Fed’s tightening is almost done.
Chairman Yellen informed Congress that a “high degree” of easing is needed given the slack in the labor market. This is in keeping with the Fed’s ongoing thematic presentation of “tapering is not tightening,” but of course tapering is indeed tightening. Call it “easing less” if you like, but going from “providing lots of liquidity” to “providing less liquidity” to “providing no added liquidity” is tightening.
I would argue that providing no added liquidity – which is where the Fed is headed, with the taper due to be completed in the autumn – is neutral policy, not an easy policy. But the Fed, like many observers, confuses the level of interest rates with the degree of accommodation. That is confusing a price (the interest rate) with a flow, but it seems not to bother them very much. (I explain the distinction, which is crucial to monetary policymaking, in this article.)
Now, whatever the Chairman thinks she’s saying, what she means is that the Fed isn’t going to be raising interest rates soon. This is partly because the main tool they had been planning to use, the reverse repo facility, isn’t as simple a solution as they believed at first. This isn’t terribly surprising; as I (and others) have been pointing out in presentations and articles for a while it isn’t trivially easy to drain $2 trillion in reverse repo transactions, even if you can do $2 billion with ease. The pattern is familiar, and should be mildly discomfiting:
- At first, the Fed thought to unwind the massive purchases of Treasuries by simply selling them. The original argument was that the Fed pushed rates lower by buying Treasuries, but selling them wouldn’t raise interest rates. This sort of perpetual motion machine never made much sense, and at some point it became clear that if the Treasury started to unwind the SOMA portfolio securities and rates rose, it would likely not be sufficient to drain all of the excess reserves, since the average selling price would most likely be lower than the average purchase price.
- The Fed then thought to just let the securities in the SOMA roll off. Then someone noticed that because of the TWIST program, the Fed doesn’t own many short-dated Treasuries, so that letting QE gradually drain itself would take more than a decade.
- No problem; we’ll just conduct massive reverse repo operations to drain a couple trillion dollars from the system. The link above shows that the Fed’s newly discovered skepticism on that matter; the website Sober Look recently had a good article on the topic as well.
None of this is surprising to people who actually have market experience; unfortunately, over the last decade or so the level of actual market expertise at the Federal Reserve has dropped significantly so they are re-discovering these things the hard way. Now, the focus is on interest on excess reserves (IOER) as the main tool for raising rates eventually.
All of this confusion is one reason that the Fed will move only slowly to ‘normalize’ interest rates. They’re simply not sure how they’ll do it. The problem with IOER is that we have no idea how sensitive the level of reserves it to the amount of interest paid on reserves…since we have never done this before. But to the Fed, that’s no problem because they don’t seem to care about reserves – they only care about the level of interest rates, which at the end of the day don’t matter nearly as much as the growth rate of the money supply.
And so US and UK money supply growth rates are both in the 6-7% range, and interestingly median inflation in the US recently accelerated to 2.3% while core inflation in the UK surprised everyone today by rising to 1.9% (as of April). Commercial bank credit growth in the US over the last 13 weeks has risen at a 10.4% pace, the highest rate since early 2008 (see chart, source Federal Reserve).
Slowing QE has not, evidently, slowed money supply growth, and this is one reason the Fed insists that tapering is not tightening. Unfortunately, this doesn’t mean that the Fed is right, but that they are wrong twice: first, tapering is tightening. Second, changing the pace of addition to reserves does not matter for growth in the money supply (and, hence, inflation) when there are enormous piles of inert reserves already. Picture a huge urn filled with coffee. The spigot at the bottom controls the pace at which coffee leaves the urn, and adding more coffee to the top of the urn has essentially no effect.
So money supply growth, and corporate loan growth, is currently not under control of the Fed in any way. Interest rates are under their control, but interest rates don’t cause changes in the money supply but rather the other way around. Here is another analogy: a robust harvest of corn pushes corn prices lower, but if the government officially sets the price of corn very low it does not cause a robust harvest of corn. This is exactly what the Fed is trying to do if they attempt to control the money supply by changing interest rates.
It actually is worse than this. Raising interest rates will tend to increase money velocity, a relationship which has held very well for the last two decades. I have written about this quite a bit in the past (see for one example this article from last September), but I – like many monetary economists – have often struggled with the fact that there was a regime shift in the early 1990s which messes up the beauty of this fit (see chart, source Enduring Investments).
We have recently resolved much of this problem in our own modeling. The following chart uses three (unstated here, but included in our quarterly inflation outlook to clients) inputs to model M2 velocity, and the regime shift is largely absent. Suffice to say that with a model that makes sense and fits a much wider range of history, we are even more confident now that any Fed move to hike interest rates, rather than to drain reserves, would be a mistake.
The bottom line is that it is good news that Yellen is not planning to hike interest rates soon. It is bad news that she is not planning to drain reserves any time soon. But the Fed is perilously close to making its big policy error of this cycle. Stay tuned.
In keeping with the topic of the month, I present this chart.
I really wanted to make the x-axis the compounded inflation rate since the World Cup began, but the data is just too difficult to find for many of these countries. Nevertheless, we see the broad outlines of the thesis in this chart. If you want to be excellent at soccer, inflate your economy.
The correlation between soccer wins and inflation (I arbitrarily decided to only include countries which have appeared in eight or more World Cups, so that there is some chance that they have some wins) is only 0.31, but notice the two blue dots at the upper left. I would argue that at least Germany has an inflation-driven history, although since the 1980s they have had fairly low inflation. One might argue the same with Italy, albeit to a lesser extent. If we exclude those two aberrations, the correlation rises to a whopping 0.67!
Ok, sure, this is somewhat spurious – it is largely driven by the fact that two of the winningest teams are Brazil and Argentina, which have quite a history of inflation as well as of soccer. But if the ECB discovers this, it should make sure all of the retail shops in Europe know…and they’ll have widespread support for inflation.
As we wait to see whether the Fed slants its statement ever-so-slightly to the hawkish side or ever-so-slightly to the dovish side (not to mention whether Chairman Yellen repeats her blunt performance in the presser), it is probably worth a few moments to think about what the Fed ought to do.
Yesterday’s inflation figures, viewed in isolation, might be perceived as a one-off bad figure. I pointed out yesterday some reasons that this would be an unfortunate error. Keep in mind that anything the Fed does to address monetary policy will take some time to impact an economic process with momentum. That is to say that even if the Fed tightened today, core inflation over 3% is probably still going to happen. The real question is how high inflation goes, and how long it stays there. There is no longer any question about whether inflation is rising. (This has actually been true for a while, but people who were focused on core rather than median and didn’t look at the particulars of inflation, as well as those who focus on the “output gap” as preventing any possibility of inflation, have been able to ignore the signs for a while).
As an aside, the “output gap” crowd – who expected deflation in 2009-10, and didn’t get it, and now expect disinflation, but aren’t getting it – aren’t defeated yet. They’ll simply re-define the gap to fit the data, I am sure. When you get to choose your own observations and change the model to fit the observations, science is easy.
What concerns me about the Fed’s next steps here, and the state of the debate, is that the Federal Reserve seems overly focused on the level of interest rates, and how to adjust them, and not on the level of reserves or controlling the transactional money supply. For example, recently the IMF published a paper arguing that central banks should raise the long-term inflation target from 2% to 4% because with a 2% target it is too easy to get deflation and have interest rates pinned at zero, leaving the central bank powerless to stop deflation. It seems not to matter to the author that Japan only recently proved that it is money, and not interest rates, that matter when they were able to get out of deflation with an aggressive QE. And, after all, “Helicopter” Ben made the point years ago that deflation is easy to prevent if only the Fed prints money.
So the cult of interest rate manipulation concerns me. Another, and more influential, example (because after all, no one really believes the central bank will start targeting 4% inflation) is in the publication recently of “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve,” co-authored by Brian Sack and Joseph Gagnon. Dr. Sack used to be head of the Fed’s Open Markets Desk, so his opinions have some weight in the institution. In this policy brief, he and his co-author suggest ways that the Fed could raise rates even without reducing the amount of excess reserves in the system. Their approach would, indeed, succeed in moving interest rates. But the proposal, in the authors’ words, “appropriately ignores the quantity of money.”
Considering that it is the quantity of money, not its price, that impacts inflation – as hundreds of years of monetary history have proven beyond any educated doubt – this is a frightening view. We are always looking for where the next policy error will come from; this is certainly a strong candidate.
There is a crucial misunderstanding here, and it is unfortunately a fundamental tenet of the interest rate cult. Interest rates are not the cause of money supply changes, but the result of them. The way the Fed operates tends to cause this confusion, because the Fed seems to adjust interest rates. But that is not in fact what happens. The Desk actually adjusts the level of reserves in the system, and reads the interest rate as an indication of whether reserves are at the right level (or at least, this was the way it used to be done, before the “environment of abundant liquidity”). The confusion has gradually developed, and the institution has contributed to the confusion by gradually altering its policy statements to obfuscate what is actually going on. The domestic policy directive of February 1989 said in part:
“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions…somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 2 and 3½ percent, respectively.”
Notice that the main focus here is how pressure on reserves leads to money supply growth. By 1994, the Fed was drawing the line to interest rates more explicitly. The press release following the February 4th, 1994 meeting said in part:
“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”
The Federal Reserve eventually stopped talking about “reserve positions,” although that continued to be how interest rates were managed in fact. Here is what the Fed was saying in January 2007:
“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”
Now, of course, the Fed not only sets the current level of interest rates but also gives us an expected path.
But again, even when the Fed was talking about the interest rate target, the Fed actually managed interest rates by managing reserves. By doing large system repos or matched sales, the supply of reserves was managed with respect to what the Fed thought the demand for reserves (which is unobservable in real time) was. If the resulting interest rate was too low or too high, then they added or subtracted to the supply reserves. And thus we get to the point that is crucial for understanding how monetary policy is conducted: the interest rate is a measurement of the pressure on reserves.
Interest rates, in other words, are like a thermometer that measures the temperature in the body. The doctor plies his trade on a feverish patient with an eye on the thermometer. He can’t see the microbes and antibodies, but the thermometer tells him (her) if he (she) is winning. In exactly the same way, the level of short-term interest rates tells the Fed if they have too many reserves or too few. But suppose the doctor lost sight of the real purpose of treatment? Suppose the doctor said “wow, this would be so much easier if I just put a little dial on the thermometer so that I could control the reading directly! Then I could just set it to the right temperature and I would be done.” We would all recognize that doctor as a quack, and the patient would probably die.
This approach, though, is what the Sack/Gagnon paper proposes. We want to control the temperature, so let’s introduce a thermometer that allows us to control the temperature! But this is wrong, because it is the reserve position that is critical to control; it is that which is out of control at the moment due to the presence of copious excess reserves; and the fact that the Fed can simply set the interest rate is irrelevant. (Why do we need a Fed? Why not have Congress set the legal interest rate at the “appropriate level” so that the Fed doesn’t even need to do open market operations?)
The Sack/Gagnon plan will clearly permit the movement of interest rates to wherever the Fed wants them to be. But it will not solve the root problem, which is that the level of required reserves is essentially out of the Fed’s control – which means the size of the money supply is out of its control as well. Excess reserves will continue to leak into transactional money, and inflation will continue to rise. Here is your error. The Fed is about to score an “own goal.”
Following is a summary of my post-CPI tweets. You can follow me @inflation_guy!
- Well, I hate to say I told you so, but…increase in core CPI biggest since Aug 2011. +0.3%, y/y up to 2.0% from 1.8%.
- Let the economist ***-covering begin.
- Core services +2.7%, core goods still -0.2%. In other words, plenty of room for core to continue to rise as core goods mean-reverts.
- (RT from Bloomberg Markets): Consumer Price Inflation By Category http://read.bi/U60bLJ pic.twitter.com/R2ufMjVRRM
- Major groups accel: Food/Bev, Housing, Apparel, Transp, Med Care, Other (87.1%) Decel: Recreation (5.8%) Unch: Educ/Comm (7.1%)
- w/i housing, OER only ticked up slightly, same with primary rents. But lodging away from home soared.
- y/y core was 1.956% to 3 decimals, so it only just barely rounded higher. m/m was 0.258%, also just rounding up.
- OER at 2.64% y/y is lagging behind my model again. Should be at 3% by year-end.
- Fully 70% of lower-level categories in the CPI accelerated last month. That’s actually UP from April’s very broad acceleration.
- That acceleration breadth is one of the things that told you this month we wouldn’t retrace. This looks more like an inflation process.
- 63% of categories are seeing price increases more than 2%. Half are rising faster than 2.5%.
- Back of the envelope says Median CPI ought to accelerate again from 2.2%. But the Cleveland Fed doesn’t do it the same way I do.
- All 5 major subcomponents of Medical Care accelerated. Drugs 2.7% from 1.7%, equip -0.6% from -1.4%, prof svs 1.9% from 1.5%>>>
- >>>Hospital & related svcs 5.8% from 5.5%, and Health insurance to -0.1% from -0.2%. Of course this is expected base effects.
- Always funny that Educ & Communication are together as they have nothing in common. Educ 3.4% from 3.3%; Comm -0.24% from -0.18%.
This was potentially a watershed CPI report. There are several things that will tend to reduce the sense of alarm in official (and unofficial) circles, however. The overall level of core CPI, only just reaching 2%, will mean that this report generates less alarm than if the same report had happened with core at 2.5% or 3%. But that’s a mistake, since core CPI is only as low as 2% because of one-off effects – the same one-off effects I have been talking about for a year, and which virtually guaranteed that core CPI would rise this year toward Median CPI. Median CPI is at 2.2% (for April; it will likely be at least 2.3% y/y from this month but the report isn’t out until mid-day-ish). I continue to think that core and median CPI are making a run at 3% this calendar year.
The fact that OER and Primary Rents didn’t accelerate, combined with the fact that the housing market appears to be softening, will also reduce policymaker palpitations. But this too is wrong – although housing activity is softening, housing prices are only softening at the margin so far. Central bankers will make the error, as they so often do, of thinking about the microeconomic fact that diminishing demand should lower market-clearing prices. That is only true, sadly, if the value of the pricing unit is not changing. Relative prices in housing can ebb, but as long as there is too much money, housing prices will continue to rise. Remember, the spike in housing prices began with a huge overhang of supply…something else that the simple microeconomic model says shouldn’t happen!
Policymakers will be pleased that inflation expectations remain “contained,” meaning that breakevens and inflation swaps are not rising rapidly (although they are up somewhat today, as one would expect). Even this, though, is somewhat of an illusion. Inflation swaps and breakevens measure headline inflation expectations, but under the surface expectations for core inflation are rising. The chart below shows a time-series of 1-year (black) and 5-year (green) expectations for core inflation, extracted from inflation markets. Year-ahead core CPI expectations have risen from 1.7% to 2.2% in just the last two and a half months, while 5-year core inflation expectations are back to 2.4% (and will be above it today). This is not panic territory, and in any event I don’t believe inflation expectations really anchor inflation, but it is moving in the “wrong” direction.
But the biggest red flag in all of this is not the size of the increase, and not even the fact that the monthly acceleration has increased for three months in a row while economists keep looking for mean-reversion (which we are getting, but they just have the wrong mean). The biggest red flag is the diffusion of inflation accelerations across big swaths of products and services. Always before there have been a few categories leading the way. When those categories were very large, like Housing, it helped to forecast inflation – well, it helped some of us – but it wasn’t as alarming. Inflation is a process by which the general price level increases, though, and that means that in an inflationary episode we should see most prices rising, and we should see those increases accelerating across many categories. That is exactly what we are seeing now.
In my mind, this is the worst inflation report in years, largely because there aren’t just one or two things to pin it on. Many prices are going up.
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years. Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
 This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
Part of the assessment of a new Federal Reserve Chairman always involves trying to figure out if the new person says particular things because they are wily, and cagey, or because they don’t really have a good idea of what they’re doing.
For example, when Chairman Bernanke said on “60 Minutes” that he was “100 percent” certain that the Fed could stop inflation from happening, some people thought he was being clever and projecting the great confidence that investors presumably needed to hear from the Fed Chairman at that time. I didn’t buy that, and rather thought that anyone associated with real-life financial markets (as opposed to models) would never attach a 100% probability to anything, and certainly not something that had never been tried. Subsequent events showed that the latter was probably closer to the truth, as the Fed went from reassuring the world that it could exit whenever it was warranted, to claiming that no exit – in the sense of needing to reduce its balance sheet – was necessary. That transition in message was largely due to the slowly-developing realization that in the real world, you can’t sell $2 trillion of securities as easily as you can buy them when the Treasury is going the same way.
We are going through a similar process of “market vetting” with Yellen. Her decision to stay the course on the taper – which is surely the right course – could be wise, or it could simply be that she doesn’t make decisions very quickly. It isn’t clear right now which of these is the case.
However, I find her recent talk about inflation to be disturbing. Yes, of course we all know that she is a dove. And, given her historical record on monetary policy topics, I don’t expect her to be as concerned as others (such as Allan Meltzer in today’s Wall Street Journal) are about the prospects for inflation – in other words, I expect her to be late and slow to respond. And that theme got no lack of support today, when Yellen remarked in testimony before the Joint Economic Committee, that “In light of the considerable degree of slack that remains in labor markets and the continuation of inflation below the Committee’s 2 percent objective, a high degree of monetary accommodation remains warranted.” Certainly, that is no surprise, and neither is her assertion (scary though it be) that “In particular, we anticipate that even after employment and inflation are near mandate-consistent levels, economic and financial conditions may, for some time, warrant keeping the target federal funds rate below levels that the Committee views as normal in the longer run.”
I’m not too keen when the Chairman basically promises to keep interest rates below neutral levels even when unemployment and inflation are at normal levels; that’s essentially a promise to raise inflation to a level higher than the Fed’s longer-term goal. Moreover, I am also unsure still whether the Chair is fully informed with respect to the current level and trajectory of inflation itself. It is soothing to hear her acknowledge that “inflation will begin to move up toward 2 percent” (headline inflation will exceed that level eight days from now, and median inflation is already above that standard so this isn’t a difficult projection for an economist) but Dr. Yellen seems to be unaware that the main reason that core PCE and CPI inflation is below 2% today is due to the fact that in April of last year, Medicare slashed prices paid to doctors due to sequester-induced cuts. Bernanke has noted this previously, and it isn’t exactly a state secret…then again, come to think of it state secrets aren’t what they used to be. But talking about persistent inflation below 2%, when there is very little chance of that, makes me wonder whether she’s really attuned to what is happening with prices. CPI and PCE are not the right indicators to be looking at right now – a point also made clearly by the deviation over the last year of PriceStats inflation from CPI inflation (see chart, source PriceStats).
If it were Bernanke talking, we would assume that he knows where the numbers actually are and is just trying to talk the market to his way of thinking. Greenspan was a notorious numbers wonk so there is no doubt that he would know the context of what he’s talking about. But with the new Chair, we don’t really know. It may be that, since she knows she’s keeping rates down for a long time regardless of what happens, she isn’t getting too fine about the details right now. Or it may be that she is alarmed and doesn’t want to let on (I doubt this). It might even be that she doesn’t really know much about inflation, and given her past remarks on the subject of LSAP and policy stimulus – linked to above – that is a possibility we cannot truly refute at this point.
The Fed is already a year or more behind schedule when it comes to removing accommodation in time to prevent an uptick in inflation. I am looking for evidence that they know that inflation will not arrest the moment they decide they are concerned, but I can’t find it. This should worry us all.
If it seems that the frequency of my posts has diminished of late, it is no illusion. There are many reasons for that, many business-related, but there is at least one which is market-related: a three-month-long, 20bp range in real and nominal yields and a year-to-date S&P return that seems locked between +2% and -2% with the exception of the January dip offers precious little to remark upon. Along with those listless markets, we have had plenty of economic data that it was very evident the market preferred to ignore and blame on “severe weather.” And, to the Fed’s lasting credit (no pun intended), the decision to start the taper under Bernanke and thus give Yellen a few months of simply sitting in the captain’s chair with the plane on autopilot has short-circuited the usual rude welcome the markets offer to new Fed Chairmen.
These sedate markets irritate momentum traders (you can’t trade what doesn’t exist) and bore value traders – at least, when the markets are sedate at levels that offer no value. For individual investors, this is a boon if they are able to take advantage of the quiet to pull their attention away from CNBC and back to their real lives and jobs, but for professional investment managers it is frustrating since it is hard to add value when markets are becalmed. Yes, successful investing – which is presumably what successful investment managers should be practicing – is very much about patience, and this is doubly or trebly true for value managers who eschew investing heavily into overvalued markets. I am sympathetic with the frustrations of great investors like Jeremy Grantham at GMO, but I will point out that his frustrations are more acute among less-legendary managers. It is, after all, much easier to pursue the patient style of a Hussman or Grantham…if you are Hussman or Grantham.
Again, I’m not whining too much about our own difficulty in securing good performance, because we’ve done well to be overweight commodities and with some of our other position preferences. I’m more whining about the difficulty of writing about these markets!
But let’s reset the picture, now.
The very weak Q1 GDP figure from last Wednesday (a mere +0.1%, albeit with strong consumption) is old news, to be sure, and investors are right to underweight this information since we already knew Q1 growth was weak. But at the same time, I would admonish investors who wish to patiently take the long view not to get too ebullient about Friday’s jobs figure. Payrolls of +288k, with solid upward revisions, sounds great, but it only keeps us on the 200k/month growth path that we have had since the recovery reached full throttle back in late 2011 (see chart, source Bloomberg).
As I wrote back in August, 200k is what you can expect once the expansion is proceeding at a normal pace, and that’s exactly what you’ve gotten for a couple of years now. Similarly, if you project a simple trend on the Unemployment Rate from late 2011 (see chart, source Bloomberg) you can see that the remarkable plunge in the ‘Rate merely operated as a ‘catch-up’ from the winter bounce higher.
If you believe that inflation is caused when economies run out of slack (I don’t), then the low unemployment rate should concern you – not because it fell rapidly, because it is nearer to whatever threshold matters for inflation. If you rather think that inflation is caused by too much money chasing too few goods, then you’ve already been alarmed by the continued healthy rise in M2 and the fact that median inflation rose to 2.1% this month. So, either way, people (and policymakers) ought to be getting at least more concerned about inflation, no matter what their theoretical predilections. And, in fact, we see some evidence of that. Implied core inflation for the next 12 months (taking 1-year inflation swaps and hedging energy) has risen in the past month to about 2.25% from 1.75%. To some extent, this seems to be seasonal, as that measure has risen and peaked in the last three March/April periods. Investors tend to mistake the rise in gasoline prices that normally happens in the spring to be inflation, even though it ordinarily falls back later in the year. But right now, the implied acceleration in core inflation from the current level of 1.7% is the highest it’s been in three years (see chart, source Enduring Investments).
The bigger spike, on the left side of that chart, corresponds with the significant fears around the time of QE2. But what’s interesting now, of course, is that the Fed is actually tightening (providing less liquidity is the definition of tightening) rather than easing. Some of this is probably attributable to base effects, as last year’s one-off price decline in medical care services due to sequestration-induced Medicare spending cuts is about to begin passing out of the data. But some of it, I suspect, reflects a true … if modest … rising concern about the near-term inflation trajectory.
 Unless, that is, you are overweight commodities…which we are. The DJ-UBS is +8.9% year-to-date.
I was convinced last week that the stock markets, as well as the inflation markets, were underestimating the importance of the Ukrainian conflict. I thought that I had a little more time to write about that before the crisis came to a head, which turned out not to be true. However, it seems that markets are still underestimating the importance of the Ukrainian conflict.
About the best possible outcome at this point is that Putin stops with an annexation of the Russian equivalent of the Sudetenland, with the episode merely pointing out (again) the impotence of Western leaders to respond to Russian aggression but not actually damaging much besides our pride. Even in that case, to me this signals a dangerous new evolution in the development of Russia’s relationship with the West. But the worse cases are far worse.
The angry fist-shaking of the old democracies is moderately amusing; less amusing are the stupid threats being made about economic sanctions. Let us stop for a minute and review what the West imports from Russia.
According to this article from Miyanville (from early 2013), Russia is the world’s largest producer of chromium (30% of the world market), nickel (19%), and palladium (43%), and is the second-largest producer of aluminum (10%), platinum (12%), and zirconium (19%). It has the largest supply of natural gas (although we are gaining rapidly), the second largest supply of coal, and the 8th-largest endowment of crude oil. The Ukraine itself is the third largest exporter of corn and the sixth-largest exporter of wheat. Meanwhile, the top 10 exports to Russia include engines, aircraft, vehicles, meat, electronic equipment, plastics, live animals, and pharmaceuticals.
So, we are fundamentally exporting “nice to haves” while importing “must haves.” Who needs trade more?
Let me make a further, suggestive observation. I maintain that the tremendous, positive trade-off of growth and inflation (high growth, low inflation) that the U.S. has experienced since the 1990s is at least partly a story of globalization following the end of the Cold War. Over the last couple of years, I have grown fond of showing the graph of apparel prices, which shows a steady rise until the early 1990s, a decline until 2012 or so, and then what appears to be a resumption of the rise. The story with apparel is very clear – as we moved from primarily domestically-sourced apparel to almost completely overseas-sourced apparel, high-cost production was replaced by low-cost production, which dampened the price increases for American consumers. It is a very clear illustration of the “globalization dividend.”
Of course, mainstream economic theory holds that the inflation/growth tradeoff suddenly became attractive for the U.S. in 1991 or so because inflation expectations abruptly became “anchored.” Why look for a good reason, when you can simply add a dummy variable to an econometric model??
But suppose that I am right, and the fall of the Soviet Union in 1991 played a role in the terrific growth/inflation tradeoff we have experienced since then. Incidentally, here are some data:
- Cold War (1963, immediately following the Cuban missile crisis, until the fall of the USSR): U.S. annual growth averaged 3.4% (not compounded); inflation averaged 5.4%. The DJIA rose at a compounded nominal rate of 5.6%.
- Post-Cold-War (1991-2013, including three recessions): U.S. annual average growth 2.6%; annual average inflation 2.4%. The DJIA rose at a compounded nominal rate of 7.5%.
This is not to say that globalization is about to end, or go into reverse, necessarily. It is to illustrate why we really ought to be very concerned if it appears that the Bear appears to be back in expansion mode – whether it is something we can prevent or not. And it is also to illustrate why putting a firm end to that expansion mode, rather than sacrificing global trade and cheap energy to a resurrection of the Cold War, is probably worth considering.
I still don’t think that equity investors understand the significance of what is going on in the Ukraine.