The following is a summary and extension of my post-Employment tweets. You can follow me @inflation_guy (and tell your friends!)
- 175k +25k revisions, nice jobs figure. Oh, but Unemployment up to 6.7%. Love how these seem to always provide opposite surprises.
- One of my favorite labor charts. Want a Job Now, versus the Unemployment Rate:
- 1 way to add more jobs is to have em all work less. Is this an Obamacare effect since part-timers don’t count?
- …regardless, fewer hours worked –>lower output. Expect more downward revisions to Q1 growth ests. Q2 too, if this is ACA.
- If we all end up with jobs, but we’re all working only 30 hours per week, is that better than if only 93% have jobs, working 40?
It will be interesting over the next few months to see if the Hours Worked figures are weather-related (as will be claimed). I suspect that for the most part, they are not. Notice that if there was any weather effect over the last few years, it is not noticeable in the data (nor is it apparent in the unrevised data, incidentally). So, while this year’s weather was colder and snowier than usual, I am skeptical that this can account for more than a small downtick in the hours worked figures.
I rather suspect that the drop is more likely to be attributable to the definition of what constitutes a “full time worker” under the Affordable Care Act. And the question I asked rhetorically above is actually worth thinking about seriously because, looked at one way, the ACA is a jobs program: it will tend to cause businesses to cut back on full-time work and replace those people with more part-time work. The effect should be to cause the Jobless Rate to decline along with Hours Worked. But is that a good thing (because more people have some job) or a bad thing (because people who formerly had a full-time job now only have a part-time job)?
That’s a normative question, not a positive question. But I would think that one effect would be to push more people from what we think of today as “middle class” to lower-middle class, while perhaps raising some who were previously in poverty to be also lower-middle class. I don’t think this was one of the purposes of the law – because frankly, it doesn’t seem that much economic thought went into the design of the ACA – but it is interested to reflect on.
I don’t know what to make of the “Want a Job Now” chart. Let me explain that series, first. “Not in the Labor Force” implies that these people aren’t even looking for jobs, because if they were then they would be counted as unemployed. But, despite the fact that they are not looking, they would like to have a job and would take one if it was offered. While the Unemployment Rate is falling, almost as many people are in the “not in labor force but want a job now” category as were in that category at the beginning of 2011. Why aren’t these people looking?
A fair number of these workers, some 2.3mm of them, are described as “marginally attached” because they’ve looked for work in the last 12 months, and want a job, but haven’t looked in the last 4 weeks so that they aren’t counted as part of the work force. And those are the ones who are holding the category up (see Chart, source Bloomberg).
Some of those workers are not looking because they are “discouraged”, but that only represents about 750k of the 2.3 million or so in this category (and discouraged workers have fallen from about 1 million in 2011, so the decline is consistent with the Unemployment Rate).
So, we are left with a category of people who have looked for work in the past, and would take a job if it was offered, but haven’t looked in the last month. Or the month before. Or the month before. But, at some point, they had at least done a cursory search of the wanted ads.
I think the story of these “marginally attached” workers is worth studying. Are these structurally-unemployed people, who should be counted as such? Are they incentivized to remain out of the work force due to governmental benefits they receive? Or are they, and the decline in the labor force participation rate generally, telling us that the jobs aren’t coming back (or that the newly-created jobs are of lower quality than the old jobs)? I don’t know, but none of the answers is good. We want to see this number decline.
The story of the declining hours worked is potentially much more serious, though – partly because it is a new effect. The nation’s total output is number of employees, times average hours worked, times output per hour. If the number of employees is rising, but they’re working less, then unless productivity rises the total output (that is, GDP) won’t grow very quickly. This could be an early recession sign, or it could be a consequence of the ACA…or it could be a sign that the ACA is pushing a fairly non-robust economy towards the recessionary tipping point. Again, none of these things are good.
So, while the stock market roars its approval about this Employment number, I growl my displeasure. But this is normal.
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.
Today new Fed Chairman Janet Yellen jumped on the bandwagon in blaming the recent growth slowdown on the weather.
Here’s what I have to say about the news and the weather.
First, although it’s becoming quite passé to point this out, the weather should account for a slowdown in economic activity – but, since economists were aware of the weather (presumably), it is less clear that it should account for a surprise in the amount of slowdown we are seeing. The chart below (source: Bloomberg) shows the Citibank economic surprise index, which measures how much recent data have exceeded (positive) or fallen short (negative) of expectations. It is not a measure of growth, per se, but merely of the direction in which economists are missing. I have plotted both the US index and the Eurozone index.
Obviously, economists were far too pessimistic about the numbers in December and January (reflecting data from October to December, and data kept exceeding their estimates. But now they are over-exuberant. So it isn’t that the numbers are falling short; it’s that they’re falling short of where economists (who can presumably recognize snow) thought they would be incorporating the known weather drags. That could simply mean the weather had a worse impact on real people than the bow-tied set thought it would. Or it could mean data is weaker than it ought to be.
Second point: just because the weather was bad should not be taken as carte blanche for the economy to collapse. If the economy was really as strong as equity investors seem to think, should weather be able to derail it so easily? Yes, weather makes it harder to detect the natural rhythm of what is going on, but it wasn’t as if that was easy to begin with. The danger is, as I suggested a week and a half ago, when all news can only be neutral or good. That’s a bad sign for once the weather normalizes again and it gets impossible to shrug off bad news as easily.
Third point: was the weather as bad in Europe? Because, as you can see from the chart above, economists have also been missing on the optimistic side for European figures. To be sure, they’ve been missing by less, and the numbers surprised less on the positive side over the last couple of months, but I don’t know that the Polar Vortex ought to be affecting Italy as seriously as it is affecting Chicago.
All of which is simply to say that the weather isn’t going to be bad forever, so … make hay while the sun doesn’t shine, I guess. Stocks are flat on the year, the hard way (but commodities are +6.5%, measured by the DJ-UBS index; according to our valuation estimates, that should be the normal case over the next few years rather than the rarity it has been over the last few).
It is interesting, too, that as bad as the weather effect has been on the construction industry and sales it hasn’t really impacted the price dynamics at all. The chart below (source: Bloomberg) shows Existing Home Sales in white, and the year/year change in median sales prices of existing single-family homes. Sales are 14% off their highs (seasonally-adjusted, which you should take with a grain of salt due to the unseasonal weather, but notice that the decline started in August when the snow was appreciably lighter), yet prices are still rising at nearly 11% year/year.
Now, a housing bull will say that these are the opposite faces of the same coin. They would say, “because there is so little inventory available – according to the NAR, only 1.9mm homes are for sale, which is higher than last winter but otherwise the lowest since 2002 – prices are rising and fewer are being sold because of the shortage of supply.” This is certainly possible, although I wonder at where all of the ‘shadow supply’ and bank REO property got off to so quickly, especially since the pace of existing home sales (and new home sales) remain at such low fractions of the pace prior to 2007 (existing home sales is currently 64% of the peak rate in 2005; new home sales are at 34% of the 2005 peak). How do you get rid of inventory without selling it?
The housing market continues to be a conundrum, but without a doubt prices are rising. And, also without a doubt, rising home prices are beginning to push rents higher. More economists are raising their forecasts for core inflation looking forward over the next year. Of course, readers of this column know that this is old news here. Speaking of which, Enduring Investments’ Quarterly Inflation Outlook for Q1 has been published. Institutional investors and others interested in our services can register for this private report on our website by filling out the contact form and requesting access to the blog.
Finally, I want to make one observation about the complete impotence of the Republicans to respond to the Democrats’ push for a higher minimum wage. It is terribly distressing to see such bad economics from one party (in this case, the Democrats) and such utter lack of common sense responses to bad economics from the other party (in this case, the Republicans). Here is the only question that needs to be answered: if raising the minimum wage has only salutatory effects on the economy and on the working class, then why not raise it to $1000/hour? Why not $10,000 per hour? Surely, if raising the minimum wage is good, then raising it more can’t be bad. Republicans should be amending the bill to make the minimum wage $10,000/hour.
The obvious answer is that if the minimum wage was $10,000/hour, no one would hire anybody – and we all know that, and even Democrats know that, and we all know why: because there is almost no one in the country who can produce enough goods or services to be worth $10,000/hour. If you are hiring people, you have to decide whether you will get enough out of them to afford their labor and still stay in business. The answer is obvious at $10,000. But it’s the same question at $10: can this group of workers produce enough so that I can afford to pay them all $10? If not, they will not be earning $10/hour but $0/hour (or at least some of them will be). We know exactly what would happen with a $10,000/hour minimum wage, and it’s easy to demonstrate it. But the Republicans are absolutely inarticulate on this point, and on most points, and that is why they keep losing arguments where they have the stronger position.
Housekeeping Note: earlier this week I published an article on the Mt. Gox/bitcoin fiasco. If you didn’t see the note (it didn’t get out on all of the syndication channels), you can find it here.
Here is a summary of my post-CPI tweets. You can follow me @inflation_guy:
- Well, that was boring. CPI exactly as expected. Although frankly, most big shops expected +0.2% on core (me too).
- Weird month where higher fuel prices seem to have taken edge off Shelter, but lower gasoline prices pushed Transp down!
- Apparel down, and New cars & trucks down despite rising in PPI. So much for new PPI. Medical care commodities up though…
- Medical Care as a whole +0.3%. Only 7.6% of the whole CPI, but reverses a recent trend caused by last year’s sequester.
- Core services remained at 2.3% y/y, core goods declined to -0.3%. My proxy, though, is rising so this latter won’t continue.
- Striking – core less shelter now at +0.933% y/y, the lowest since the real deflation crisis in 2004.
- accelerating CPI categories: Housing, Med Care, Other (52.4%), Decel: Apparel, Educ/Comm (10.5%). Unch: 37.1%
- Primary rents +2.88% y/y, virtually unch from +2.87%. But Owners’ Equiv Rent +2.517% from +2.488%.
- New & Used cars and trucks under tremendous pressure, +0.3% y/y, and that’s 7.5% of core CPI. And Apparel (another 4%) has flatlined.
The reason that most big shops – and me too – expected +0.2% or even +0.3% on core, as opposed to the +0.13% that we got, boils down to three things: second, the housing part of core CPI, which is huge, is clearly accelerating and continues to do so. Second, core goods, which represents most of the rest, has been flat or deflating for a while, and normally that part of inflation is more mean-reverting.
The housing part of that view is working out. The Shelter subcomponent of Housing (which is ¾ of it, after extracting utilities and household furnishings and operations) is now rising at 2.58%, the fastest rate since 2008. Owners’ Equivalent Rent, the largest single component of the CPI, is at 2.52% y/y, and as I’ve illustrated often – here comes that chart again – there is every reason to expect this to continue. OER should be in the 3.3%-3.5% range by year-end.
Core Goods, on the other hand, remains stuck in the mud. There was some reason to expect a rise in that index this month, as the Passenger Cars component of PPI rose +0.5% (but new vehicles in the CPI rose only 0.08% m/m), and the pharmaceuticals part of PPI was +2.7% (but only +0.9% in the CPI). In all likelihood, this suggests that core goods will move higher in the months ahead.
However, the weakness in Apparel and in vehicles has a commonality – those are sectors that are either sourced from non-US manufacturers or (in the case of vehicles) receive heavy competition from non-US manufacturers, and especially Japanese manufacturers in the case of autos. The recent strength of the USD with respect to the Yen and Yuan is not irrelevant here. Although early 2014 has seem some reversal in that trend with respect to the Yen, it’s not likely to have a serious reversal for a while – the Yen is going to keep getting weaker, and that will keep pressure on goods prices in the US.
Indeed, by one measure price dynamics in the US are closer to deflation than they have been since 2004. And it’s not a measure which should be taken lightly: core inflation, ex-shelter, is only 0.9% y/y, as the chart below (source: Enduring Investments) shows.
In the mid-2000s, the Fed flirted much more with deflation than they thought they were, because the housing bubble hid the underlying dynamic. Conversely, in 2010 we weren’t really very close to deflation, but the fact that housing was collapsing made it appear that we were. You can see both of these episodes on the chart. It is possible that the 2004-type stealth deflation could be happening again, but I don’t think so for one big reason: in 2004, money growth was in the 4-5% range as the economy was recovering, which created disinflationary tendencies. But now, we’re coming off a period of 8-10% money growth, and it’s still at 6%. It’s much harder to get deflation in such a circumstance.
And, with rents rising smartly, there is almost no chance that core inflation ends 2014 lower than it currently is. I continued to expect core inflation to move towards 3% over the course of this year (and median CPI to reach that level).
Investors have learned the same wrong lessons over the last couple of years that they learned in the run-up to 2000, evidently. I remember that in the latter part of 1999, every mild equity market setback was met immediately with buying – the thought was that you had to jump quickly on the train before it left the station again. There was no thought about whether the bounce was real, or whether it “made sense”; for quite a number of them in a row, the bounce was absolutely real and the train really did leave the station.
Then, the train reached the end of the line and rolled backwards down the mountain, gathering speed and making it very difficult to jump off. I remember getting a call from my broker at the time, recommending Lucent at around $45 – quite the discount from the $64 high. I noted that I was a value investor and I didn’t see value in that stock, and to not call me again until he had a decent value idea. He next called with a recommendation later that year, with a stock that had just hit $30…a real bargain! And, as it turned out, that stock was also Lucent. The lesson he had learned was that any stock at a discount from the highs was a “value” stock. (Lucent ended up bottoming at about $0.55 in late 2002 and was eventually acquired by Alcatel in 2006).
This lesson appears to have been learned as well. On Thursday and Friday a furious rally took stocks up, erasing a week and a half of decline. This happened despite the fact that Friday’s Employment number was just about the worst possible number for equities: weak enough to indicate that the December figure was not just about seasonal adjustment, but represented real weakness, but nowhere near weak enough to influence the Federal Reserve to consider pausing the recent taper. We will confirm this fact tomorrow, before the market open, when new Fed Chairman Janet Yellen delivers the Monetary Policy Report (neé Humphrey-Hawkins) testimony to the House Financial Services Committee (her comments to be released at 8:30ET). While I believe that Yellen will be very reluctant to raise rates any time soon, and likely will seize on signs of recession to stop the taper in its tracks, she will be reluctant to be a dove right out of the gate.
And that might upset the apple cart tomorrow, if I’m right.
I have been fairly clear recently that I see a fairly significant risk of market volatility to come, both on the fixed-income side but especially on the equity side. I think stocks are substantially overvalued and could fall markedly even without any important change in the underlying economic dynamics. But there is actually good news which should be considered along with that fact: when markets were last egregiously overpriced, financial institutions were also substantially more-levered than they are today. The chart below (source: Federal Reserve) shows that as a percentage of GDP, domestic financial institutions are about one third less levered than they were at the 2008 peak.
Now, this exaggerates the deleveraging to some extent – households, for example, appear to have deleveraged by about 20% on this chart, but the actual nominal amount of debt outstanding has only declined from about $14 trillion to about $13.1 trillion. Corporate entities have actually put on more debt (which made sense for a while but probably doesn’t now that equity is so highly valued relative to earnings), but in terms of a percentage of GDP they are at least not any more levered than they were in 2008.
The implication of this fact is some rare good news: since the banking system has led the deleveraging, the systemic risk that could follow on the heels of a significant market decline is likely to be much less, at least among U.S. domestic financial institutions. So, in principal, while it was clear that a decline in equity and real estate prices in 2007-2008 would eventually cause damage to the real economy as the financial damage was amplified through the financial system, this is less true today. We can, in other words, have some reasonable market movements without having that automatically lead to recession. The direct wealth effect of equity price movements is very small, on the order of a couple of percent. It’s the indirect effects that we have to worry about, and the good news is that those indirect effects are smaller now – although I wouldn’t say those risks are absent.
Now for the bad news. The bad news is that significant market volatility – say, a 50% decline in stock prices – would likely be met with “help” from the federal government and monetary authorities. It is that help which likely would hurt the economy by increasing business uncertainty further. It is probably not a coincidence that the last couple of months, which correspond to the implementation of the Affordable Care Act, have led to some weaker growth figures. Whether change is perceived as positive or negative, it’s the constant changing of the rules – and especially now that these rules are increasingly changed by executive fiat without the moderating influence of Congress (I never thought I would write that) – that damages business confidence.
In other words, I wouldn’t be concerned about the direct economic effect of a 50% decline in equity prices; but I would be concerned if such a decline led to meddling from the Fed, the Congress, or the White House.
While investors learned the hard lessons after 2000 and 2008 about the wisdom of automatically buying dips, they eventually forgot those lessons. But that makes them almost infinitely smarter than policymakers, who have refused to learn the obvious lesson of the last few years: your ministrations do little to help, and most likely hurt. So, maybe it really is true that there are two types of people: those who listen to everybody, and those who listen to nobody. The former become investors, and the latter enter government service!
Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week’s events. [Note to editors at sites where this comment is syndicated. Feel free to split this article into separate articles if you wish.]
Follow the Bouncing Market
In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday’s sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday’s weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed’s taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong – but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher’s observation that the Fed’s adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with “beer goggles.” It’s not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!
The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn’t seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn’t necessarily imply that today’s equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) – the ones you can see by eyeballing a chart, by the date the drawdown ended.
I mentioned last week that in equities I’d like to sell weakness. We now have some specificity to that desire: a break of this week’s lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.
There is nothing about this week’s price action, in short, that is remotely soothing to me.
A Couple of Further Thoughts on Thursday’s CPI Data
I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation – the deceleration in medical care CPI – which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).
Moreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners’ Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.
Sorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%…in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.
For the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.
Famous Last Words?
So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the “Buddha of Banking,” as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.
“The problem with Q.E.,” he said, with more than a hint of a smile, “is that it works in practice, but it doesn’t work in theory.” “I don’t think that’s a concern and those who’ve been saying for the last five years that we’re just on the brink of hyperinflation I would point them to this morning’s C.P.I. number.” (“Reflections by America’s Buddha of Banking“, NY Times)
Smug superiority and trashing of straw men aside, no one rational ever said we were on the “brink of hyperinflation,” and in fact a fair number of economists these days say we’re on the brink of deflation – certainly, far more than say that we’re about to experience hyperinflation.
“He noted the Labor Department’s report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.
“Such readings, he said, ‘suggest that inflation is just not really a significant risk of this policy.’“ (“Bernanke Turns Focus to Financial Bubbles, Instability”, Wall Street Journal )
And that’s simply idiotic. It’s simply ignorant to claim that the policy was a complete success when you haven’t completed the round-trip on policy yet by unwinding what you have done. It’s almost as stupid as saying you’re “100 percent” confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.
I will also note that if QE doesn’t have anything to do with inflation, then why would it be deployed to stop deflation…which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman (“Deflation: Making Sure “It” Doesn’t Happen Here”, 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn’t that mean you think it causes inflation?
On inflation, Bernanke said, “I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed’s) balance sheet stays where it is or gets bigger.” (“Bernanke downplays cost of economic stimulus”, USA Today)
No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke’s watch, although it has wussied out by saying it wasn’t tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.
It’s not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It’s no fun going the other way, and I don’t think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.
The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke – which is good, because otherwise you’d really wonder why they want to retreat from a policy that only has salutatory effects.
“Bernanke said the only genuine risk of the Fed’s bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets ‘seem to be within historical ranges.’” (Ibid.)
I suppose this is technically true. If you include prior bubble periods, then today’s equity market valuation is “within the historical range.” However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won’t re-prosecute that case here.
So, this is perhaps Bernanke’s last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.
The following is a summary of my tweets following the CPI release today. You can follow me @inflation_guy. I am about to get on a plane to visit a reinsurance company to talk about inflation, so forgive me if I don’t add much color to the original tweets (as I usually do).
- CPI +0.3%, +0.1% ex-food-and-energy. About as-expected but core a little soft in that range. 1.71% is y/y core.
- Another 0.0% for Medical Care CPI. It’s hard to get core goods rising when Medical Care remains flaccid. That will change.
- Core #inflation ex-housing is down to only 1.1%! Core goods still in deflation dragging it all down…-0.1% vs +2.3% for core services.
- Owner’s Equiv Rent to 2.49% y/y. Clearly accelerating and a big risk to core going forward.
- Accel Major Grps: Housing, Apparel, Transp, Other (64.8%) decel: Food/Bev, Med Care, Recreation (28.4%). Educ/Comm unch.
- Med Care CPI only +2.01% y/y. That’s very unlikely to continue.
Big risk to core remains housing, which accelerated a heady +0.1% y/y, which is a big move for a ponderous group like Housing. Not surprising – I’ve been forecasting it for a long time, and it’s happening.
Since I wrote a blog post in early December on “The Effect of the Affordable Care Act on Medical Care Inflation,” in which I lamented that “I haven’t seen anything of note written about the probable effect of the implementation of the Affordable Care Act on Medical Care CPI,” several things have come to my attention. This is a great example of one reason that I write these articles: to scare up other viewpoints to compare and contrast with my own views.
In this case, the question is not a trivial one. Personally, I approach the issue from the perspective of an inflation wonk, but the ham-handed rollout of the ACA has recently spawned greater introspection on the question for purely political reasons. This is awkward territory, because articles like that by Administration hack Jason Furman in Monday’s Wall Street Journal do not further the search for actual truth about the topic. And this is a topic on which we should really care about a number of questions: how the ACA is affecting prices, how it is affecting health care utilization and availability, how it is affecting long-term economic growth, and so on. I will point out that none of these are questions that can be answered definitively today. My piece mentioned above speculated on possible effects, but we simply will not know for sure for a long time.
So, when Furman makes statements like “The 7.9 million private jobs added since the ACA became law are themselves enough to disprove claims that the ACA would cause the sky to fall,” we should immediately be skeptical. It should be considered laughably implausible to suggest that Obamacare had a huge and distinguishable effect before it was even implemented. Not to mention that it is very bad science to take a few near-term data points, stretching only for a couple of years in a huge and ponderous part of the economy, to extrapolate trends (this is the error that Greenspan made in the 1990s when he heralded the rise in productivity growth that was eventually all revised away when the real data was in). Furman also conflates declines in the rate of increase of spending with decelerating inflation – but changes in health care spending include price changes (inflation) as well as changes in utilization. I will talk more about that in a minute, but suffice to say that the Furman piece is pure politics. (A good analysis of similar logical fallacies made by a well-known health care economist that Furman cites is available here by Forbes.)
I want to point you to another piece (which also has flaws and biases but is much more subtle about it), but before I do let’s look at a long-term chart of medical care inflation and the spread of medical care inflation to headline inflation. One year is far too short a period to compare these two things, not least because one-time effects like pharmaceuticals losing patent protection or sequester-induced spending restraints can muddy the waters in the short run. The chart below (source: Enduring Investments) shows the rolling ten-year rise in medical care inflation and, in red, the difference between that and rolling ten-year headline inflation.
You can see from this picture that the decline in medical care inflation, and the tightening of the spread between medical care inflation and headline inflation, is nothing particularly new. Averaging through all of the year-to-year wiggles, the spread of medical care has been pretty stable since the turn of the century (which, since this is a 10-year average, means it has been pretty stable for a couple of decades). Maybe what we are seeing is actually the anticipation of HillaryCare? (Note: that is sarcasm.)
Now, the tightening relative to overall inflation is a little exaggerated in that picture, because for the last decade or so headline inflation has been somewhat above core inflation due to the persistent rise in energy prices throughout the ‘00s. So the chart below (source: Enduring Investments) shows the spread of medical care inflation over core inflation, which demonstrates even more stability and even less reason to think that something big and long-term has really changed. At least, not that we would already know about.
The other piece I mentioned, which is more worth reading (hat tip Dr. L) is “Health Care Spending – A Giant Slain or Sleeping?” in the New England Journal of Medicine. The authors here include David Cutler, whom Forbes suspected was tainting his views with politics (see link above), so we need to be somewhat cautious about the conclusions but in any event they are much more nuanced than in the Furman article and the article makes a number of good points. And, at the least, the authors distinguish between spending on health care and inflation in health care. A few snippets, and my remarks:
- “Estimates suggest that about half the annual increase in U.S. health care spending has resulted from new technology. The role of technology itself partly reflects other underlying forces, including income and insurance. Richer countries can afford to devote more money to expensive innovations.” This is an interesting observation that we ought to think carefully about when professing a desire to “bend the cost curve.” If we are reining in inflation, that’s a good thing. But is it a good thing to rein in innovation in health care? I don’t think so.
- The authors, though, clearly question the value of technological innovation. “The future of technological innovation is, of course, unknown. But most forecasts do not call for a large increase in the number of costly new treatments… some observers are concerned that a wave of costly new biologic agents (for which generic substitutes are scarce) will soon flood the market.” Heaven forbid that we get new treatments! “The use of cardiac procedures has slowed as well.” This is a good thing?
- “Health spending has clearly been associated with health improvements, but analysts differ on whether the benefits justify the cost.” Personally, it makes me uncomfortable to leave this question in the hands of the analysts. If the benefits don’t justify the cost, and the market was free, then no one will pay for those improvements. It’s only with a highly regulated market – replete with “analysts” doing their cost/benefit analysis on health care improvements – that this even comes up.
- Some of the statistical argument is a little weak. “The recent reduction in health care spending appears to have been correlated with slower employment growth in the health care field; this suggests that such changes may continue.” I’m not sure that the causality runs that way. Surely tighter limits on what health care workers can earn might cause slower employment growth? That’s at least as plausible as the direction they are arguing.
That sounds very critical, but I point these things out mainly to make them obvious. Overall, the paper does a very good job of discussing the possible causes of the recent slowdown in health care inflation (although they focus inordinately on “the first 9 months of 2013”, a period during which we know the sequester impacted health care prices), give plenty of credit to reforms instituted far before ACA implementation, correctly distinguish between utilization and prices, and highlight some of the promising trends in health care costs – and yes, there are some! The authors are clearly supportive of the ACA, which I am not, but by and large they raise the salient questions.
It matters less if we instantly agree on the solution than that we agree on the questions.
We are a people of language. The way we talk about a thing affects how we think about it. This is something that behavioral economists are very aware of; and even more so, marketers. There is a reason that portfolio “insurance” was such a popular strategy. Language matters. When we call a market decline a “correction,” we tend to want to buy it; when we call it a “crash” or a “bear market”, we tend to want to sell it.
And so as the “arctic vortex” reaches its cold fingers down from the frozen northland, it is really hard for us to think about economic “overheating.” Even though economic overheating doesn’t lead to inflation, I really believe that it is hard for investors to worry about inflation (the “fire” in the traditional “fire versus ice” economic tightrope that central bankers walk) when it is so. Darn. Cold.
But nevertheless, we can take executive notice of certain details that may suggest, overheating or not, inflation pressures really are building. I have been writing for some time about how the recent rapid rise in housing prices was eventually going to pass through to rents, and although the lag was a couple of months longer than it has historically been, it seems to be finally happening as an article in today’s Wall Street Journal suggests. This is significant for at least two reasons. The first is that housing costs are a very large part of the consumption basket for the average consumer, so any acceleration in those prices can move the otherwise-ponderous core CPI comparatively quickly. The second reason, though, is more important. Over the last couple of years, as housing prices have improbably spiked again and inventories have declined sharply, many observers have pointed out the presence of an institutional element among home purchasers. That is to say that homes have been bought in large numbers not only by individuals, but by investors who saw an inexpensive asset (they sure solved that problem!). And some analysts reasoned that the prevalence of these investors might break the historical connection between rents and home prices, at least in the short run, in the same way that a sudden influx of pension fund money could change the relationship between equity prices and earnings (that is, P/Es).
In the long run, of course, this is unlikely, but to the extent it happens in the short run it could delay the upturn in core inflation for a long time. But recent indications, such as that article referred to above, are that this effect is not as large as some had thought. The substitution effect does work. Higher home prices do cause rents to rise as more potential buyers choose to rent instead. It is a question for econometricians in the next decade whether the institutions had a large and lasting effect, or a short and ephemeral effect, or no effect at all. But what we can begin to say with a bit more confidence is that this influx of investors did not remove the tendency of home prices and rents to move together, with a lag.
On to other matters. The market curve for inflation has remained remarkably static for a long time. It is relatively steep, and perennially seems to forecast benign inflation for the next couple of years before headline inflation becomes slightly less-benign (but still not high) a few years down the road. The chart below (Source: Enduring Investments) shows the first eight years of the inflation swaps curve from today, and one year ago.
If that was the only story, I probably wouldn’t bother mentioning it. But inflation swaps settle to headline CPI, like TIPS and other inflation-linked bonds do; however, a fair amount of the volatility in headline inflation comes from movements in energy. This is why policymakers and prognosticators look at core inflation. You cannot directly trade core inflation yet, but we can extract expected energy inflation (implied by other markets) from the implied headline inflation rates and derive “implied core inflation swaps” curves. And here, we find that the relatively static yield curves seen above hide a more interesting story. The chart below (Source: Enduring Investments) shows these two curves as of today, and one year ago.
At the beginning of 2013, investors has just experienced a 1.94% rise in core prices (November to November, which is the data they would have had at the time), yet anticipated that core inflation would plunge to only 1.22% in 2013. They actually got 1.72% (as of the latest report, so still Nov/Nov). Now, investors are anticipating about 1.8% over the next 12 months – I am abstracting from some lags – but expect that inflation will ultimately not rise as much as they had feared at this time last year.
Another way to look at this change is to map the implied forward core inflation rates onto the years they would apply to. The chart below (Source: Enduring Investments) does that.
The blue line shows the market’s forecast of core inflation as of January 7th, 2013, year by year. So investors were implicitly saying that core CPI would be 1.22% in 2013, 2.36% in 2014, 2.68% in 2015, 2.87% in 2016, and so on. One year later, the forecast (in red) for 2014 has come down to 1.80%, the forecast for 2015 has declined to 2.20%, the forecast for 2016 has dropped to 2.41%, etcetera.
Has this happened because inflation surprised to the downside in 2013? Hardly. As I just noted, the market “expected” core inflation of 1.22% in 2013 and actually got 1.72%. And yet, investors are pricing higher confidence that inflation will stay low – remaining basically unchanged in 2014 before rising very slowly thereafter – and in fact won’t seriously threaten the Fed’s core mission basically ever.
As I wrote yesterday, we need to tread carefully around consensus. Now, some investors might prefer to be non-consensus by anticipating and investing for deflation in the out years, but taking the whole of the information I look at and model I think the more dangerous break with consensus would be a more-rapid and more-extreme rise in core inflation. I do not think that this economically-cold pricing environment will continue into what is essentially a monetary summer.
Note: The following blog post originally appeared on April 4th, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
I routinely deride economists who rely on the discredited notion that growth in excess of a nation’s productive capacity is what causes inflation – and, conversely, a surplus of productive capacity is what causes deflation. See, for example, here, here, and here. And that is just in the last month!
I want to point out that it isn’t that I don’t believe in microeconomics (where an increase in supply causes prices to fall and a decrease in supply causes prices to rise). I believe deeply in the supply-demand construct.
But the problem with applying these ideas to the macroeconomy is that people get confused with real and nominal quantities, and they think of the “productive frontier” of an economy as being one thing rather than a multi-dimensional construct.
When an economy reaches “productive capacity,” it isn’t because it has used up all of its resources. It is because it has used up the scarcest resource. Theory says that what should happen isn’t that all prices should rise, but that the price of the scarce resource should rise relative to the prices of other resources. For example, when labor is plentiful relative to capital, then what should happen is that real wages should stagnate while real margins increase – that is, because productivity is constrained by the scarce resource of capital, more of the economy’s gains should accrue to capital. And so Marx was right, in this sort of circumstance: the “industrial reserve army of the unemployed” should indeed increase the share of the economic spoils that go to the kapitalists.
And that is exactly what is happening now. In the banking crisis, the nation’s productive capacity declined because of a paucity of available capital, in particular because banks were forced to de-lever. Output declined, and after the shock adjustments the margins of corporate America rose sharply (which I recently illustrated here), near record levels from earlier in the decade of the 00s. And real wages stagnated. Be very clear on this point: it is real wages which are supposed to stagnate when labor is plentiful, not nominal wages.
Now, what should happen next in a free market system is that the real cost of capital should decline, or real wages should increase, or both, as labor is substituted for capital because of the shortage of capital. We indeed see that the real cost of capital is declining, because real rates are sharply negative out to 10 years and equities are trading at lusty multiples. But real wages are stagnating, going exactly nowhere over the last 36 months. Why is the adjustment only occurring on the capital side, with bull markets in bonds and stocks?
We can thank central bankers, and especially Dr. Bernanke and the Federal Reserve, for working assiduously to lower the cost of capital – also known as supporting the markets for capital. This has the effect, hopefully unintended, of lowering the level at which the convergence between real wages and the real cost of capital happens; and of course, it obviously also favors the existing owners of capital. By defending the owners of capital (and, among other things, refusing to let any of them go out of business), the Fed is actually helping to hold down real wages since there is no reason to substitute away from capital to labor!
But all of this happens in real space. One way that the real cost of capital and the real wage can stay low is to increase the price level, which is exactly what is happening. We call this inflation.
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