Back to school! It is the beginning of September, post-Labor Day, and students everywhere are back to school.
It is the time of year when investors, too, tend to be schooled – as bond markets tend to strengthen and equity markets to weaken (relative to the overall drift). It doesn’t happen every year, but the tendency in fixed income markets is strong enough that, as a rule, I demand much stronger reasons to sell bonds in September and October than during the rest of the year.
This year, we appear to be in for a special treat. We all get to learn new acronyms, like ISIS, and Americans are learning where Ukraine is on a map of the world. What fun.
Monetary policymakers tend to be resistant to further lessons, since after all they have had so many years of book learning that, darn it, they should know enough by now! And yet – there is so much about economics and monetary policy that we just don’t know; so much that isn’t knowable; and so much that we know with great confidence but just isn’t so.
However, I have been delighted to find that recently, the subject of money velocity has been appearing more frequently in policy circles. To a monetarist, velocity is one of a very small handful of things that matter, and its absence from discussions among the learned has been a terrible sign that monetarism was not merely in retreat, but almost extinct. And yet, the predictions of monetarism have been borne out time and time again (that is, the actual predictions, not the idea that printing money causes economic growth – a prediction that presupposes a high degree of money illusion is at work), while the predictions of Keynesian economists have only worked once the parameters are revised post-hoc to fit the crisis. Increased money supply growth got Japan out of its deflationary spiral – as predicted. None of the Keynesian solutions deployed over the last two decades have worked, but the first attempt at serious money-printing worked. (Although it remains to be seen if the BOJ will keep its pedal to the metal; it certainly hasn’t yet “doubled the money supply” as it had pledged to do).
High money growth – that is, transactional money and not inert reserves – always accompanies high inflation. For a time, money growth may be offset by declining money velocity, but we also know quite a bit about what causes money velocity to move. Last year I cited a rare paper by a central banker (Samuel Reynard at the Swiss National Bank) that really had insight on these almost-forgotten tenets of monetarism. And this year, I am delighted to note that some economists at the St. Louis Fed have published a brief note entitled “What Does Money Velocity Tell Us about Low Inflation in the U.S.?” While the authors, Yi Wen and Maria Arias, mistakenly focus on the velocity of base money, and thus reach an incorrect conclusion that individuals are “hoarding” money (when it in fact is sitting in bank reserves, untouched), it is nevertheless the right topic and the right question, and that’s most of the battle.
I have previously shown the chart of interest rates and money velocity, so let me show it again.
This is important, because it’s the single biggest risk to a significant inflation accident. While the low vacancy rate and the rapid growth in housing prices will continue to push rents higher, bringing median and/or core inflation above 3% by early next year, we can live with 3%. The risk for much worse inflation is all tied to a rebound in monetary velocity. It bears repeating. From 2008 to 2013, money growth was rapid but declining money velocity (tied to interest rate declines, mainly) restrained inflation. If money growth remains at the same level but money velocity merely stabilizes, it is consistent with inflation of 3%-4%. But if money velocity reverses even a part of its post-crisis decline, then inflation could move appreciably higher. Since Q2 of 2008, the velocity of M2 has fallen at a 3.76% annualized rate; were that to reverse, with the same money supply growth, then the 3-4% inflation becomes 6.75%-7.75% inflation, which I think we would all agree is a bad thing.
Now, the unfortunate thing is that models of velocity that incorporate interest rates and certain other factors already indicate that money velocity should be rising. The chart below shows our proprietary model of money velocity; as you can see, since mid-2013 there has been a large and growing gap between what the model implies and where money velocity has actually been recorded. This might well mean that the model is wrong. But we should also take it as indicating the risk of a rise in velocity is real, whether it is a 1% or 2% rise per year, or a 15% snap-back over a shorter period of time.
As I always admonish, that’s a big picture concern, and not something to trade tomorrow. I would be gradually accumulating positions in inflation swaps, caps, breakevens, and broad commodity indices. There is time before people start to get really concerned. But to my mind, what is interesting is that the central bankers are now at least starting to reconsider velocity.
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.
A very common refrain among stock market bulls these days – and an objection some made to my remarks yesterday that markets are still not making sense – is that the low level of interest rates warrants a high multiple, since future earnings are being discounted at a lower interest rate.
My usual response, and the response from far more educated people than me, like Cliff Asness who published “Fight the Fed Model” back in 2003, is that low interest rates explain high multiples, but they do not justify high multiples. High multiples have always historically been followed – whether explained by low interest rates or not – by poor returns, so it does no good to say “multiples are high because rates are low.” Either way, when multiples are high you are supposed to disinvest.
But I thought it would also be useful, for people who are not as familiar with the argument and only familiar with the sound bite, to see the actual data behind the proposition. So, below, I have a chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year nominal interest rates.
Note that it is generally true that lower nominal interest rates are associated with higher multiples, although it is far more clear that higher nominal interest rates are associated with lower multiples, whether we are talking about the long tail to the right (obviously from the early 1980s) or the smaller tail in the middle that dates from around 1920 (when 5% was thought to be a pretty high interest rate). But, either way, the current multiples represent high valuations whether you compare them to high-rate periods or low-rate periods. The exception is clearly from the late 1990s, when the long downtrend in interest rates helped spark a bubble, and incidentally spurred the first widespread discussion/excuse of the so-called “Fed model.” If you take out that bubble, and you take out the 1980s high-rates tail, then there is left just a cloud of points although there does seem to be some mild slope to it from lower-right to upper-left.
But in short, the data is hardly crystal clear in suggesting that low interest rates can explain these multiples, never mind justify them.
More interesting is what you get if you compare P/E ratios to real rates. Because equities are real assets, you should technically use a real discount rate. Since real economic growth in earnings should be reflected in higher real interest rates generally, only the incremental real growth in earnings should be discounted into higher values today. This eliminates, in other words, some of the ‘money illusion’ aspect of the behavior of equity multiples.
I haven’t seen a chart like this before, probably because the history of real interest rates in the U.S. only dates to 1997. However, using a model developed by Enduring Investments (and used as part of one of our investment strategies), we can translate those historical nominal rates into the real rates we would have expected to see, and that allows us to produce this chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year real interest rates – using Enduring’s model until 1997, and actual 10-year real interest rates thereafter.
I find this picture much more interesting, because there seems to be almost no directionality to it at all. The ‘tail’ at upper right comes from the late 1990s, when again we had the equity bubble but we also had real rates that were higher than at equilibrium since the Treasury’s TIPS program was still new and TIPS were very cheap. But other than that tail, there is simply no trend. The r-squared is 0.02 and the slope of the regression line is not statistically different from zero.
And, in that context, we can again see more clearly that the current point is simply at the high end of the cloud of historical points. The low level of real interest rates – actually quite a bit higher than they were last year – is of no help whatsoever.
None of that should be particularly surprising, except for the buy-and-hope crowd. But I thought it constructive to show the charts for your amusement and/or edification.
The Employment number these days is sometimes less interesting than the response of the markets to the number over the ensuing few days. That may or may not be the case here. Thursday’s Employment report was stronger than expected, although right in line with the sorts of numbers we have had, and should expect to have, in the middle of an expansion.
As the chart illustrates, we have been running at about the rate of 200k per month for the last several years, averaged over a full year. I first pointed out last year that this is about the maximum pace our economy is likely to be able to sustain, although in the bubble-fueled expansion of the late 1990s the average got up to around 280k. So Thursday’s 288k is likely to be either revised lower, or followed by some weaker figures going forward, but is fairly unlikely to be followed by stronger numbers.
This is why the lament about the weak job growth is so interesting. It isn’t really very weak at all, historically. It’s merely that people (that is, economists and politicians) were anticipating that the horrible recession would be followed by an awe-inspiring expansion.
The fact that it has not been is itself informative, although you are unlikely to see economists drawing the interesting conclusion here. That’s because they don’t really understand the question, which is “is U.S. growth unit root?” To remember why this really matters, look back at my article from 2010: “The Root of the Problem.” Quoting from that article:
“what is important to understand is this: if economic output is not unit root but is rather trend-stationary, then over time the economy will tend to return to the trend level of output. If economic output is unit root, then a shock to the economy such as we have experienced will not naturally be followed by a return to the prior level of output.”
In other words, if growth is unit root, then we should expect that expansions should be roughly as robust when they follow economic collapses as when they follow mild downturns. And that is exactly what we are seeing in the steady but uninspiring job growth, and the steady if not-unusual return to normalcy in the Unemployment Rate (once we adjust for the participation rate). So, the data seem to suggest that growth is approximately unit root, which matters because among other things it makes any Keynesian prescriptions problematic – if there is no such thing as “trend growth” then the whole notion of an output gap gets weird. A gap? A gap to what?
Now, it is still interesting to look at how markets reacted. Bonds initially sold off, as would be expected if the Fed cared about the Unemployment Rate or the output gap being closed, but then rallied as (presumably) investors discounted the idea that the Federal Reserve is going to move pre-emptively to restrain inflation in this cycle. Equities, on the other hand, had a knee-jerk selloff on that idea (less Fed accommodation) but then rallied the rest of the day on Thursday before retracing a good part of that gain today. It is unclear to me just what news can actually be better than what is already impounded in stock prices. If the answer is “not very darn much,” then the natural reaction should be for the market to tend to react negatively to news even if it continues to drift higher in the absence of news. But that is counterfactual to what happened on Thursday/Monday. I don’t like to read too much into any day’s trading, but that is interesting.
Commodities were roughly unchanged on Thursday, but fell back strongly today. Well, a 1.2% decline in the Bloomberg Commodity Index (formerly the DJ-UBS Commodity Index) isn’t exactly a rout, but since commodities have been slowly rallying for a while this represents the worst selloff since March. The 5-day selloff in commodities, a lusty 2.4%, is the worst since January. Yes, commodities have been rallying, and yet the year-to-date change in the Bloomberg Commodity Index is only 2% more than the rise in M2 over the same period (5.5% versus 3.5%), which means the terribly oversold condition of commodities – especially when compared to other real assets – has only barely begun to be corrected.
I do not really understand why the mild concern over inflation that developed recently after three alarming CPI reports in a row has vanished so suddenly. We can see it in the commodity decline, and the recent rise in implied core inflation that I have documented recently (see “Awareness of Inflation, But No Fear Yet”) has largely reversed: currently, implied 1 year core inflation is only 2.15%, which is lower than current median inflation – implying that the central tendency of inflation will actually decline from current levels.
I don’t see any reason for such sanguinity. Money supply growth remains around 7%, and y/y credit growth is back around 5%. I am not a Keynesian, and I believe that growth doesn’t matter (much) for inflation, but the recent tightening of labor markets should make a Keynesian believe that inflation is closer, not further away! If one is inclined to give credit in advance to the Federal Reserve, and assume that the Committee will move pre-emptively to restrain inflation – and if you are assuming that core inflation will be lower in a year from where it (or median inflation, which is currently a better measure of “core” inflation) is now, you must be assuming preemption – then I suppose you might think that 2.15% core is roughly the right level.
But even there, one would have to assume that policy could affect inflation instantly. Inflation has momentum, and it takes time for policy – even once implemented, of which there is no sign yet – to have an effect on the trajectory of inflation. Maybe there can be an argument that 2-year forward or 3-year forward core inflation might be restrained by a pre-emptive Fed. But I can’t see that argument for year-ahead inflation.
Of course, markets don’t always have to make sense. We have certainly learned this in spades over the last decade! I suppose that saying markets aren’t making a lot of sense right now is merely a headline of the “dog bites man” variety. The real shocker, the “man bites dog” headline, would be if they started making sense again.
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.