In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”
At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.
To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.
I am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!
It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.
Ten-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.
Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.
None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?
All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.
The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).
I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.
And all it took was a few trillions!
It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.
So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.
We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.
The data has started to arrive.
Tuesday’s Employment report (gosh, it seems strange to write that) was weaker-than-expected with Payrolls +148k versus expectations for +180k. As I wrote back at the beginning of August, something in the realm of 200k is about as good as you’re going to get, so we’re not very short of that…we’re just very far short of what the consensus seems to expect we’re eventually going to get. No doubt, 148k isn’t 200k, and the six-month average of 163k is the lowest of the year. But it is also not a calamity, on the growth front.
And yet, 10-year interest rates are 50bps below the highs of early September. (Real yields are actually down 60bps, which means inflation expectations have risen slightly during that period). Interest rates are down because everyone knows that the trajectory of policy, with Yellen as likely to be the next Chairman of the Fed, is going to be “lower for longer.” But why? This goes back to the observation that growth is not far short of the best that it is likely to get. The only point of “lower for longer” is to support asset markets – housing, equity, and the bond market whence our nation’s interest burden is determined – and it seems to be doing this quite well. The alternate theory is that the Fed still fears deflation, despite all evidence (and copious theory) that the risk arrow is pointing in the other direction. In neither case does the Federal Reserve come out looking particularly on top of things, but more and more we are expecting that from Washington whether the officials are elected or appointed.
I really thought at one point that the bond market was going to be where the profligate monetary policy was going to first come unglued, but I am now wondering if it isn’t that denizen of hair-trigger shooters, the foreign exchange markets. The dollar index is plumbing the lows of the last two years, although it remains considerably above the lows of 2008 and 2011. As the chart below shows, the dollar has actually left behind the commodity markets where, as we know, investors suffer from the delusion that growth is more important for the nominal price of commodities than is the overall price level. Weak-ish growth means that commodities are only weakly above its August lows, although the buck is quite a bit lower since then.
I don’t think we can learn much right now watching stocks, where investors are simply playing Icarus. We all know where it leads, but any words of warning are laughed off as they soar with Fed-induced wings. Of course they’ll turn away in time!
I think housing is interesting. Having gotten back barely to fair, or maybe just a smidge cheap, compared to incomes, housing is expensive once again. But it isn’t in bubble territory yet, at least in the sense that when it cracks it could cause the carnage it did once before.
Bonds are on tenuous footing. With the consensus currently in place that the Fed might keep QE in place more or less forever, there are a lot of ways to disappoint the status quo: Fed speakers might suddenly try to start sounding stern again and imply that QE might not last forever; inflation might continue to tick higher and make obvious the unsustainability of the current course; or growth numbers might surprise to the high side.
The barbarians are already overrunning the dollar, and I suspect only the fact that Japanese monetary policy is far worse is keeping the descent slow. But people plugged into the supply and demand for currency are probably most likely to understand what happens when too much is supplied (hint: it’s the same thing that happens to the price of corn when too much corn is supplied). For a while, monetary authorities have been chasing each other to see which could be the least respectable, but it now seems that Japan wins that race and the US is likely to place.
As the chart above shows, reasons for increasing exposure to broad-based commodity indices (especially those that do not overweight energy, as the GSCI does) continue to accumulate.
There is much more data to come, of course, but to me it seems the battle lines have been more or less drawn in this fashion.
Obama started backing off the “absolute default” tactic by today saying “This week, if we don’t start making some real progress both in the House and the Senate, and if Republicans aren’t willing to set aside some of their partisan concerns in order to do what is right for the country [ed. note: our guys are always the patriots and the other guys are always the partisans, right?], then we stand a good chance of defaulting.” So, it’s no longer a sure thing, and the hurdle he has laid out is “good progress” rather than a hard stop.
As I have said before, there should be no default even if there is no agreement reached in our day. There simply is no reason to default unless the Administration decides it is politically opportune to do so. Last week, White House spokesman Jay Carney said “prioritization is default,” meaning that the government would somehow be defaulting by choosing to pay debtholders before others, but that’s simply wrong. Servicing the bonds is most assuredly not a default no matter what else you do. Carney might mean “prioritization is a bad political situation for us,” and he might mean “not paying some vendors would be, if we were a private company, grounds for being forced into bankruptcy,” but the US Govt isn’t a private company and there is no way to force it into default if it services its debt. And it is interesting that the President is now walking back his threats that a default was inevitable if no agreement is in place by the time the debt ceiling is reached.
I am not so sanguine that the current developing deal in the Senate is going to end the impasse. Although Senate Republicans seem willing to give the Administration all that it wants, and probably to apologize as well, the House Republicans already tried their version of a complete surrender and it was roundly rejected by the Administration (and why shouldn’t it be rejected? With the government shut down and the constant threat of default in the air, stocks are +1.7% this month. Toy with us some more, please!). By the time this crisis is over, the Republicans will probably be offering to repeal the 22nd Amendment and let Obama serve another term!
If, in fact, the standoff is resolved, it remains to be seen how quickly all of the economic data releases get back on line once the government is back at work. In any case, some of the data from this month will be suspect because the regular collection procedures will not be followed. For example, even if CPI is released on Thursday (or delayed and released before the end of the month), it will not be based on a full month’s regular survey of prices since for the last week or two no one has been collecting prices. This will be corrected in the next release (since what the price collectors are surveying is the level of prices, not the change in prices), but it may lead to near-term confusion due to the indeterminate effects. Other releases suffer from similar problems of greater or lesser order, but considering how important CPI is right now this is a prime concern.
It is a prime concern right now firstly because the artificial inflation trough induced by the original sequester has passed and inflation will be rising going forward, and secondly (and more importantly) because we will soon have a new Federal Reserve Chairman in Janet Yellen who will have to confront the issue very quickly and either burnish or reject her dovish credentials. So far, it seems clear to most of us that Yellen is a committed dove although a story that circulated in late September tried to argue that since she had been an advocate of a formal inflation target it means she is actually a hawk.
Favoring an annual inflation target has almost no implications for interpreting whether a monetary policy maker is a hawk or a dove. In fact, of the various targeting regimes proposed the non-correcting annual target is the most dovish proposal. That’s because there is no penalty for missing the target. With this sort of target, if you have 2% inflation followed by 20% inflation followed by 2% inflation, you’re back on target and the central bank need do nothing further. But, of course, prices are much higher than if you’d experienced 2%, 2%, and 2%. Other proposals, such as the long-term price-level proposal, force the central bank to steer to a particular compounded inflation level, which means that a big miss to the upside must be “paid back” by a subsequent miss to the downside. Now that is a much more hawkish proposal, because it defends long-term inflation levels rather than declaring a toothless goal. (You can read more about inflation targeting in my article here from 2010). Yellen is among those who thinks it’s important to convince everyone there is a goal, because “grounded inflation expectations” (even if they’re not rationally grounded but rather grounded because you tricked consumers into thinking you really have a target) help to restrain inflation. And on this point there is really not much evidence.
But it also misses the point in the extant environment. If Yellen desires to limit inflation, merely stating that she wants inflation to stay around 2% isn’t a policy action, or even a policy preference. It’s merely an expression of her preference for possible states of the universe. My children do approximately the same thing, with the same effect, when they say “I wish we could have a horse/travel to the Caribbean/build an indoor pool.” Yeah, and I wish I had a Jaguar, too.
Wishing doesn’t make it so. If Bernanke/Yellen want to limit inflation to 2%, merely talking about it is insufficient. What Yellen needs to do is to take action now. (Actually, they needed to take action two years ago, but it’s like James Carville famously said: “the best time to plant a tree was twenty years ago. The second-best time is right now.”) To the extent that Yellen is not urging action to reduce the Fed’s balance sheet and restrain future money growth it means that either she doesn’t really care about 2% inflation, at least in the near-term, or she doesn’t understand what causes inflation. I suppose I hope it is the latter cause, since that would be consistent with Bernanke’s position: he probably cares about limiting inflation but doesn’t understand that letting the balance sheet grow without bound is among the worst things he can do to limit inflation in the medium-term.
I suppose it should not be surprising that there is a great deal of misinformation and misunderstanding about the debt limit and government default. A lot of people and especially folks in the media don’t understand these issues because they have never confronted them, and the warring parties seem to believe they have an incentive to get the media telling their story by whatever means necessary, even if that means spreading disinformation.
Some of this is confusion among non-financial people about what “default” actually means. An individual defaults when he or she fails to pay bills within a reasonable time after they come due. If the default is serious enough, a creditor can force the defaulting party into bankruptcy and attach assets.
This isn’t what it means to default as a sovereign country, however. A sovereign default is when a nation fails to pay interest or principal on its debt when due. And that’s all. If the U.S. fails to pay its soldiers, that is not default. It’s a bad move, perhaps, but it is not default. If the government doesn’t pay you, you can sue…but even if you win, there is no Chapter 7 or Chapter 11 bankruptcy for the U.S. government so you cannot attach assets. So this distinction is key: if the U.S. services the debt, there is no default. This is the case whether or not the debt limit increases or not.
It is much more surprising to read James Baker, who among other things has been Treasury Secretary, equating the debt limit increase with solvency. Mr. Baker was interviewed for Peggy Noonan’s column this week in the Wall Street Journal and said, speaking of the President, “He has to get the debt limit raised to avoid default.”
We can walk this through and show why there need not be a default in the case where the debt limit is not raised.
While the government at some point ceases to spend, since it doesn’t have Congressional authorization to do so, it still continues to collect revenue. The U.S. takes in a little less than $3 trillion per year in revenues, and if you think those taxes don’t need to be paid while the government is shut down I invite you to try. Against that revenue, interest payments on Treasury bonds are on the order of $300bln (I don’t have the exact figure). Principal repayments aren’t relevant for this calculation, because as bonds mature the Treasury can re-issue the same nominal amount of bonds. So all the Treasury needs to do in order to avoid default is to pay the interest. They probably also want to pay the $1.6 trillion in Social Security and Medicare payments, and maybe a fair amount of the $700bln in defense and homeland security spending although a lot of that is procurement. But there’s plenty more than is needed to avoid a default.
Incidentally, in theory the Treasury could take in more money by issuing Treasuries with above-market coupons. Perhaps there is a statute that requires the Treasury to always pay the minimum coupon possible, although I am not aware of it. But if there isn’t such a statute, then the Treasury could raise more money by doing the following: when a $10bln TBill issue comes due, the Treasury immediately re-issues a $10bln, 10-year, 10% bond at a price of around 165% of par. Voila, an extra $6.5bln for the coffers. What is limited by statute, as far as I know, is the face amount of bonds that may be issued, not the amount of money that can be taken in.
Now, the Treasury claims that it is unable to pay selected obligations. According to them, it is not operationally possible – the check run is either on, or it is off. All, or nothing. This represents either ridiculous incompetence, or an outright lie. Seriously? The Treasury has no way to cut a single check if it wants to? How about this: take a big stack of blanks and, instead of running them through the printer, fill them out by hand and have the Secretary sign ‘em. Painful? Absolutely. But it is inconceivable that it isn’t possible to run only some checks. The Secretary should speak to his I.T. guys.
We should keep in mind that the Secretary is the President’s former Chief of Staff, and probably knows a lot more about the politics of appearing to be unable to pay than he does the actual capabilities of the machinery.
Does any of this make default impossible? Of course not. There is always the possibility that politics or petulance cause the President to simply refuse to order the Secretary to prioritize interest payments on the debt. It would most likely cause dramatic long-term costs for the government and precipitate a real crisis, and I wonder if it might even be impeachable (the 14th Amendment does not seem to me to give the President the power to raise the debt ceiling and pay anything he wants, but it certainly seems to give him the power to cut checks in order to defend the “validity of the public debt of the United States authorized by law, including debts incurred for payments of pensions.”) But there is no financial reason that failure to raise the debt ceiling should result in an actual default.
Since there is no data of note for a little while, there are some other topics I suppose I have time to remark upon.
I recently read a piece by Morgan Stanley called “Of Dogs, Deflation and Inflation.” In it, the authors essentially argue that the relative stasis of inflation recently is “best interpreted as a balance between inflation and deflation rather than concluding that neither is a material risk. While bold central bank action has been successful in stabilising inflation over the past five years, it has also increased the two-way risk to the future price level – both longer-term inflation and deflation risks have increased.”
If I see a photograph of a golf ball sitting on the rim of the cup, I might conceive of several reasons for that configuration. One is that there are no important forces acting on the ball, so it is sitting still on the edge of the cup. Another is that there are massive forces that are all canceling out: say, a strong wind blowing from right to left, and the golfer using a huge club rather than a putter to put the ball from left to right. Which of these two is inherently more likely? Is it possible that inflation has been relatively stable around the Fed’s target (using Median CPI) because massive quantitative easing just happened to exactly cancel the deflationary forces of the credit collapse? Well, of course it is possible. It is also possible that a derivatives book with two hundred trades in it just happens to have no risk at all. But when you are talking large numbers, it takes extreme precision to balance a system.
So it is more likely that neither force was very strong. However, there is yet a third explanation for that photograph, and that is that the ball was actually in motion and the picture just happens to capture a moment in time. The ball, in fact, proceeded to fall into the cup, but we don’t know that because the picture doesn’t tell us what came after.
This is the situation I believe we are in with inflation in the aftermath of the great recession. There is no doubt that the Fed’s aggressive easing helped ameliorate the deflationary pressures, although I think they were never as great as we thought at the time since the main deflationary pressure came from the decline in money velocity…which was caused mainly by a Fed-induced decline in interest rates. But these two forces, Fed easing and the deflationary impulses from a credit crunch, don’t act simultaneously. The Fed’s action takes longer to materialize in inflationary outcomes…especially when, as in this case, most of the easing from QE was sequestered in sterile bank reserves. We have, though, seen what is happening in the housing market, and it is foolishness to think that this has anything to do with strong household incomes or Congressional support for housing. It is plainly the result of a higher float of money, which has manifested in higher prices for real assets. And that putt was set in motion not this year, but with the earliest QEs that pushed money growth over 10% at times over the years since 2008.
Don’t look at the current state of the ball, that is core inflation, as being a deterministic snapshot. There is a delay between monetary policy and inflation outcomes (the old rule of thumb was 9-12 months, but it was pretty flexible), and that delay is even longer this time around because of the excess-reserves issue. The ball is in motion, and my guess is that the Fed struck the putt too hard.