Targeting Tuition as a Long Run Goal

September 21, 2017 2 comments

A few months ago, in a couple of articles entitled “The Bias in Investor Perceptions” and “What’s Wrong With the Long Run?”, I started to lay out the case for individuals and family offices to approach the investment challenge like a well-run pension fund or endowment would. Most well-run pensions and endowments these days are run in a “liability-driven” manner, which means that instead of maximizing the performance of the fund’s assets, subject to the risk of those assets – classic “mean variance optimization” based on “Modern Portfolio Theory” – the manager aims to maximize the funded status of the plan subject to the variance in the funded status. That is, the manager recognizes that having assets which mimic the behavior of the liabilities is valuable and worth at least some sacrifice in expected return. Many such portfolios, especially when they are fully funded, have two “buckets” for assets, one that is designated as the “liability immunizing” portfolio and one that is designated the “return-seeking” portfolio.

The reason this is a valuable mode of thought for an individual or family office is that it tends to force a focus on the long run, since the “liabilities” in question (such as retirement, college education, bequests, etc) tend to be long-term in nature. But there are a couple of challenges.

One such challenge is to get the client to focus on that long run, rather than on the brokerage statement that shows up in the mail every month and is always one mouse-click away. And that’s what I discussed/lamented on in those prior two articles.

The other challenge is that, unlike a pension fund or endowment, an individual has a kaleidoscope of different liabilities that behave differently from each other. Some of these, like saving for retirement, can be approximated by general consumer price inflation (CPI). But some, like saving for college or saving for future health care costs, behave in their own unique ways. And so the conundrum for many years has been “sure, personal Liability-Driven-Investing makes sense, but what assets do I hold against those liabilities?”

This has driven calls for “goal-appropriate financial instruments,” led by people like Arun Muralidhar (who specifically used that term in “Goals Based Investing, the KISS Principle, and the Case for New Financial Instruments”) and Robert Shiller, who muses on making “previously untradable risks tradable” in Finance and the Good Society, and has a history of innovative enterprises to attempt the same.

What I am excited about is a step forward in creating these instruments…one that my company Enduring Intellectual Properties has had a key role in. Last week, S&P Dow Jones Indices announced the launch of the “S&P Target Tuition Inflation Index,” which is designed to reflect inflation of college tuition and fees over long-term periods. The index was designed by S&P on the basis of a method that we developed a very long time ago but could never figure out how to commercialize. It involves liquid securities, and so can easily be made into investible products such as mutual funds, ETFs, UITs, and other structured products that individual investors can buy. The chart below shows the index, alongside CPI for College Tuition and Fees (NSA).

As with any liquid markets-based index compared to a periodic economic indicator, the tracking error on a day to day basis is not necessarily good. But it is also not terribly relevant – how your fund does next week should not affect how you feel about your college fund! The strategy is built on an understanding of what the main drivers of college tuition are, and these turn out to be fairly simple (unlike is the case with, say, Medical Care). Because the main drivers of college tuition inflation are the same as the drivers of the index, the errors tend to be “mean-reverting,” meaning that the longer you hold the index the closer (in annualized terms) you tend to be to the target.

Investing in a product linked to this index will not be a substitute for saving money in the first place. But, having saved, investing in such a product should help to reduce the risk that the money saved for college suddenly evaporates, as it did for many parents in 2000-2002 and 2007-2009.

I am ecstatic that we were able to team up with S&P to create such an important index – one that will help investors save in a goal-driven way, with their eyes turned to the future rather than to the latest wiggle in the markets.

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Money and Credit Growth Update

September 19, 2017 Leave a comment

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It has been a challenging few years to be a monetarist. That isn’t because monetarist predictions have failed, but rather because monetarists have had to spend a lot of time explaining why money velocity has been declining (the answer is: low interest rates) and why “printing money” hasn’t led to runaway inflation (the answer is: inert reserves don’t count, but M2 money growth has been growing between 5%-8% for the last 5 years and that would be too fast for stable prices if velocity was stable).

Money velocity declines when interest rates decline because the demand for real cash balances increases when the opportunity cost of those cash balances is low. That is, if interest rates are at 10%, then you won’t leave cash sitting around idle; it becomes a hot-potato and either gets reinvested in term loans or other assets, or spent. On the other hand if term interest rates are at 0%, then what’s the hurry? The chart below (source: Bloomberg) shows the simple relationship since the early 1990s between 5-year Treasury rates and M2 velocity. This is not a mystery – it has been a critical part of monetarist theory since the 1970s.

You can see that there is a modest conundrum, since interest rates bottomed a couple of years ago but money velocity has continued to sag. I don’t see this as a major mystery; it makes sense to me that there could be some nonlinearities in this relationship near and below the 0% level that we just don’t have enough data to resolve. These nonlinearities have certainly made forecasting more difficult and led generally to forecasts that were modestly too high compared with actual inflation outturns. Again, there’s no mystery about why the forecast misses – the mystery is why money velocity has remained low while interest rates have bounced (we believe economic policy uncertainty has led people to hold somewhat higher real cash balances than they otherwise would, but that’s just a hypothesis). At some point, higher interest rates will snap money velocity back as it gets too ‘expensive’ to leave cash balances sitting around. But this hasn’t happened yet.

Meanwhile, money growth has been slowing. It is still rising faster than 5% per annum, which means that if money velocity was stable and potential GDP growth is 2.5% then we would see the GDP Deflator rising at 2.5%. So money growth is still a bit too fast, unless money velocity is going to decline forever. But it is better at 5% than at 8%, to be sure.

Credit growth has also been slowing, as the chart below (source: Federal Reserve) shows.

Now, regardless of what you read credit growth has essentially no relation to money velocity. Obviously, credit growth has been fairly rapid – as money velocity continued to sag – and is now slowing – as money velocity has continued to sag. It is moderately better connected to M2 growth, so it tends to reinforce the notion that money growth is slowing somewhat, but people who are saying that velocity will continue to slow because banks are slowing loan growth need to explain why rapid growth didn’t lead to velocity acceleration. One-way relationships in economics are pretty rare.

I doubt very seriously that M2 growth is about to drop off a cliff. The Fed’s rate hikes and any balance sheet reduction is not going to affect money supply growth while bank reserves are still “abundant,” to use the Fed’s phrase. Banks are neither capital nor reserve-constrained at the moment, so a decline in credit growth is either coming from the supply side as banks voluntarily reduce loan growth perhaps because credit quality is diminishing, or it is demand side as borrowers are not seeing the growth opportunities that require financing. Money growth is still, and always, something to keep an eye on. But, just as changes in velocity dominated changes in money growth when velocity was falling, velocity changes will dominate changes in money growth when (if?) money velocity starts to rise. As the first chart above shows, velocity when interest rates were “normal” was around 1.8 or higher. I invite you to go to the calculator on the Enduring Investments website and play around using a starting money velocity of 1.43 to see what sort of money supply contraction is required to keep inflation low, if velocity returns to 1.80 over some period of time.

And then, realize that M2 has not declined on a y/y basis as far back as the Fed has records on FRED (about 1960). It seems unlikely to do so now. This leaves few low-inflation exit paths as long as money velocity isn’t permanently dead.

I think the decline in credit growth has implications, but they are mainly implications for growth and not for inflation. Along with the weakness that is starting to be seen in some other areas of the economy (e.g. autos, until the hurricanes caused some “forced replacement”), I think this could be seen as a harbinger of a potential recession in 2018.

Categories: Causes of Inflation Tags: ,

Summary of My Post-CPI Tweets (Sep 2017)

September 14, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • 15 minutes to go to CPI. Consensus on core is for 0.17% or so. But due to tough year-ago comparison, y/y should drop to 1.6%
  • Hurricane effects may boost headline a bit, though most of that will be later. Shouldn’t see core effects yet.
  • Core effects may potentially be seen (eventually) in shelter and vehicles; both were destroyed in large amounts in Harvey/Irma
  • well well well. Core +0.249%, ALMOST 0.3% rounded. y/y to 1.69%
  • Turnabout is fair play. Highest core CPI in 8 months, and haven’t seen hurricane effect yet.

  • Note the easy comparisons from year ago for the next couple of months, too. Might just have seen the lows in core.
  • housing up, medical care down again. Drilling down now…
  • core services was up to 2.5% from 2.4%…core goods down to -0.9% from -0.6%! With dollar weakening that’s going to change.
  • Housing 2.91% from 2.83% y/y. Primary rents 3.88% from 3.81%; OER 3.27% vs 3.21%.
  • Lodging Away from Home +0.23% vs -2.36% y/y. That was one of those one-offs. Poof.
  • Motor vehicles -1.57% vs -1.72%. No hurricane effect yet but as I said on Bloomberg today…that’s likely to be a big + going forward
  • 81% vs 2.58% last month on Medical Care as a whole. Medicinal Drugs: 2.51% v 3.84%. Hospitals 4.09% v 5.31%. Insurance 0.17% v 1.24%
  • Professional services (medical) unch at just +0.2% y/y.
  • Figure out whether this medical care pricing collapse is temporary or real and you have the big story.
  • medicinal drugs:

  • Housing and medical care. I think the Medical Care move is mostly a composition change, catching more self-pay from insurance-pay.

  • Does this change anything for the Fed? Not with the hurricanes. Expect movement to reduce balance sheet, while holding rates down.
  • Enough for today. Will put up my summary article later. If you want the chartbook go to https://store.enduringip.com
  • [later:] Median CPI was 0.247%, y/y at 2.15% up from 2.13%, basically stable since June between 2.13% and 2.18%.

This was a shorter string of tweets than I usually produce. Part of the reason for that was that I was in a car careening down the highway returning from my appearance on Bloomberg TV to talk about the Phillips curve and auto inflation, and partly it was because this one was pretty easy.

Lodging Away from Home jumped. But it had previously plunged inexplicably, so this is just a reversal. I didn’t tweet about that one, but it is symptomatic – there are a number of one-offs, and some of them are going to reverse.

Rents rose a bit, but again that is partly just a retracement of the recent slide. As I pointed out last month, that slide merely put rents back on the model where they had been running ahead of the model, so this isn’t terribly surprising.

The really surprising part was and is the Medical Care part. All subcomponents of that index are now decelerating, although pharmaceuticals are doing so in a slightly less-dramatic fashion than medical professional services. This is very outside of anyone’s forecast ranges. It is possible this is just payback for the rises the previous year, but if that’s the case then it’s not going to continue. Is it possible that we suddenly have reined in the price of medical care by making it hard to acquire? I suppose that’s possible, but I would think the better bet is that the composition of services is changing as people are paying for more out of pocket – so we buy the band-aid rather than the tourniquet, and that looks like lower prices. It is, however, really hard to tell at this point and that’s the main remaining conundrum.

I said up top that the important hurricane effects, notably in Motor Vehicles but also in Shelter, have not been felt yet. (Read more about these upcoming effects in my column “Some Effects on Inflation from Harvey and Irma”). Moreover, the next few months will see core CPI comparisons of 0.12%, 0.15%, and 0.18% from last year. Accordingly, I think core which is currently at 1.69% will be at 1.77% next month, 1.82% the following month, and 1.84% the month after that. Importantly, none of that is enough to scare the Fed into hiking again, and with the hurricane damage I think they’ll eschew further rate hikes for a while. However, they will probably start reducing the balance sheet, and if they can manage to sustain that – reverse QE, but holding policy rates down – then they will have lucked into the “right” policy that could keep inflation’s peak in the 3%-4% range rather than the 5%+ trajectory that many of their other paths have. I am skeptical they will stay the course, because reverse QE will have bad effects on asset prices. But it’s a start.

Categories: CPI, Tweet Summary

Some Effects on Inflation from Harvey and Irma

September 11, 2017 3 comments

It has been a rough few weeks. First, Hurricane Harvey drenched Houston and south Texas with feet of rain, turning millions into temporary refugees and tens of thousands of them into longer-term refugees as 40,000 homes were destroyed along with a million automobiles. Then, Hurricane Irma battered Miami and Tampa Bay, which is a rare feat, and seems likely to make it the fourth most-damaging hurricane in nominal dollar terms in US history (behind Katrina, Sandy, and Harvey).

And of course, there’s the memorial of September 11th. I once thought that this day would someday become less raw, but remarkably the passage of time has not applied the usual salve in this case. I don’t know why. But the terrorist attacks of that day no longer affect the markets, so we nod and somberly reflect, and move on.

But those other two events will have an impact on markets and on data. Interestingly, the initial response to Irma was a strong rally in equity markets, as the damage was not as great as originally feared – perhaps $50bln, rather than $250bln, in damages. Aside from the human toll, whose value is beyond accounting, this is potentially a large figure for insurance companies and owners of catastrophe bonds (or what is left of them) but a mere scratch on the GDP of the nation as a whole. The total cost of the two hurricanes will be something in the neighborhood of 1% of GDP – although very unevenly distributed.

It is de rigeur in times like these to point out that GDP will increase over time with the expenditure of rebuilding, but of course the nation is not better off and so this is not good for the economy. More thoughtful models note that the national accounts gain that 1% back over the next few years, but local production from the affected areas is at least temporarily reduced so that the net effect is actually somewhat negative over the next several years. The net effect overall is small…but very unevenly distributed.

Some of the upward inflation pressure from the hurricanes comes from the additional pressure in commodities markets. Demand for steel and wood are likely to be elevated as these areas rebuild. For a short time, there will be higher prices for these things locally, and for gasoline, due to the difficulty of delivery to the affected communities. The additional demand might even cause some marginal pressure in commodities markets for industrial metals (e.g.). But in the longer-term there will be no shortage of these items because these goods are bought and sold on international markets and are easily delivered to ports in Houston, Miami, and Tampa Bay. It just takes some time to get the logistics train running. But the uneven distribution of the damage will matter in other ways. For example, there is no way to take a surplus of shelter in one area of the country and move it to another area (mobile homes excepted). Those 40,000 homes in Texas and thousands of others in Florida will need to be rebuilt in situ. Many others will need significant repairs to be nominally habitable. This will not happen overnight, which means that there is an abrupt shelter shortage in Houston and in Florida, and this can be expected to affect inflation.

It is very hard to assess just how much shelter inflation can be expected to follow from these storms. There aren’t many major hurricanes, and for each data point there are lots of other effects that get entangled so that my thoughts here are clearly speculative. But consider the chart below (Source: BLS), which shows Houston-area Shelter CPI (year/year) and compares it to the national Shelter CPI.

In September 2008, when Hurricane Ike hit Texas, housing prices nationally were already decelerating. They had remained elevated in Houston up to that point – thanks in part to $120/bbl oil – but probably would have rolled over almost immediately when the global financial crisis smashed energy markets along with housing markets. Yet, in Houston home prices actually accelerated over the next year before finally declining in late 2009. This is likely to be a side-effect of Ike, and I think we will see similar effects in the cost of shelter in Houston, Miami, and Tampa Bay this time too. This will likely provide a small upward lift to national Shelter prices and hence core CPI over the next year.

The other way that the hurricanes will help push core CPI higher is by helping to alleviate the recent pressure on motor vehicle prices. As the chart below (Source: BLS) shows, new and used vehicle inflation has not been a significant contributor to inflation since early 2012, thanks partly to years of channel-stuffing by manufacturers offering 0% financing along with great lease terms for those who don’t want to buy.

But consider late 2009. The “Cash for Clunkers” program, which took effect in mid-2009, provided cash rebates for consumers to swap used cars for new cars. While largely considered a failure as a stimulus plan, it did produce a sharp increase in motor vehicle prices overall. Prior to C4C, motor vehicle prices were stagnant; by the program’s end prices were rising and they kept rising for some time, at a rate of about 5% per annum between late 2009 and late 2010 – about 4% faster than core inflation at the time. Cash-for-Clunkers took about 700,000 cars off the road. Harvey is taking out about a million. Though those are all in Texas cars, unlike houses, are mobile and surplus inventories will surely be shipped southward with alacrity.

I don’t know why this is a bullish thing for the equity market. But I understand why inflation swaps are at three-month highs and headed higher.

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Some Further (Minor) Thoughts on the Phillips Curve

September 6, 2017 3 comments

Before I begin, let me say that if you haven’t read yesterday’s article, please do because it represents the important argument: the Phillips Curve doesn’t need rehabilitating, because it is working fine. In fact, I would argue that the Phillips Curve – relating wages to unemployment – is a remarkably accurate economic model prediction. The key chart from that article I reproduce here, but the article (which is brief) is worth reading.

Following my publication of that article, I had a few more thoughts that are worth discussing on this topic.

The first is historical. It’s incredibly frustrating to read article after article incorrectly stating what the Phillips Curve is supposed to relate. Of course one writer learns from another writer until what is incorrect becomes ‘common knowledge.’ I was fortunate in that, 30 years ago, I had excellent Economics professors at Trinity University in San Antonio, and I was reflecting on that fact when I said to myself “I wonder if Samuelson had it right?”

So I dug out my copy of Economics by Samuelson and Nordhaus (the best-selling textbook of all time, I believe, and the de rigeur Intro to Economics textbook for generations of economists). My copy is the 12th Edition, so perhaps they have corrected this since then…but on page 247, there it is – the Phillips Curve illustrated as a “tradeoff between inflation and unemployment.” Maybe that is where this error really propagated – with a Nobel Prize-winning economist making an error in his incredibly widely-read text! Interestingly, the authors don’t reference the original Phillips work, but refer to “writers in the 1960s” who made that connection, so to be fair to Samuelson and Nordhaus they were possibly already repeating an error that had been made even earlier.

My second point is artistic. In yesterday’s article, I said “The Phillips Curve…simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand,…” But students of economics will note that the Phillips Curve seems to obfuscate this relationship, because it is sloping the wrong way for a supply curve – which should slope up and to the right rather than down and to the right. This can be remedied by expressing the x-axis of the Phillips Curve differently – making it the quantity of labor demanded rather than the quantity of labor not demanded…which is what the unemployment rate is. So the plot of wage inflation as a function of the Employment Rate (as opposed to the Unemployment Rate) has the expected shape of a supply curve. More labor is supplied when the prices rise.

Again, this is nuance and not a really important point unless you want your economics to be pretty.

My third point, though, is important. One member of the bow-tied fraternity of Ph.D. economists told me through a friend that “the Phillips Curve has evolved to the relationship between Unemployment and general prices, not simply wages.” I am skeptical of any “evolution” that causes the offspring to be worse-adapted to the environment, but moreover I would argue that whoever led this “evolution” (and as I said above, it looks like it happened in the 1960s) didn’t really understand the way the economy (and in particular, business) works.

There is every reason to think that wages should be tied to available labor supply because one is the price of the other. That’s Microeconomics 101. But if unemployment is going to be a good indicator of generalized price inflation too, then it means that prices in the economy are essentially set as the price of the labor input plus a spread for profit. That is not at all how prices are set. Picture the businessperson deciding how to set prices. According to the “evolved Phillips Curve” understanding, this business owner looks at the wages he/she is paying and then sets the price of the product. But that’s crazy. A business owner considers labor as one input, as well as all of the other inputs, improvements in productivity in producing this good or service in question, competitive pressures, and the general state of the national and local economy. It would be incredible if all of these factors canceled out except for wage inflation, wouldn’t it? So in short, while I would expect that unemployment might have some explanatory power for inflation, I wouldn’t expect that explanatory power to be very strong. And, in fact, it isn’t. (But this isn’t new – it never has had any power.)

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The Phillips Curve is Working Just Fine, Thanks

September 5, 2017 1 comment

I must say that it is discouraging how often I have to write about the Phillips Curve.

The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.

Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).

Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.

And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).

But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.

The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?

I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.

So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.

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Avoiding the Rattlesnakes in Monetary Policy

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And now on to today’s rant.

Today we got the minutes from the last FOMC meeting, but that is of course old news by now. The nuance of whether the central bankers at the meeting were a little more dovish or a little more hawkish used to matter more when every utterance of every Fed official wasn’t carried live on television. By the time we get the FOMC minutes, even the nuance is outdated if Fed speakers have been active at all.

Make no mistake: I once would stop what I was doing when the minutes came out, and pored over the fine detail to pick out that nuance; but it’s no longer necessary. I am less intrigued by the wording in today’s minutes than I am by what Neel Kashkari said a few days ago.

Mr. Kashkari, who is President of the Minneapolis Fed despite his tender age of 44, declared last Friday that his colleagues’ desire to raise interest rates is attributable to a “ghost story” they are telling themselves:

 “People are worried that, if wages start to climb, if businesses have to compete with each other, you may not get gradual wage growth. You might all of a sudden get an acceleration in wages.

“I call this — and I mean this with no disrespect — I call this a ghost story, meaning, I cannot prove to you that there’s not a ghost underneath this table. I cannot prove it definitively. There may be. But there is no evidence that there is a ghost under this table. There is no evidence in any of the data that wages have this acceleration factor and are all of a sudden going to take off.”

I guess perhaps I am getting old and so am more easily irritated when young whippersnappers are blatantly disrespectful to their elders. Sure, at every age we think we have the answers. But Mr. Kashkari is so far off base here it is fair to wonder how the hell he got this job in the first place…because he clearly doesn’t understand one of the basic principles of monetary policy.

It is true what he says. There is no evidence that wages are about to take off, and I sympathize with his frustration about the Phillips-Curve cult at the Fed. I would go further and say that even if wages were to suddenly accelerate, moving higher before inflation moves higher in what is a fairly unusual occurrence, there’s very little support for the notion that this would in turn push prices higher. The data supporting “wage driven” inflation is very thin indeed. This is why the Phillips Curve tends to work fairly well on wages, but not very well on inflation. That is, low unemployment rates tend to precede increases in wages, but aren’t particularly predictive when it comes to increases in inflation.

But despite the fact that what he says is true, he is wrong about the implications for policy because he doesn’t appreciate the nonlinear effects of forecasting errors here. One of the basic rules of monetary policy is (or at least should be) this: because there are large error bars on your forecasts, try to nudge policy in the direction least likely to &*@#$^@ it up.

Kashkari is saying that there’s no reason not to keep rates low, because we haven’t seen any sign of wage inflation. But that’s not the right question. The right question is this: is it more likely that we will &*@#$^@ it up by keeping rates too low, or by moving them too high? Being wrong and being slightly too tight when you’re already incredibly accommodative is probably a small error. Being wrong and being slightly too loose when you’re already incredibly accommodative has at least the potential to be a massive error, because inflation has long tails – so making that error could have nonlinearly bad results.

One might argue that being too tight could crack the stock and bond markets. This is true, but it will always be true unless the markets crack on their own. It’s true because markets are ridiculously overvalued, so there will always be a risk of nonlinearly bad moves in asset markets. But that risk is inescapable: at some point, rates will have to be normalized, and it is likely to move the equilibrium prices for those markets lower. The Fed is trying to address that part of the risk by being so outlandishly incremental that asset markets won’t care. So far, so good.

(There is an additional irony here, and that is that raising interest rates is the action which is more likely to ignite inflation as money velocity moves up so that you might also get nonlinearly bad outcomes in inflation by raising rates. But that is not what Kashkari is saying.)

No one, it seems, is worried about the nonlinear outcomes these days. If they were, implied volatilities would be much higher, since it is through options that you can best protect your assets from nonlinear market moves. As investors, we can choose to take that risk with our own little piece of the pie. Policymakers don’t have access to option hedges on economy-wide economic variables, though. Their best strategy is to try and walk the course least likely to result in their stepping on a rattlesnake.

Categories: Federal Reserve
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