Side Bet With Ben?

The markets are saying pretty clearly that there will be no more business done until the results of the Greek elections are known. For the last six trading sessions, the S&P has traded mostly in a range between 1310 and 1329, having made roughly seven round-trips of that range since last Wednesday’s updraft. Ten-year nominal yields have been between 1.56% and 1.70% for the most part. Ten-year real yields have oscillated between -0.60% and -0.50%. That’s despite disappointing Retail Sales on Wednesday, disappointing Initial Claims (386k, with an upward revision to last week), and a CPI release that bond and equity bulls certainly wanted to seize hold of. Late in the day, Egan Jones downgraded France to BBB+ with a negative outlook, but this news – not really news, in a way – was overshadowed by the rumor which circulated (sourced to Reuters) that said the G20 central banks had prepared coordinated “action” in the event that the Greek election this weekend rattled markets. The S&P spiked 15 points on that story, but then came back to the high end of the range.

Headline consumer prices fell -0.3% on the month, dropping the year-on-year rate of increase to +1.7%. As I predicted, the airwaves were replete with talk about the Fed’s response to an indicator that they largely ignore. According to Bloomberg, the renewed “stimulus speculation” was responsible for the decline in Treasury prices, the rise in oil prices (“The cost of living in the U.S. fell in May by the most in more than three years, Labor Department data showed today, giving Fed policy makers more flexibility to take further action to bolster U.S. economic growth”), and the fall in the dollar, and NASDAQ chimed in suggesting that stocks were rallying on Fed stimulus hopes. So many “hopes” on such a slim reed! To be sure, these articles all mentioned the weak ‘Claims figure, but it wasn’t that far out of line. It has been running around 380k, and 386k appeared on the tape. If that’s good enough for QE, then we should be on about QE14 by now.

Outside of the decline in headline inflation, core inflation didn’t show any signs of rolling over. As I suggested yesterday, economists were looking for a “soft” 0.2% on core inflation, causing the year-on-year rate to drop to 2.2% on a rounded basis. The BLS actually reported something just barely above 0.2%, which caused y/y CPI to stay at 2.3%. Keep in mind that the only reason that a downtick was even threatened was because last May showed a +0.3% and that is now rolling out of the data. Today’s figure, annualized, would produce 2.45%. Over the next few months, the hurdle for core CPI to move higher – or at least to avoid declining – grows easier. We’re unlikely to see core CPI dipping any time soon, so if the Fed wants to do QE, they’ll need to suddenly grow interested in headline inflation. (But if they do, they run the risk of getting caught sounding stupid if there’s a Middle East flare-up, or if Natural Gas follows up on the 14% rally it had today after a very weak inventory build).

That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?

The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:

“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”[1]

But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.

That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.

A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:

That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).

That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.

 

So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.

Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.

I do not expect core inflation to begin to fall any time soon.

---

[1] The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.