A reader pointed out to me today a piece by Amy Higgins and Randal Verbrugge on the Cleveland Fed’s website entitled “Is a Nonseasonally Adjusted Median CPI a Useful Signal of Trend Inflation?” I will let readers draw their own conclusions about the new measure that Higgins and Verbrugge are proposing, but I wanted to point out the research because I often cite Median CPI as the best way to look at the central tendency of inflation (what the researchers call “trend inflation”) and this article confirms and reinforces that point of view.
And it is worth looking, therefore, at the recent movements in Median CPI. Yes, I know you’ve seen this over and over from me, but take a look anyway (chart is sourced from Bloomberg).
I don’t believe for a second that the FOMC is unaware of this picture; nor, however, do I believe they really care equally about inflation and growth. The talk right now is moderately hawkish, and with growth fair and inflation heading higher it is time to withdraw reserves. Indeed, it is long past time. As I have said for a while, the time to withdraw reserves was roughly when the Fed was busy implementing their last QE. Also note that I am not saying “raise rates,” since raising rates is an effect of withdrawing reserves and it is the withdrawal of reserves, not the raising of rates, that matters.
Practically speaking, since growth is slowing, the Fed is now back in a pickle of its own making. Inflation is clearly heading higher; growth is probably heading lower. If the FOMC had a balanced mandate (inflation and employment equal) then they would probably be at a neutral rate right now, so that would argue for tightening. But the FOMC has nothing remotely close to a balanced mandate. Against all evidence that monetary policy can affect inflation but not growth, the Fed is totally biased to act to support growth. The bankers believe that slow growth solves the inflation problem, so they should fight recession and just worry about inflation when growth gets “too hot.” Therefore, I currently do not expect the Fed to tighten in December.
Moreover, this increase in core or median inflation is happening in most major economies (with the notable exception of the UK, where it was nearing 4% in 2011 but has gradually come back to around 1%). This is in contrast to the conventional wisdom being propagated that inflation is falling everywhere. Consider the chart below, which is of core Japanese CPI (with the effect of the one-off tax increase in 2014 smoothed out).
Core inflation in Japan is the highest it has been in more than 17 years. Seventeen years. Tell me again how the BOJ’s money printing is having no effect? It is having no effect on growth, but it is doing what we would expect it to do on inflation.
Eurozone inflation is rising less impressively (see chart), but still rising. But then, the ECB has been less aggressive on monetary policy than either the US or Japan. Still, Europe is not, as the popular press would have you believe, flirting with deflation.
All of these economies are only flirting with deflation if you include energy quotes (these pictures may be worse if we had median CPI rather than core CPI for these economies). Now, energy quotes matter, just as much when they are going down as when they are going up, but it is a separate question whether including energy is at all helpful for predicting future inflation. And the answer is, as the Higgins and Verbrugge point out: no, it really isn’t. We are entering a period with weakening growth and strengthening inflation.
This should be “fun.”
I think it is time to talk a little bit about “anchored inflation expectations.”
Key to a lot of the inflation modeling at the Fed, and in some sterile economics classrooms around the country, is the notion that inflation is partially shaped by the expectations of inflation. Therefore, when people expect inflation to remain down, it tends to remain down. Thus, you often hear Fed officials talk about the importance of inflation expectations being anchored, and that phrase appears often in Federal Reserve statements and minutes.
I have long found it interesting that with as much as the Fed relies on the notion that inflation expectations are anchored, they have no way to accurately measure inflation expectations. Former Fed Chairman Bernanke said in a speech in 2007 that three important questions remain to be addressed about inflation expectations:
- How should the central bank best monitor the public’s inflation expectations?
- How do changes in various measures of inflation expectations feed through to actual pricing behavior?
- What factors affect the level of inflation expectations and the degree to which they are anchored?
According to Bernanke, the staff at the Federal Reserve struggle with even the first of these questions (“while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks”), although this has not deterred them from tackling the second and third questions. Economists use the Hoey survey, the Survey of Professional Forecasters, the Livingston survey, the Michigan survey, and inflation breakevens derived from the TIPS or inflation swaps markets. But all of these suffer from the fundamental problem that what constitutes “inflation” is a difficult question in itself and answering a question about a phenomenon that is hard to quantify viscerally probably causes people to respond to surveys with an answer indicating what they expect the well-known CPI measure to show. I talked about many of these problems in my paper on measuring inflation expectations (“Real-Feel” Inflation: Quantitative Estimation of Inflation Perceptions), but the upshot is that we don’t have a good way to measure expectations.
So, with that as background, consider this fact: next year, some Medicare participants will face a 0% increase in premiums while some Medicare participants will face increases of more than 50%.
I am skeptical of the notion of inflation anchoring. But I am really skeptical if it is the case that different segments of the population see totally different inflation pictures. Which anchor counts, if one large group of people expects 7% inflation and another large group expects 1% inflation?
I would argue that none of those anchors matter, because the whole notion is silly. Let’s think through the mechanism of “inflation anchoring.” So the idea is that when people expect lower inflation, they make decisions that tend to produce lower inflation. What decisions are those? If you expect 1% inflation, but Medicare costs go up 50%, what decision are you going to make that will cause that increase to be closer to your expectations? If eggs go up 25 cents per carton and you were expecting 5 cents…is the idea that no one will buy eggs and so the vendor will have to lower the price? What about his costs? Pretty clearly, the mechanism will have to work on the seller’s side, but since every seller is a buyer except for the original seller of labor, the idea must be that if people expect high inflation they argue for higher wages, which causes prices to rise.
I have put paid to that notion in this space before. It doesn’t make any sense to think that wages lead inflation, for if they did then we would all love inflation because we would always be ahead of it. But we know that’s not how it works – prices rise, and then we get higher wages. And sometimes we don’t.
Let’s try another hypothetical. Suppose the Federal Reserve literally drops $50 trillion, unexpectedly, from helicopters. And suppose that consumers did not change their expectations for inflation because they believed, much like the Fed does, that money doesn’t play a role in causing inflation – in other words, their expectations were “extremely well-anchored.” Does anyone think that the price level wouldn’t change, a lot, in contrast to the expectations of the crowd? (I sometimes wonder if Lewis Carroll’s Red Queen, who “sometimes…believed as many as six impossible things before breakfast,” was a Fed economist.)
The whole idea that inflation expectations matter is an effort to explain why parameterizations of inflation models have a regime break in the early 1990s. That is, you can fit a model to 1970-1992, or to 1994-present, but you need different parameters for almost anything you try in the Keynesian-modeling world. Econometricians know that outcome means that you are missing an explanatory variable somewhere; econometricians also know that a very convenient way to gloss over the problem is to introduce a “dummy” variable. In this case, the dummy variable is explained as “inflation expectations became anchored in the early 1990s.”
With all of the problems affecting the notion of expectations-anchoring, I find this solution to the modeling problem deeply unsatisfying. I do not believe that inflation expectations anchor for everybody collectively, but that different groups of people have different (and widely different) anchors. And I don’t think that these anchors themselves play much of a role at all in causing a certain level of inflation. There are better models, simpler models, which do not require you to believe six impossible things.
Unfortunately, they do require you to believe in monetarism. And to some people, that is a seventh impossible thing.
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. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.
- core CPI +0.21%, higher than expected. y/y core to 1.89%.
- core services up to 2.7%; core goods remains at -0.5%
- The rise in core CPI #inflation is no surprise to anyone watching Median. But a surprise to many apparently.
- Owners’ Equiv (3.09% from 3.02%), Primary Rent (3.71% v 3.62%), Lodging Away from Home (1.94% v 1.69%).
- Overall housing 2.12% vs 2.02% last month. All in keeping with established trends and unsurprising; this has further to go.
- Medical Care approx unch (2.45% y/y); Recreation unch (0.64%); Apparel down slightly.
- within Medical, medical drugs decelerated to 2.9% from 3.5%, but professional services and health insurance counteracted that.
- Core #inflation ex-housing up to 1% vs 0.9%. That’s low but highest it has been since last July.
- Worth pointing out: derivatives markets are pricing core CPI to be below 1.5%, compounded, for 8yrs. It’s above that now.
- …and implied core for the next year is below zero (even after today’s rally so far). Core deflation is not happening.
- US (headline) #Inflation mkt pricing: 2015 0.5%;2016 1.3%;then 1.6%, 1.7%, 1.7%, 1.8%, 2.0%, 2.1%, 2.2%, 2.3%, & 2025:2.3%.
- So Fed, what do you believe? the market or your own lying eyes? They’re focused on headline now so their deflation worries persist.
- This is a fun chart. Note that about half of the weight of CPI is inflating >3%. But 12% is deflating.
- That’s why median matters.
- Warning: Back of the envelope on Median CPI suggests chance of +0.3%; would imply Median would go to post-crisis high near 2.5%.
- My back-of-the-envelope lacks seasonal adjustment for regional housing indices but it has been pretty close recently.
- Cleveland Median CPI +0.3%, +2.5% y/y. QED.
- inflation is now officially higher than it has been since 2009, on the way down.
- And Fed to continue to do nothing about it.
- Median CPI thru this month. In line with what we have been forecasting. Any questions?
At 2.5%, median inflation is not only at or above the equivalent level on core PCE, given historical spreads, but also is clearly rising as the chart above shows. However, this Fed believes very strongly that inflation cannot go up if the economy is slowing, despite generations’ worth of counterevidence (the 1970s, anyone?). The economy does seem to be slowing, not just domestically but globally. Therefore, whether the Fed thinks Median CPI is relevant or not, they will continue to focus on headline inflation numbers that flirt with deflation because of the drastic decline in energy quotes. If they talk about the central tendency of inflation, they will talk about core PCE (and ignore the question of whether the slowdown in medical care which shows up there is illusory or transitory). If pressed, they may mention core CPI, which is still below target because of the “tail” categories.
You will not hear them talk about Median CPI at 2.5% and rising.
Inflation is headed higher. How much higher, and how quickly, depends on several factors such as how quickly the Fed raises rates (I have already said this is unlikely, but note that I think raising rates would initially accelerate inflation) and whether bank lending slows for reasons unrelated to monetary policy. But the sign is clear. Inflation is headed higher.
This will be a brief but hopefully helpful column. For some time, I have been explaining that the new Fed operating framework for monetary policy, in which the FOMC essentially steers interest rates higher by fiat rather than in the traditional method (by managing the supply of funds and therefore the resulting pressure on reserves), is a really bad idea. But in responding to a reader’s post I inadvertently hit on an explanation that may be clearer for some people than my analogy of a doctor manipulating his thermometer to give the right reading from the patient.
Right now, there is a tremendous surplus of reserves above what banks are required to hold or desire to hold. With free markets, this would result in a Fed funds interest rate of zero, or even lower under some circumstances, with a substantial remaining surplus. In this case, the Fed funds effective rate has tended to be in the 10-20bps range since the Fed started paying interest on excess reserves (IOER).
So what happens when there is a floor price established above the market-clearing price? Economics 101 tells us that this results in surplus, with less exchange and higher prices than at equilibrium. Consider a farm-price support program where the government establishes a minimum price for cheese (as it has, actually, in the past). If that price is below the natural market-clearing price, then the floor has no effect. But if the price is above the natural market-clearing price, as in the chart below where the minimum cheese price is set at a, then in the market we will see a quantity of cheese traded equal to b, at a price of a.
But what also happens is that producers respond to the higher price by producing more cheese, which is why the supply curve has the shape it does. In order to keep this excess cheese from pushing market prices lower, the government ends up buying c-b cheese at some expense that ends up being a transfer from government to farmers. It can amount to a lot of cheese. This is the legacy of farm price supports: vast warehouses of products that the government owns but cannot distribute, because to distribute them would push prices lower. So the government ends up distributing them to people who wouldn’t otherwise buy cheese, at a zero price. And eventually, we get the Wikipedia entry “government cheese.” https://en.wikipedia.org/wiki/Government_cheese
Now, this is precisely what has happened with the artificial price support for overnight interest rates. Whatever the clearing interest rate is with the current level of reserves, it is lower than the 0.25% IOER (and we know this, among other ways, because there are excess reserves. If the price floating to the actual clearing price, then there would be no excess reserves, although the mechanism for this result is admittedly more confusing than it is for cheese). So the Federal Reserve is forced to “buy up the surplus reserves” by paying interest on these reserves; this amounts to a transfer from the government to banks, rather than to farmers in the cheese example.
You should realize too that setting the floor rate higher than the market-clearing rate artificially reduces the volume of trade in reserves. The chart below, which comes from this article on the New York Fed’s blog, illustrates this nicely.
Creating such a floor also causes the supply of excess reserves themselves to increase beyond what it would otherwise be. This confusing result derives because while the Fed supplies the total reserves number to the market, banks can choose to create more “excess” reserves by doing less lending, or can create fewer excess reserves by doing more lending. Of course, banks aren’t deciding to create excess reserves per se; they are deciding whether it is more advantageous to make a loan or to earn risk-free money on the excess reserves. A higher floor rate implies less lending, all else equal – and, as I have said in the past, this means the Fed could cause a huge increase in bank lending by setting IOER at a penalty rate. This would create the conditions necessary for these lines to cross in negative nominal interest rate territory, with much higher volumes of credit and much lower levels of excess reserves being the result.
In this environment, and as recognized by the Sack-Gagnon framework that is now the presumed operating framework for Fed policy, raising IOER is the only way to change the overnight interest rates unless the Desk undertakes to shift the entire supply curve heavily to the left, by draining trillions in reserves. But raising IOER, just like raising the floor price of cheese, will create more imbalances: bigger excess reserves, less lending, and a bigger transfer from government to banks.
(Note: this is subtly different from what I have said before, which is that raising IOER will have no effect on the growth rate of the transactional money supply. Depending on the shape of the supply curve, it will reduce lending which in turn may reduce the growth rate of the monetary aggregates that we care about, such as M2. My suspicion is that the supply curve is in fact pretty steep, meaning that banks are relatively insensitive to small changes in rates, and thus loans and hence the monetary aggregates won’t see much change in the rate of growth – or, more likely, any change will be the result of other effects beyond this one such as the effect of general economic prospects on the quality of credits and the demand for loans).
Price supports, as any economist can tell you, are an inefficient way to subsidize an industry. And in fact, I don’t think the Fed is really interested in subsidizing banks at this stage in the cycle: they seem to be doing just fine. But they are taking on all of these imbalances, creating all of this government cheese, because they believe the effects I talk about parenthetically above are quite large, rather than vanishingly small as I believe. And the ancillary effect, by raising interest rates, is to spur money velocity – an unmitigated negative in this environment, as it will push inflation higher.
Now, all of this discussion may be moot since the current betting is that the Fed won’t raise interest rates any time soon. But it is good to understand this mechanism as clearly as we can, so that we can prepare ourselves for those effects when they occur.
 It is really hard to say how low interest rates would go, and/or how much surplus would remain, because we have no idea at all what the supply and demand curves for funds look like at sub-zero rates. Most likely there is a discontinuity at a zero rate, but how much of one and the elasticities of supply and demand below zero are likely to be “weird.”
 In fact, in high school I won an economics prize for my paper “That’s a Lotta Cheese.” No joke.
The Employment Report on Friday was bad – but it wasn’t the unmitigated disaster that the consensus seems to have spun it into. It is true that there were no bright spots. It is true that the net number of new jobs added was worse than consensus and indeed worse than some of the more pessimistic expectations. But 142k new jobs is not a recessionary collapse (yet). Let us remember that one or two months every year fall below that figure (see chart, source Bloomberg).
Folks, it’s just not a robust recovery and never has been. It has been slow and steady, and now it is probably petering out, but…let’s not jump off the buildings just yet. In fact, one of my favorite indicators during this period while the Unemployment Rate has been falling but the general perception of the employment picture has been poor has been the “Not in labor force, want a job now” series, which shows people who are discouraged enough to not be looking for work, but would take a job if it was offered. As the chart below shows, that number is far above the lows from the last couple of expansions, and so has been a good check on the improvement in the Unemployment Rate. Now, however, we must also recognize that it is near the recent lows.
So not all of the “job market internals” are flashing red. True, none of them are exactly flashing green, either! Nor have they really ever been, in this cycle.
At the same time, it is incredible to me that the ex-Chairman of the Fed is taking a victory lap, claiming in the Wall Street Journal today that his policies led to a non-inflationary decline in the unemployment rate. Surely a professional economist ought to know the difference between correlation and causality. It is absolute madness to claim that the Fed’s policies did nothing for the price level but had a huge effect on the real economy. That is almost exactly opposite of what generations of monetary policy experience teaches us: that monetary policy has almost no effect on real variables but only affects the price level. A more thorough retort will be given in “What’s Wrong with Money?”, which you can pre-order now! (If you prefer, send a note to WWWM@enduringinvestments.com and I will email you when it is published).
The unemployment rate declined for two reasons: the first is that just as no tree grows to the sky, no hole is bottomless. Eventually, even without any intervention at all, the business cycle takes over and recessions end. The second reason in this case is that the federal government ran (and continues to run) massive fiscal deficits, which demonstrably affect near-term growth. Yes, those deficits merely rearrange growth, stealing growth from the future to improve growth today, but if current growth is given by Y=C+I+G+(X-M) there is no way that the Fed can claim what is the biggest contribution over the last few years, percentage-wise. Madness, I say.
Is the economy headed for recession? In all likelihood, yes. But this employment number was not the first nor even the best sign of that possibility.
So now we have all noticed that the Fed eschewed tightening a week and a half ago, and we have digested all of the analysis of the “negative dots” which indicate some member of the Fed projected not just unchanged rates but actually negative rates.
(Incidentally, here is a good article in The Telegraph about Sweden’s negative rate regime. One of the observations worth pondering is that in a cashless society, there is no zero-percent floor on interest rates: normally, rates below zero percent shouldn’t be possible since someone can always earn zero percent by holding cash. Unless there is no cash. That is simultaneously a deep thought and a terrifying thought – if there is no cash, and all of your money is in electronic deposits at financial institutions, then there is no limit to how much you can be robbed of – or in popular financial parlance, no limit to the “financial repression” that can be visited upon you.)
And we have read all of the analysis of Yellen’s coughing spell after she appeared to express a desire to tighten in 2015 anyway, as long as it is later, and as long as – well, you know, as long as things work out. The NY Fed’s Dudley today echoed Dr. Yellen; but Chicago Fed President Evans (father of the eponymous rule) opined that further delay is acceptable and desirable.
In other words, we are just exactly where we usually are. It depends. One of the great imponderables, of course, is “on what does it depend?”
For what it is worth, which to be sure isn’t much, I think the Fed is terrified about that first step. If the Fed tightened and the world didn’t end (and indeed, I don’t think it would end; or, alternatively, judging from the stock market’s behavior recently it may already be ended before that), then I think they would tighten again…and again, and again. And I think they would keep tightening until markets cracked and/or the economy swooned, whereupon they would begin a panicky easing campaign. That is, after all, the record of the last three decades or so.
This is just my opinion, of course (and this is a good place to remind readers both new and old that I endeavor to raise the right issues, and don’t care as much about whether I have the right answers), but I believe if the Fed met today they wouldn’t tighten rates. This isn’t terribly shocking, since we are only eleven days removed from when the Fed last skipped such a step, but the salient point is that nothing about time passing should change the decision. Unless the economy displays more strength, which I doubt it will, or the FOMC abruptly decides to focus on better measures of inflation like Median CPI, which I doubt it will, there is no reason for the Fed to tighten in 2015 just because it happens to be 2015. Ergo, I don’t think the Fed will tighten in 2015.
That being said, I think they will continue to talk about tightening until a short time before they decide to ease. The hurdle to ease may be higher than it was for QE3, but it is still much lower than the hurdle for tightening. But they will talk like hawks because for some reason the Federal Reserve believes that talking about tightening gives them credibility.
Now, there is no reason to actually do any more QE. If the Fed wanted some more stimulus, then the right approach is to do what the “negative dots” imply, and that is to lower the interest paid on excess reserves to a penalty rate. I want to point out that I first wrote about this in 2010 in an article entitled “Being Negative Might Be A Positive.” So it isn’t a new idea. Do I think the Fed will lower IOER to a negative rate? Not really, but either this or another round of QE is likely if the Fed becomes convinced that the economy is turning south. Historically-speaking, of course, the Fed tends to arrive fairly late to that conclusion so I don’t expect QE very soon!
I will give the Fed this much. Although they have historically been lousy forecasters, I think that at least a few of them may be dovish at this moment not just because they are always dovish, but because they believe there is a legitimate reason right now to be dovish. That is, they are afraid that the recent global retreat in equities is not merely a correction from lofty multiples – it is that, at least, of course – but signs of something more fundamentally amiss. Heck, a member of the FOMC suggested in the most-recent “dot plot” that negative policy interest rates may be appropriate this year and next year!
Probably, China scares them quite a bit; I am not sure it should because I think China’s impact is generally exaggerated in terms of its effect on the US, given the relatively small amount of trade that we do with China, but it is reasonable to be concerned about that large economy right now.
The recent plunge in domestic manufacturing indices may also be disconcerting. While many of these are relative indices (are conditions better or worse than they were last month?) rather than absolute indices (how are conditions now, compared to what they were in some fixed base period?), it is difficult to ignore that today the Richmond Fed index dropped to -5 from 0, when +2 was expected, which puts it at the lowest level in a couple of years. Actually, the Richmond Fed Index alone would be quite easy to ignore, but last week’s surprise in Empire Manufacturing (-14.67, versus expectations for a bounce to -0.50) made back-to-back months that were the worst since 2009; the Philly Fed Index fell to -6 when +6 was expected (and -6 is the lowest level since 2012); and both Capacity Utilization and the Michigan Sentiment index have continued their decline from highs set late last year.
At some point, even if these are all small fry, one begins to sense a pattern. Even if one has a Ph.D. in economics and works at the Fed!
So I will give the Fed credit, or perhaps I ought to say the benefit of the doubt, that they are delaying tightening because they perceive weakness on the horizon. I believe that they are likely correct in that. In my view, this does not mean the Fed ought not to tighten but merely means they are so far overdue that they completely missed the opportunity to normalize policy during the expansion and now face another recession with no bullets. Policy still needs to be normalized, but in this case that perhaps means returning rates not to the mid-expansion norm but the recession norm (say, 3% on Fed funds rather than 5% on Fed funds). However, I will give them credit at least for recognizing at last that they are in a box. I wonder how long it will take them to understand that the box is of their own making; that the Fed ought long ago to have led the world’s central banks in raising rates rather than pursuing more and bigger QE to do what monetary policy cannot do well, if at all: buoy real variables.
And I will give credit to Governor Bullard, who is not always perhaps the sharpest knife in the drawer (why is it that whenever I give credit to the Fed it doesn’t sound like a good thing?) but was spot-on when he dissed Jim Cramer on CNBC on Monday. Not that Jim Cramer is the only cheerleader for permanent easing to permanently support equities, but he certainly is a standard-bearer. Bullard said:
“I’ve got a message for your friend Jim Cramer. The Fed cannot permanently raise stock prices. The idea that the Fed is going one way or the other, and this is what’s driving the stock market, is not true. He’s one of the great people at looking at businesses, how good is this business, what’s the profitability of the business, what’s this thing worth? And to have him cheerleading for lower rates 24-hours a day is, I think, unsavory.”
A the least, I can empathize with the Fed’s dilemma. They have missed a whole cycle by over-easing the last time around. Okay, that was all in the past. “Mistakes were made.” So now what? What does the Fed do with growth evidently slowing, but inflation at the target and employment below the target?
What they should do, probably, is tighten with all due haste, but as I said above tighten to what is still an easy policy. The problem, as I have pointed out before, is that (a) this will cause a further acceleration in inflation, by tending to raise money velocity without a corresponding decline in money growth, and (b) there isn’t a chance of them actually doing that. At this point, they may be stuck. Ray Dalio may be right. More QE…more disastrous QE…may be the next step. But let us hope that, having tried and failed by doing too much, our central bankers might attempt to succeed by doing as little as possible.
Administrative Note: For those who missed my appearance on Bloomberg TV’s “What’d You Miss” program last Wednesday, here is a link to my segment: http://bloom.bg/1Jo7DDb Hope you enjoy!