Pension Fund Perils: Why Conventional Pairing of LDI with De-risking Glide Paths Produces Inferior Outcomes
Combined use of traditional Liability Driven Investment (LDI) and funded status responsive de-risking strategies should be decoupled or rebuilt. Embedded inconsistencies in the treatment of risks in these two elements of what has become a popular pension strategy cause irreconcilable conflicts in their execution and imperils the positive pension fund outcome.
This article provides a critique of the combined LDI / De-risking Glide Path strategy as currently implemented by many pension plan managers and also provides an example of an alternative solution that better improves pension plan outcomes.
Approaches to pension risk management have passed though many phases over the past 40+ years. Higher rate environments of the 1980s made liability immunization programs with treasuries very attractive, but traditional 60/40 or balanced fund strategies persisted as the dominant strategy for pensions. As rates began their secular decline, funding levels continued to deteriorate and while liability-driven investing became popular again in the beginning of the new millennium, significant levels of underfunding prevented most pensions from fully matching their assets and liabilities. A variety of partial risk mitigation solutions began to emerge as the lower rate environment of the past 20 years forced institutional investors to be exposed to higher levels of market risk. New asset classes were introduced into pension plan portfolios in order to achieve higher returns and higher levels of diversification. Adverse market volatility was further reduced through creative solutions that incorporated smart beta and risk allocation strategies that delivered lower-volatility at similar levels of long term return. Other strategies sold liquidity back to the market in order to generate additional return in a low yielding environment. Some risk-based approaches also introduced interest rate derivative overlay programs to extend interest rate duration of total assets along with equity risk reduction programs to reduce equity market risk. Finally, de-risking glide paths – and ultimately liability risk transfer to insurance companies – became in vogue as companies continued to struggle with their asset-liability risk and found it expedient to pay insurance companies to assume the problem for them.
In recent years, much has been written about whether pension funds have sufficient assets to support their liabilities, and clearly the source of much of this angst is that…many of them don’t. One thing that is clear is that after decades of chasing new and creative solutions, the problem of underfunded pension plans is still here and the debate about who should manage the assets, and how they should be managed, continues with ever-increasing urgency.
This article represents our contribution to this debate, with a special focus on the asset allocation requirements for cost effective pension plan de-risking.
Two Shortcomings of Traditional LDI and De-risking Strategies, as Combined
Type of risk
At this point it is important to differentiate the assets that function as liability hedges and those assets that better assist with the process of de-risking as the plan glides towards a fully hedged status. Long duration bonds function as the best hedge for the liabilities, and as the plan’s funded status improves and the de-risking process proceeds, the allocation to bonds increases. While bonds and bond-like derivatives are a core staple of liability-driven investing (LDI) strategies, for most underfunded plans that have a goal of full funding with some help from asset performance it is economically infeasible to allocate 100% of the assets to the liability-matching portfolio. A gradual increase in bond assets over time as funding status increases is part of the de-risking asset allocation process. This is an important distinction between LDI and the process of de-risking. If the liability-matching assets allow the plan to better lock in the current funded status level, then it is only the remaining assets that allow that plan to reach the next funded status threshold in order for the plan to de-risk further. Traditionally, these non-LDI assets are exposed to a significant amount of equity beta, as the long-term expected compensation from taking equity risk is positive. While it is thought to be true that, in the long term, equity beta risk is well compensated, the trouble is that in the shorter time horizon of de-risking process the equity beta is very much dependent on market valuations that are not related to the valuation of the pension liabilities. Therefore, it becomes a tactical rather than a strategic decision to hold equities for a de-risking plan.
While all pension models focus on longer-term horizons, pensions in a de-risking mode have a much lower risk tolerance in the short term. This has caused many pensions to allocate assets to a variety of alternative investments in order to diversify away from equity beta risk. However, this practice also introduces other risks to the plan, some of which are illiquidity, currency, and/or additional credit default risk. So there is an inconsistency: while pension funds are known for taking the very long view when it comes to illiquidity, if the sponsors are pursuing an LDI/de-risking strategy the additional illiquidity is counterintuitive, given the objective to be dynamic and nimble in the de-risking process.
But assuming that potential illiquidity is at least somewhat of a concern to a pension fund manager, then the Hobson’s choice between equity risk or illiquidity likely means that underfunded pension plans that are pursuing joint LDI/de-risking strategies are still carrying too much equity beta risk, or are slowing down the de-risking process while equity risk is mitigated through other less liquid investments, or both. Pension fund managers and their advisors sense this, but tend to reach a type of asset allocation compromise where pension returns may be less optimal and de-risking results are less effective.
So if equity beta isn’t desirable as unrelated to the liability, and illiquidity of many other alternatives make them less-desirable for dynamic rebalancing into LDI assets, what is the most effective way to replace the equity beta for a de-risking plan? What other forms of beta and/or alpha are appropriate in aiding in the process of de-risking? From the standpoint of Markowitz efficient frontier generation, risk is a function of return variance and the covariance of the returns of the eligible portfolio elements. Beyond that, to the optimization routine risk is risk. That is, it doesn’t matter whether the risk comes from beta or from alpha. From the standpoint of the de-risking process, when it comes to the non-LDI assets or return generating assets, alpha is preferred to most beta since alpha is more process-dependent as opposed to market-dependent. In the shorter-term horizon of de-risking, non-LDI beta introduces more risk. So our only choice seems to be some combination of liquid alpha and/or well compensated liquid beta that has some correlation to liabilities. This particular beta may be different from how the liability matching or LDI assets are invested and doesn’t need to match the performance of the liabilities, but should have a positive correlation with liability performance. That’s a tall order.
Some of the more publicized alpha alternatives are hedge funds, private investments in equity or debt of corporations, or real estate. We don’t intend to dive into the merits and disadvantages of these or other alternative investments on a stand-alone basis but will only superficially observe their fit in a de-risking framework. Many hedge funds return as much beta as alpha – indeed, the fact that there are successful hedge-fund replication techniques is virtual proof that many hedge funds are actually beta masquerading as alpha. The obvious visual correlation between hedge fund returns and equity returns, too, should make one suspicious that hedge funds are a pure source of alpha (see Chart, source Bloomberg, comparing the HFRI Fund of Funds Composite Index to the S&P 500).
While those hedge funds or private investments that have a higher correlation to fixed income beta may benefit plans with a long time horizon, they suffer from varying degrees of illiquidity, which impedes the de-rising process as previously discussed.
While there may be other examples for a better alternative, we can provide one strategic example that better fits the combined LDI / de-risking criteria we have discussed in this article.
The Better Alternative
We have addressed above the type of risk that pension funds do not want to have. But it behooves us as well to point out one type of risk that pension funds really ought to have, and yet tend to be underinvested in: inflation exposure, or more accurately real interest rates.
There is a competent literature about the importance of inflation-linked assets to the pension plan. Importantly, inflation-linked assets are relevant even if the pension benefits are not themselves inflation-linked, since for most pension plans the formula which links the work history of active participants to their future retirement benefits implicitly means that pension benefit accruals for a particular employee are higher the more that employee earns. Since wages generally rise at least partly because of inflation, this implies that any pension fund with active participants still accruing benefits does in fact have some inflation exposure.
But the importance of inflation to the pension plan goes beyond that liability-side insight. Additionally, pension assets are exposed to inflation – and, especially, large changes in inflation – because on the asset side the majority of the assets of most plans are invested in equities and nominal fixed-income. Both of these asset classes are terribly exposed to increases in inflation, especially when inflation rises above 3-4%.
We can go still further. While the effects just mentioned are well-established in the literature, one additional benefit from owning inflation-linked assets has not been discussed as far as we can tell, and that is this: the relative value of inflation-linked bonds, compared to nominal bonds, is related to the business cycle and/or level of interest rates level in the same way that corporate spreads are – but without default risk. The chart below (source: Bloomberg data) highlights the connection between credit spreads and 10-year breakevens. This is important because for most pension funds, the relevant interest rate for discounting liabilities is not the risk-free Treasury rate, but a risky corporate rate; therefore, the liability has credit spread risk and an asset that co-moves with credit spreads – especially without actually having credit risk – is valuable.
In our opinion, given a choice between equity beta and inflation/real rate beta, there is no choice: inflation-linked assets are clearly the more valuable risk for a pension fund to own.
Now, pension plans that are pursuing de-risking along with LDI are typically loathe to replace equity risk, given its advantage (over a full cycle, although not necessarily at any given point) in expected return, with real interest rate risk. But inflation-linked markets have an additional benefit, at least in 2017 – they are inefficient, and produce myriad opportunities to generate alpha along with their useful beta. Indeed, we have designed an investment strategy that addresses all of these requirements:
- Historical return commensurate with equity returns, with slightly lower total risk
- Beta from inflation-linked bond markets, which is relevant to pension fund liabilities
- Risk sourced from useful beta, as well as alpha
- Implied credit spread exposure, without actual credit risks, which is relevant to pension fund liabilities
- Superior liquidity to “alts” such as real estate, private equity, or hedge funds – which is more consistent with the de-risking mandate
We call this strategy “Enhanced Systematic Real Return.” In a nutshell, this strategy holds the combination of inflation-linked bonds and breakevens that most efficiently adds inflation protection for a given level of interest rates, and adjusts these proportions based on the richness or cheapness of inflation-linked bonds to capture additional alpha.
Magnitude of risk
After determining a different, if not more efficient risk vehicle for the non-LDI assets we now turn to the discussion of how much of this risk should be taken at every point of the glide path. Should the risk allocation to return generating risk assets (i.e non-LDI assets) only depend on the dollars allocated to these investments or should the risk allocation be independent of dollars allocated and vary based on the level of leverage and/or asset composition?
Not All Risk is Bad
As we have already alluded, prudent risk has some place in the management of a pension fund on a glide path. Yet, as with the villain in the black hat, we have been conditioned to look at the word “risk” and recoil. But not all risk is bad. Certainly, with LDI approaches risk is a negative – after all, the goal of LDI is to maximize the funded status (difference between assets and liabilities), subject to a limit on the maximum volatility (risk) of the funded status. In that construction, there is no doubt that risk is bad, or anyway that less risk is better. But risk is not necessarily bad for de-risking.
This seems counter-intuitive. If we are trying to remove risk, doesn’t that imply that risk is bad? Yes – as we just said, risk is bad for the LDI-driven mandate. But the plan that takes less risk has fewer opportunities to reach de-risking thresholds. That is, the more that you de-risk the longer the next increment of de-risking takes. In this context, it is actually helpful to retain more rather than less risk in the non-LDI assets at each de-risking step.
Here is an analogy from basketball: consider the player who constantly heaves up three-point shots. He shoots a lower percentage from beyond the arc, and so the variance of his scoring is quite a bit higher than his variance shooting short jumpers or layups. Let us suppose that on average, he scores the same amount per game whether he shoots three-pointers or short jumpers. In an asset management context, we would say that this is a “non-optimized” shooter. He should aim for the same average scoring with lower volatility, right?
Now let us suppose that in a particular game, this player’s team is down by 18 points in the final quarter. The coach sends the player onto the court. If this coach is from the pension industry, he instructs his shooter to take only safe shots, because that is how he maximizes his Sharpe Ratio. But if this is actually a basketball coach, he orders his player to take as many three-pointers as he can. Why? He does this because in this situation, risk is good. A strategy of only taking safe shots is guaranteed to lose in this context; only a highly-volatile strategy has a chance of working.
In the same way, prudent addition of volatility as the plan is de-risking helps to de-risk a plan that is under water. So we can see that there is a tension here, and one that is routinely ignored in most LDI/de-risking plans: more volatility is helpful for de-risking, but hurtful inasmuch as it departs from the LDI mandate to maximize the return/risk tradeoff for the funded status. This leads to the phenomenon that is common today, of “hurry up and wait.” As we noted previously: the more that a fund has been de-risked, the longer the next increment of de-risking takes. Each reduction of the proportion of return generating assets to total assets significantly increases the average time until the next de-risking point is reached, as the table below, illustrates:
This is problematic. By de-risking, this plan is becoming too conservative as it approaches being fully funded. We can show that the plan reaches a fully-funded status more quickly when it prudently avoids full de-risking. What happens when we allow leverage, and maintain the total portfolio risk even as the bond allocation increases at each trigger? The following table shows the significant result:
Combining the Right Type, and the Right Magnitude, of Risk
When the pension plan pursues a strategy that focuses on risks sourced from alpha and the “right kinds” of beta sources that will tend to match the liability, and de-risks in a way that recognizes that some risk helps the de-risking task, then the combined result can be powerful. The chart below (Source: Enduring Intellectual Properties, Inc) compares this new approach with the “classic” LDI plus de-risking approach. The dashed lines represent the “classic” approach, while the solid lines represent an approach that uses our “Enhanced Systematic Real Return” strategy as a substitute for the equity risk of the traditional strategy. In each case, this imaginary pension fund starts year zero at 60% funded, and liabilities grow with the Bloomberg/Barclays/Lehman U.S. Long Government/Credit Index. Also in each case, the top line represents the 90th percentile outcome of the Monte Carlo simulation; the bottom line represents the 10th percentile, and the middle line represents the median outcome.
There are several facets of this chart worth noting.
Importantly, observe how the median outcome line is linear with our approach, but flattens out with the traditional de-risking approach. This phenomenon is the visual counterpart to Tables 1 and 2; it illustrates how the closer one gets to being fully funded with a traditional glide path, the slower the funded status converges. Our approach, as highlighted in Table 2, is designed to remove that effect. The benefits of that approach aren’t only felt on the median outcome, but are apparent on every path as the funded status moves above 75%.
Also, observe that the superior “good” outcomes aren’t “paid for” by much worse “bad” outcomes. After all, we could have had even better “good” outcomes if we took lots of extra risk. But in that case, the benefit would have come at a price, and we would see it manifesting in much worse “bad” outcomes. The outcomes here are actually skewed to the positive side.
Finally, although you cannot tell this from the illustration, you should know that this simulation assumes that stocks and bonds have expected returns that are somewhere near their historical mean returns. Unfortunately, presently this seems a generous assumption for the traditional approach. It seems more likely that, going forward, pension plans which are invested heavily in equities will be drawing from a distribution with worse-than-average characteristics due to the high starting valuations. Ditto, of course, for fixed-income…but at least bonds affect both sides of the LDI equation.
LDI and de-risking glide paths can be combined under certain conditions, but current implementation practices create inconsistencies in how risks are treated and do not facilitate achievement of strategic goals.
Asset beta risks that do not match liability beta risks are useful only in a tactical setting, and then only if they are associated with exceptional returns (that is, the market is cheap tactically).
More effort is required to search out new sources of liquid alpha and beta that facilitate the de-risking process. We have produced one that we believe is useful in this context.
As the plan de-risks along the glide path, the level of risk in the non-LDI assets should be adjusted to preserve a quantum of variance that is useful in the de-risking process, as opposed to just mechanically adjusting allocation dollars in a simple glide path.
 Milla Krasnopolsky is an investment strategist and investment manager. Milla held previous positions as a Managing Director of Fixed Income Markets and Strategic Solutions at General Motors Asset Management and as a Principal and Senior Investment Consultant at Mercer Investments. Michael Ashton is the Managing Principal of Enduring Investments and CEO of Enduring Intellectual Properties, Inc.
 For the iconic example, see Siegel and Waring, “TIPS, the Dual Duration, and the Pension Plan” (Financial Analysts Journal, September/October 2004).
 Remarkably, the myth that common stocks confer some inflation protection has survived decades of contrary experience, both before and after Zvi Bodie’s classic “Common Stocks as a Hedge Against Inflation” (Journal of Finance, Vol. 31, No. 2, May 1976), in which he concluded forcefully “The regression results…leads to the surprising and somewhat disturbing conclusion that to use common stocks as a hedge against inflation one must sell them short.”
 The 10-year simple “breakeven” is merely the yield difference between the 10-year nominal Treasury yield and the 10-year TIPS real yield; it represents roughly the amount of future inflation at which an investor would be indifferent between the two types of bonds.
 It would be inappropriate to discuss the fine details of this strategy in a thought piece such as this. However, we thought it important to point out that demand for a solution with these characteristics is not hopeless or uninformed. There does exist at least one such solution, and probably others!
 This idea isn’t exactly alien in finance: if you own an out-of-the-money option, a higher implied volatility increases your delta while if you own an in-the-money option, a higher implied volatility decreases your delta. It’s just alien in pension fund management.
 Both Table 1 and Table 2 represent simplified examples where LDI hedging assets and pension liabilities are proxied by the same long-duration bonds, and future pension contributions are excluded from the analysis.
 Table is based on a Monte Carlo simulation of a pension fund that begins with the indicated funding status and allocated as shown until it reaches the next de-risking trigger. Returns for stocks and bonds are simulated; the correlation from the last five years is used. The importance of the table isn’t derived from the precision of the assumptions, but from the illustration of the increased difficulty in reaching the next de-risking increment when the fund is already de-risked substantially.
One of the problems that inflation folks have is that the historical data series for many of the assets we use in our craft are fairly short, low-quality, or difficult to obtain. Anything in real estate is difficult: farmland, timber, commercial real estate. Even many commodities futures only go back to the early 1980s. But the really frustrating absence is the lack of a good history of real interest rates (interest rates on inflation-linked bonds). The UK has had inflation-linked bonds since the early 1980s, but the US didn’t launch TIPS until 1997 and most other issuers of ILBs started well after that.
This isn’t just a problem for asset-allocation studies, although it is that. The lack of a good history of real interest rates is problematic to economists and financial theoreticians as well. These practitioners have been forced to use sub-optimal “solutions” instead. One popular method of creating a past history of “real interest rates” is to use a nominal interest rate and adjust it by current inflation. This is obvious nonsense. A 10-year nominal interest rate consists of 10-year real interest rates and 10-year forward inflation expectations. The assumption – usually explicit in studies of this kind – is that “investors assume the next ten years of inflation will be the same as the most-recent year’s inflation.”
We now have plenty of data to prove that isn’t how expectations work – and, not to mention, a complete curve of real interest rates given by TIPS yields – but it is still a popular way for lazy economists to talk about real rates. Here is what the historical record looks like if you take 10-year Treasury rates and deflate them by trailing 1-year inflation:
This is ridiculously implausible volatility for 10-year real rates, and a range that is unreasonable. Sure, nominal rates were very high in the early 1980s, but 10%? And can it be that real rates – the cost of 10-year money, adjusted for forward inflation expectations – were -4.6% in 1980 and +9.6% in 1984? This hypothetical history is clearly so unlikely as to be useless.
In 2000, Jay Shanken and S.P. Kothari wrote a paper called “Asset Allocation with Conventional and Indexed Bonds.” To make this paper possible, they had to back-fill returns from hypothetical inflation-linked bonds. Their method was better than the method mentioned above, but still produced an unreasonably volatile stream. The chart below shows a series, in red, that is derived from their series of hypothetical annual real returns on 5-year inflation-indexed bonds, and backing into the real yields implied by those returns. I have narrowed the historical range to focus better on the range of dates in the Shanken/Kothari paper.
You can see the volatility of the real yield series is much more reasonable, but still produces a very high spike in the early 1980s.
The key to deriving a smarter real yield series lies in this spike in the early 1980s. We need to understand that what drives very high nominal yields, such as we had at that time in the world, is not real yields. Since the real yield is essentially the real cost of money it should not ever be much higher than real potential economic growth. Very high nominal yields are, rather, driven by high inflation expectations. If we look at the UK experience, we can see from bona fide inflation-linked bonds that in the early 1980s real yields were not 10%, but actually under 5% despite those very high nominal yields. Conversely, very low interest rates tend to be caused by very pessimistic real growth outcomes, while inflation expectations behave as if there is some kind of floor.
We at Enduring Investments developed some time ago a model that describes realistically how real yields evolve given nominal yields. We discovered that this model fits not only the UK experience, but every developed country that has inflation-linked bonds. Moreover, it accurately predicted how real yields would behave when nominal yields fell below 2% as they did in 2012…even though yields like that were entirely out-of-sample when we developed the model. I can’t describe the model in great detail because the method is proprietary and is used in some of our investment approaches. But here is a chart of the Enduring Investments real yield series, with the “classic” series in blue and the “Shanken/Kothari” series in red:
This series has a much more reasonable relationship to the interest rate cycle and to nominal interest rates specifically. Incidentally, when I sat down to write this article I hadn’t ever looked at our series calculated that far back before, and hadn’t noticed that it actually fits a sine curve very well. Here is the same series, with a sine wave overlaid. (The wave has a frequency of 38 years and an amplitude of 2.9% – I mention this for the cycle theorists.)
This briefly excited me, but I stress briefly. It’s interesting but merely coincidental. When we extend this back to 1871 (using Shiller data) there is still a cycle but the amplitude is different.
So what is the implication of this chart? There is nothing predictive here; about all that we can (reasonably) say is what we already knew: real yields are not just low, but historically low. (Current 10-year TIPS yields are higher than our model expects them to be, but not by as much as they were earlier this year thanks to a furious rally in breakevens.) Money is historically cheap – again, we knew this – in a way it hasn’t been since the War effort when nominal interest rates were fixed by the Fed even though wartime inflation caused expectations to rise. With real yields that low, how did the war effort get funded? Who in the world lent money at negative real interest rates like banks awash in cash do today?
On Friday, I was on Bloomberg TV’s “What’d You Miss?” program to talk about the PCE inflation report from Friday morning. You can see most of the interview here.
I like the segment – Scarlet Fu, Oliver Renick, and Julie Hyman asked good questions – but we had to compress a fairly technical discussion into only 5 or 6 minutes. As a result, the segment might be a little “wonky” for some people, and I thought it might be helpful to present and expand the discussion here.
The PCE report itself was not surprising. Core PCE came in as-expected, at 1.7%. This is rising, but remains below the Fed’s 2% target for that index. I think it is interesting to look at how PCE differs from CPI to see why PCE remains below 2%. After all, core PCE is the only inflation index that is still below 2% (see chart, source Bloomberg). And, as we will see, this raises other questions about whether PCE is a reasonable target for Fed policy.
There are several differences between CPI and PCE, but the main reasons they differ can be summarized simply: the CPI measures what the consumer buys, out-of-pocket; the PCE measures not only household expenditures but also spending on behalf of consumers, including such things as employer-purchased insurance and some important government expenditures. As pointed out by the BEA on this helpful page, “the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.”
This leads to two major types of differences: weight effects and scope effects.
Weight effects occur because the PCE is a broader index covering more economic activity. Consider housing, which is one of the more steady components of CPI. Primary rents and owners’-equivalent rent constitute together some 32% of the CPI and those two components have been rising at a blended rate of about 3.4% recently. However, the weight of rent-of-shelter in PCE is only 15.5%. This difference accounts for roughly half of the difference between core CPI and core PCE, and is persistent at the moment because of the strength in housing inflation.
However, more intriguing are the “scope” differences. These arise because certain products and services aren’t only bought in different quantities compared to what businesses sell (like in the case of housing), but because the two surveys include and exclude different items in the same categories. So, certain items are said to be “in scope” for CPI but “out of scope” for PCE, and vice-versa. One of the places this is most important is in the category of health care.
Most medical care is not paid for out-of-pocket by the consumer, and therefore is excluded from the CPI. For most people, medical care is paid for by insurance, which insurance is usually at least partly paid for by their employer. Also, the Federal government through Medicare and Medicaid provides a large quantity of medical care goods and services that are different from what consumers buy directly – at least, purchased at different prices than those available to consumers!).
This scope difference is enormously important, and over time accounts for much of the systematic difference between core CPI and core PCE. The chart below (source: BEA, BLS) illustrates that Health Care inflation in the PCE essentially always is lower than Medical Care inflation in the CPI.
Moreover, thanks in part to Obamacare the divergence between the medical care that the government buys and the medical care consumers buy directly has been widening. The following chart shows the spread between the two lines above:
It is important to realize that this is not coincidental, but likely causal. It is because Medicare and other ACA control structures are restraining prices in certain areas (and paid by certain parties) that prices to the consumer are rising more rapidly. Thus, while all of these inflation measures are likely to continue higher, the spread between core CPI and core PCE is probably going to stay wider than normal for a while.
Now we get to the most interesting question of all. Why do we care about PCE in the first place? We care because the Fed uses core PCE as a policy target, rather than the CPI (despite the fact that it has ways to measure market CPI expectations, but no way to measure PCE expectations). They do so because the PCE covers a wider swath of the economy. To the Fed, this means the PCE is more useful as a broader measure.
But hang on! The extra parts that PCE covers are, substantially, in parts of the economy which are not competitive. Medicare-bought prices are determined, at least in the medium-term, by government fiat. The free market does not operate where the government treads in this way. The more-poignant implication is that there is no reason to suspect that these prices would respond to monetary policy! Ergo, it seems crazy to focus on PCE, rather than CPI (or one of the many more-useful flavors of CPI), when setting monetary policy. This is one case where I think the Fed isn’t being malicious; they’re just not being thoughtful enough.
Every “core” inflation indicator, including the ones above (and you can throw in wages and the Employment Cost Index as well!), is at or above the Fed’s target even accounting for the typical spread between the CPI and PCE. Not only that, they are above the target and rising. The Fed is most definitely “behind the curve.” Now, as I have noted before in this space I don’t think there’s anything the Fed can do about it, as raising rates without restraining reserves will only serve to accelerate inflation further since it will not entail a slowing of money supply growth. But it seems to me that, for starters, monetary policymakers should focus on indices that are at least in principle (and in normal times) more responsive to monetary policy!
Recently I’ve been thinking a lot about what might happen in the event of a banking crisis redux. While I’m not very concerned about US banks these days, there is a ‘developing situation’ in China that could well eventually lead to crisis (although the state might prevent outright collapses), and of course ongoing gnashing of teeth over Deutsche Bank’s capital situation if it is fined as heavily as some have suggested they will be.
I am not yet really worried about the banking side of things. But there are plenty of sovereign issuers who are clearly heading down unsustainable paths (not least of these is the US, especially if either of the leading Presidential candidates really implements the high-cost programs they are declaring they will), and when sovereigns tremble it is often banks that bear the direct brunt. After all, you can’t form a line outside of the sovereign to withdraw your money.
But, in a spirit of looking forward to anticipate potential crises, let us pretend we are confronting another banking crisis. The question I often hear next is, “how deflationary would it be to have another crisis when inflation is already low?”
Unpeeling the onion, there are several reasons this doesn’t concern me much. First, inflation is stable or rising in most developed nations. Yes, headline inflation is still sagging due to energy prices, but median inflation is 2.6% in the US and core inflation is 0.8% in Europe and 1.3% in the UK. To be sure, all of those are lower than they were in mid-2008. But remember that in 2009 and 2010, median (or core) inflation never got below 0.5% in the US, 0.8% in Europe, and 2.7% in the UK. Japan of course experienced deflation, but that wasn’t the fault of the crisis – as I’ve pointed out before, Japan has been in long-running deflation due to the BOJ’s inability or unwillingness to grow the money supply.
So, if the worst crisis in 100 years didn’t take core inflation negative – a major, major failure of Keynesian predictions – then I’m not aflutter about it happening this time. Heck, in 2009 and 2010 core inflation wouldn’t even have been as low as it was, had the cause of the crisis not been the bursting of the housing bubble. The chart below (source: Bloomberg) shows the Atlanta Fed’s “sticky” CPI (another way to measure the underlying inflation trend) ex-shelter. Note that in 2010, the low in this measure was about 1.25%…it was actually lower in 2014 and 2015.
But we can go further than that. One reason that inflation decelerated in 2009 and 2010 was because money velocity dropped sharply. As I’ve shown before, and argued in my book, the decline in money velocity was not particularly unusual given the decline in interest rates. That is, if you had known what was going to happen to interest rates, you would have had a very good forecast of money velocity and, hence, core inflation.
Back in 2008, I never dreamed that interest rates would go so low, or stay so low for so long. Few of us did! But the outcome, in the event, was consistent with the monetarist model while being completely inconsistent with the Keynesian model. And here’s the point, when thinking about the next crisis: interest rates are already at incredibly low levels, lower even than the 36-year downtrend channel would have them (see chart, source Bloomberg).
With the wisdom of experience, I would never be so cavalier as to say that interest rates cannot go lower from here! But in 2008, 10-year rates were around 3.80% and they’re 1.60% now (in the US, and lower elsewhere). Real rates were around 2% at the 10-year point; they are at 0% now. It is difficult to imagine how rates can have another dramatic move as they did in 2008-09.
It is important to understand, that is, just why inflation tends to fall in recessions. It is not, as the Keynesians would have it, that a growing “output gap” reduces the pressure on resources and relieves price increases. It is because slack demand for credit causes interest rates to decline, which leads to lower money velocity and hence, lower inflation. If the central bank responds in a timely manner to increase money supply growth by increasing reserves, then inflation doesn’t fall very far. In the last crisis, the Fed and other central banks added enough liquidity to ramp up M2 growth, and that kept the decline in money velocity from causing outright deflation (then, they kept adding reserves for a few more years, which led to the situation we are in now – too many reserves in the system, so that central banks no longer control the marginal dollar that goes into the money supply).
So, in the next crisis I expect central banks will add still more reserves to the pile of excess reserves, which will be meaningless but will make them feel better. Interest rates will decline, but not by as much as they did in the last crisis, and money velocity will fall. So, in a real serious crisis, inflation will decline – however, it will not decline very much.
That is the world we are now living in: higher highs to inflation on each subsequent peak, and higher lows in each subsequent trough. The vicious cycle counterpart to the virtuous cycle we have enjoyed for 35 years. This is true, I think, whether or not we get a crisis or just a garden-variety recession.
I should be clear that I think that such a crisis would be horrible for growth. That is, our current weak growth in global GDP would turn negative again, and possibly even more painful. And times would be truly bad in the stock market. But inflation will not follow, just as it didn’t follow in 2009-2010, and turn into deflation.
Japan is doomed. Again.
A couple of years ago, the Bank of Japan began to pursue QE, with the intention of doubling its money supply. While this is a bad plan for almost every country, it was exactly the right plan for Japan, whose economy had been mired in deflation from 1999 until this policy began (see chart, source Bloomberg).
To a monetarist, it was no surprise that Japan was experiencing deflation. Since the early 1990s, annual money supply growth in Japan has been below 4% (see chart, source Bloomberg). It averaged 2.4% from 1992-2012. (The new policy pushed M2 growth above 4% for the first time since the 1990s, albeit briefly as it turned out).
Remember, the monetarist equation says MV≡PQ. With unchanged money velocity and an economy with, say, a 3% potential growth rate in GDP, a 2.4% growth in M2 should result in deflation. And, in fact, just as in the US lower interest rates in Japan produced lower monetary velocity.
Quantitative easing does nothing to help economic growth, and so QE was the wrong prescription for most of the world after 2010. But if deflation is your disease, QE is your cure and that is Japan’s situation. When the BOJ decided to start QE, money supply growth moved above 4% for the first time in years, and “miraculously” core inflation moved above zero as the first chart above illustrates. (Abstract from the spike over 2%, which was due to a one-time consumption tax effect; but core inflation in Japan was over 1% even excluding that spike). When that happened, I wrote in our Quarterly Inflation Outlook that Japan was no longer the poster child for inept central banking; that award had been moved to the European Central Bank.
Unfortunately, even though QE did exactly what it was supposed to do, to Japanese policymakers it seemed to have failed because their intention had been to raise real growth. So, since the hammer they were using did not function very well as a saw, they discarded the tool.
Japan’s problems with growth are structural. There’s not a lot that can be done, and nothing that can be done in the short run and with monetary policy, about the demographic train wreck they are experiencing. But the problem with inflation was, and is, fixable. But only if the Bank of Japan does QE, and a lot of it, and keeps doing it. As they shifted from straight QE to targeting negative interest rates, money supply growth began to ebb (now back to 3.3% y/y) and inflation began to roll over (now 0.3% ex-food-and-energy). Indeed, with lower rates the BOJ is making it worse by helping to push money velocity even lower.
There had been hope that the BOJ might abandon the NIRP experiment, which was clearly not working by every metric you can use to measure it, and go back to the policy that had been working at least with respect to the fixable problem. But instead, last night the Bank of Japan “shifted the policy framework” to targeting the yield curve. According to the Bloomberg story, the Bank is moving away from a “rigid target for expanding the money supply, while seeking to control bond yields across different maturities.”
So money? The heck with that. We just want to make sure that prices are at the “right” levels. Clearly, the BOJ thinks the market is totally failing when it comes to setting the interest rate correctly (to be fair, all central banks seem to now view interest rates as a tool rather than an indicator, as they used to), and so it is assuming control of that job. Clearly, only the wise policymakers at the BOJ can divine the right level for interest rates: the one which leads to great growth and moderate inflation for the country. Sure.
Japan had a chance. Whether by design or pure chance, they had stumbled on the policy that was able to banish the deflation that had plagued them, and perverted decision-making, for two decades. But because they are pursuing a pot of gold at the end of the rainbow – growth springing from monetary policy in the same way that you can plant olive trees and harvest carrots – they abandoned the working policy to pursue one that has no chance of success.
Japan is back in its comfort zone: the developed world’s basket case. Congratulations to the Bank of Japan.
I haven’t written an article for a couple of weeks. This is not entirely unusual: I have written this commentary, in some form, since about 1996 and there are occasional breaks in the series. It happens for several reasons. Sometimes it is simple ennui, as writing an analysis/opinion article for twenty years can occasionally get boring especially when markets are listless as they frequently are in August. Other times, it is because work – the real work, the stuff we get paid for – is too consuming and I have not time or energy left to write a few hundred words of readable prose. Maybe that’s part of the reason here, since the number of inflation-investing-related inquiries has definitely increased recently, along with some new client flows (and not to mention that we are raising capital for Enduring Investments through a 506(c) offering – you can find details on Crowdfunder or contact me through our website). Finally, in recent years as the ability to track the number of clicks/eyeballs on my writing has improved, I’ve simply written less during those times…such as August…when I know that not many people will read the writing.
But this time is a little different. While some of those excuses apply in some measure, I’ve actually skipped writing over the last two weeks because there is too much to say. (Fortunately, I said some of it on two Bloomberg TV appearances, which you can see here and here.)
Well, my list of notes is not going to go away on its own so I am going to have to tackle some of them or throw them away. Unfortunately, a lot of them have to do with the inane nattering coming out of Federal Reserve mouthpieces. Let’s start today with the publication that gathered a lot of ink a couple of weeks ago: San Francisco Fed President John Williams’ FRBSF Economic Letter called “Monetary Policy in a Low R-star World.”
The conclusion that Williams reached was sensational, especially since it resonates with the “low return world” meme. Williams concluded that “The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest.” This article was grating from the first paragraph, where Williams casts the Federal Reserve as the explorer/hero:
“As nature abhors a vacuum, so monetary policy abhors stasis. Instead of being a rigid set of precepts, it follows the adage, that which survives is that which is most adaptive to change… In the wake of the global financial crisis, monetary policy has continued to evolve… As we move forward, economic conditions require that central banks and governments throughout the world carefully reexamine their policy frameworks and consider further adjustments in terms of monetary policy strategy—both in its own right and as it relates to other policy arenas—to successfully navigate these new seas.”
One might give the Federal Reserve more credit if subsequent evolutions of policy prescriptions were not getting progressively worse rather than better. Constructive change first requires critical evaluation of the shortcomings of current policy, doesn’t it?
Williams carries on to argue that the natural rate of interest (R-star) is lower now than it has been in the past. Now, Fed watchers should note that if true, this implies that current monetary policy is not as loose as has been believed. This is a useful conclusion for the Fed, since it would explain – within their existing model framework – why exceptionally low rates have not triggered better growth; it also would allow the Fed to raise rates more slowly than otherwise. I’ve pointed out before the frustrating tendency of groupthinking economists to attribute persistent poor model predictions to calibration issues rather than specification issues. This is exactly what Williams is doing. He’s saying “there’s nothing wrong with our model! If we had simply known that the natural rate was lower, we would have understood that we weren’t as stimulative as we thought.” Possible, but it might also be that the whole model sucks, and that the monetarists are right when they say that monetary policy doesn’t move real variables very well. That’s a hypothesis that at least bears examining, but I haven’t seen any fancy Fed papers on it.
What is really remarkable is that the rest of the paper is largely circular, and yet no one seems to mind. Williams attributes the current low r-star to several factors, including “a more general global savings glut.” Note that his estimates of r-star take a sharp turn lower in 2008-9 (see chart below, source FRBSF Economic Letter, figure 1).
Wow, I wonder what could have caused an increase in the global savings glut starting in 2008? Could it be because the world’s central banks persistently added far more liquidity than was needed for the proper functioning of the economy, leading to huge excess reserves – aka a savings glut?
So, according to Williams, the neutral interest rate is lower at least in part because…central banks added a lot of liquidity. Kind of circular, ain’t it?
Since according to Williams this fact explains “uncomfortably low inflation and growth despite very low interest rates,” it must mean he is bravely taking responsibility – since, after all, quantitative easing caused the global savings glut which, in his construct, caused low growth and inflation. Except that I don’t think that’s what he wants us to conclude.
This isn’t research – it’s a recognition that what they did didn’t work, so they are backfilling to try and find an excuse for why their theories are still good. To the Fed, it is just that something happened they didn’t realize and take account of. Williams wants to be able to claim “see, we didn’t get growth because we weren’t as stimulative as we thought we were,” because then they can use their old theories to explain how moving rates around is really important…even though it didn’t work this time. But the problem is that low rates don’t cause growth. The model is wrong. And no amount of calibration can fix a mis-specified model.
It is rare that I write early on a Monday morning, but today there is this. A story on Bloomberg highlighted the pressure that the IMF is putting on Japan to institute an “incomes policy” designed to nudge (and force, if necessary) companies to increase wages. IMF mission chief for Japan told reporters a couple of weeks ago that “we need policies to support wage increases in Japan;” the Bloomberg article also names a former IMF chief economist and the current president of the Peterson Institute for International Economics as proposing an immediate boost of salaries of 5-10% for unionized workers.
It is truly appalling that global economic policymakers are essentially illiterate when it comes to economic history. The IMF suggestion to institute wage hikes as part of triggering inflation is not a question of misunderstanding macroeconomic models (although it manages to do this as well, since wages follow prices and thus increasing wages won’t cause inflation unless other conditions obtain). At some level, it is a question of ignorance of history. After the stock market crash in 1929, President Hoover persuaded major industrial firms (such as GM, U.S. Steel, and the like) to hold wages constant or raise them. Since prices were falling generally, this had the effect of raising the real cost of production, which of course worsened the subsequent Depression. According to one analysis, this single decision caused GDP loss in the Great Depression to be triple what it otherwise would have been if wages were allowed to adjust (because, again, wages follow prices and are the main mechanism by which a surplus or shortage of labor is cleared). It wasn’t just Hoover, of course: later, FDR established the National Recovery Administration to administer codes of “fair competition” for every industry that established minimum wages and prices. The NRA was struck down in large part by the Supreme Court, but the notion of arresting deflation by adjusting wages was quickly reintroduced in the National Labor Relations Act of 1935.
There is wide agreement, although I am sure it is not universal, that preventing markets from adjusting is a big part of what made the Great Depression so Great. And this isn’t theory…it’s history. There is no excuse, other than ignorance, for policymakers to whiff on this one.
Deflation can be bad, but it doesn’t need to come with massive unemployment. In Japan, it has not: the unemployment rate is 3.1%, the lowest it has been since 1995. But push wages higher artificially, and Japan can have the massive unemployment as well. Thanks, IMF.