Archive for the ‘Theory’ Category

Fed Nonsense and Error Bars

February 5, 2016 Leave a comment

Today’s news was the Employment number. I am not going to talk a lot about the number, since the January jobs number is one of those releases where the seasonal adjustments totally swamp the actual data, and so it has even wider-than-normal error bars. I will discuss error bars more in a moment, but first here is something I do want to point out about the Employment figure. Average Hourly Earnings are now clearly rising. The latest year-on-year number was 2.5%, well above consensus estimates, and last month’s release was revised to 2.7%. So now, the chart of wage growth looks like this.


Of course, I always point out that wages follow inflation, rather than leading it, but since so many people obsess about the wrong inflation metric this may not be readily apparent. But here is Average Hourly Earnings, y/y, versus Median CPI. I have shown this chart before.


The salient point is that whether you are looking at core CPI or PCE or Median CPI, and whether you think wages lead prices or follow prices, this number significantly increases the odds that the Fed raises rates again. Yes, there are lots of reasons the Fed’s intended multi-year tightening campaign is unlikely to unfold, and I am one of those who think that they may already be regretting the first one. But a number like this will tend to convince the hawks among them otherwise.

Speaking of the Fed, last night I attended a speech by Cleveland Fed President Loretta Mester, sponsored by Market News International. Every time I hear a Fed speaker speak, afterwards I want to put my head into a vise to squeeze all of the nonsense out – and last night was no different. Now, Dr. Mester is a classically-trained, highly-accomplished economist with a Ph.D. from Princeton, but I don’t hold that against her. Indeed, credit where credit is due: unlike many such speakers I have heard in the past, Dr. Mester seemed to put more error bars around some of her answers and, in one of the best exchanges, she observed that we won’t really know whether the QE tool is worth keeping in the toolkit until after monetary conditions have returned to normal. That’s unusual; most Fed speakers have long been declaring victory. She is certainly a fan and an advocate of QE, but at least recognizes that the chapter on QE cannot yet be written (although I make what I think is a fair attempt at such a chapter in my book, due out in a month or so).

But the problem with the Federal Reserve boils down to two things. First, like any large institution there is massive groupthink going on. There is little true and significant diversity of opinion. For example there are, for all intents and purposes, no true monetarists left at the Fed who have any voice. Daniel Thornton at the St. Louis Fed was the last one who ever published pieces expressing the important role of money in monetary policy, and he retired a little while back. As another example, it is taken as a given that “transparency” is a good thing, despite the fact that many of the questions posed last night to Dr. Mester boiled down to problems that are actually due to too much transparency. I doubt seriously whether there has ever been a formal discussion, internally, of the connection between increased financial leverage and increased Fed transparency. Many of the problems with “too big to fail” institutions boil down to too much leverage, and a transparent Fed that carefully telegraphs its intentions will tend to increase investor confidence in outcomes and, hence, tend to increase leverage. But I cannot imagine that anyone at the Fed has ever seriously raised the question whether they should be giving less, rather than more, information to the market. It is significantly outside of chapter-and-verse.

The second problem is that the denizens of the Fed overestimate their knowledge and their ability  to know certain things that may simply not be knowable. Again, Dr. Mester was a mild exception to this – but very mild. When someone says “We think the overnight rate should normalize more slowly than implied by the Taylor Rule,” but then doesn’t follow that up with an explanation of why you think so, I grow wary. Because economics in the real world, practiced honestly, should produce a lot of “I don’t know” answers. It may be boring, but this is how the question-and-answer with Dr. Mester should have gone:

Q: What do you think inflation will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think short rates will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think the Unemployment Rate will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think the Unemployment Rate will do in 2017?

A: I don’t know. I can tell you my point estimate, but it has really, really wide error bars.

Q: What do you think the consensus is at the Fed about the optimal pace of raising rates?

A: I don’t know. Each person on the Committee has a point estimate, each of which has really wide error bars. Collectively, we have an average that has even wider error bars. We cannot therefore usefully characterize what the path of the short rate will look like. At all.

Indeed, this is part of the problem with transparency. If you are going to be transparent, there is going to be pressure to provide “answers.” But a forecast without an error bar is just a guess. The error bars are what cause a guess to become an estimate. So we get a “dot plot” with a bunch of guesses on it. The actual dot plot, from December, looks like this:


But the dot plot should look more like this, where the error bars are all included.

betterdotplotObviously, we would take the latter chart as meaning…correctly…that the Fed really has very little idea of where the funds rate is going to be in a couple of years and cannot convincingly reject the hypothesis that rates will be basically unchanged from here. That’s simultaneously transparent, and very informational, and colossally unhelpful to fast-twitch traders.

And now I can release the vise on my head. Thank you for letting me get the nonsense out.

Why So Negative?

February 2, 2016 2 comments

The news on Friday that the Bank of Japan had joined the ECB in pushing policy rates negative was absorbed with brilliant enthusiasm on Wall Street. At least, much of the attribution for the exceptional rally was given to the BoJ’s move. I find it implausible, arguably silly, to think that a marginal change in monetary policy by a desperate central bank on the other side of the world – however unexpected – would have a massive effect on US stocks. Subsequent trading, which has reversed almost all of that ebullience in two days, suggests that other investors also may agree that just maybe the sorry state of earnings growth rates in this country, combined with a poor economic outlook and still-lofty valuations, should matter more than Kuroda’s gambit.

To be sure, this is a refrain that Ben Bernanke (remember him? Of helicopter infamy?) was singing last month, before the Federal Reserve hiked rates impotently, and clearly the Fed is investigating whether negative rates is a “tool” they should add to their oh-so-expansive toolbox for fighting deflation.

Scratch that. The Fed no longer needs to fight deflation; inflation is at 2.4% and rising. The toolbox the Fed is interested in adding to is the one that contains the tools for goosing growth. That toolbox, judging from historical success rates, is virtually empty. And always has been.

Back to Japan: let me point out that if the BOJ goal has been to extinguish deflation, it has already done so. The chart below (source: Bloomberg) shows core inflation in Japan for the last 20 years or so. Abstracting from the sales-tax-related spike, core inflation has risen fairly steadily from -1.5% to near 1.0% since mid-2010.


They did this, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015 (see chart, source: Bloomberg).


Not rocket science, folks. Monetary science.

Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that and wants to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was exactly the wrong thing to do. The regression below (source: Bloomberg) illustrates in a different way what I have shown here before: interest rates and money velocity are closely tied (as Friedman explained decades ago). The r-squared of this relationship – assuming that functionally a linear fit is appropriate, which I am not sure of – is a heady 0.822.


You may notice the data is from the US; that’s because Bloomberg doesn’t have a good velocity series for Japan’s M2 but the causal relationship is the same: lower term interest rates imply less reason not to hold cash.

Now, it may be the case that this relationship ceases to apply at negative rates even though the idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as if investment opportunities suddenly appeared. And rates, not just overnight but term rates, just went negative in Japan. The chart below (source: Bloomberg) shows the 5y JGB rate.


Several observations:

  1. The speculation that sub-zero rates might cause a rise in velocity is just that: speculation. There’s no data to suggest that this effect exists.
  2. Frankly, I suspect it doesn’t, but it’s possible. However, if it does I would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.
  3. If it does exist, it still doesn’t mean that cutting rates to a negative rate was wise. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same. Lots more.
  4. More likely, the BoJ is doing this because they believe that negative rates will stimulate growth. This is much more speculative than you might think, and I may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.
  5. Whatever the point of the BoJ’s move, the size of any growth effect from currency reactions is utterly dependent on the reaction function of trading counterparties. If other countries seek to devalue their currencies as well, then the whole operation will be inert.

So, will the BoJ’s move save US stocks? Heck, it won’t even save the Japanese economy.

Zigs and Zags

January 13, 2016 Leave a comment

“The market,” said J.P. Morgan, when asked for his opinion on what the market would do, “will fluctuate.”

Truer words were never spoken, but the depth of the truism as well is interesting. One implication of this observation – that prices will vary – is that the patient investor should mostly ignore noise in the markets. Ben Graham went further; he proposed thinking about a hypothetical “Mister Market,” who every day would offer to buy your stocks or sell you some more. On some days, Mister Market is fearful and offers to sell you stocks at a terrific discount; on other days, he is ebullient and offers to buy your holdings at far more than they are worth. Graham argued that this can only be a positive for an investor who knows the value of the business he holds. He can sell it if Mister Market is paying too much, or buy it if Mister Market is selling it too cheaply.

Graham did not give enough weight to momentum, as opposed to value – the idea that Mister Market might be paying too much today, but if you sell your holdings to him today, then you might miss the opportunity to sell them to him next year for double the stupid price. And, over the last couple of decades, momentum has become far more important to most investors than has value. (I blame CNBC, but that’s a different story).

In either case, the point is important – if you know what you own, and why you own it, and even better if you have an organized framework for thinking about the investment that is time-independent (that is, it doesn’t depend on how you feel today or tomorrow), then the zigs and zags don’t matter much to you in terms of your existing investments.

(As for future investments, young people should prefer declining asset markets, since they will be investing for long periods and should prefer lower prices to buy rather than higher prices; on the other hand, retirees should prefer rising asset prices, since they will be net sellers and should prefer higher prices to lower prices. In practice, everyone seems to like higher prices even though this is not rational in terms of one’s investing life.)

We have recently been experiencing a fair number of zigs, but mostly zags over the last couple of weeks. The stock market is near the last year’s lows – but, it should be noted, it still holds 84% of its gains since March 2009, so it is hardly disintegrating. The dividend yield of the S&P is 2.32%, the highest in some time and once again above 10-year Treasury yields. On the other hand, according to my calculations the expected 10-year return to equities is only about 1.25% more per annum than TIPS yields (0.65% plus inflation, for 10 years), so they are not cheap by any stretch of the imagination. The CAPE is still around 24, which about 50% higher than the historical average. But, in keeping with my point so far: none of these numbers has changed very much in the last couple of weeks. The stock market being down 10%, plus or minus, is a fairly small move from a value perspective (from a momentum perspective, though, it can and has tipped a number of measures).

But here is the more important overarching point to me, right now. I don’t worry about zigs and zags but what I do worry about is the fact that we are approaching the next bear market – whether it is this month, or this year, or next year, we will eventually have a bear market – with less liquidity then when we had the last bear market. Dealers and market-makers have been decimated by regulations and constraints on their deployment of capital, in the name of making them more secure and preventing a “systemic event” in the next calamity. All that means, to me, is that the systemic event will be more distributed. Each investor will face his own systemic event, when he finds the market for his shares is not where he wanted it to be, for the size he needed it to be. This is obviously less of a problem for individual investors. But mutual fund managers, pension fund managers – in short, the people with the big portfolios and the big positions – will have trouble changing their investment stances in a reasonable way (yet another reason to prefer smaller funds and managers, but increasing regulation has also made it very difficult to start and sustain a smaller investment management franchise). Another way to say this is that it is very likely that while the average or median market movement is likely to be similar to what it has been in the past, the tails are likely to be longer than in the past. That is, we may not go from a two-standard-deviation event to a four-standard-deviation event. We may go straight to a six-standard-deviation event.

If market “tails” are likely to be longer than in the past because of (il)liquidity, then the incentive for avoiding those tails is higher. This is true in two ways. First, it creates an incentive for an investor to move earlier, and lighten positions earlier, in a potential downward move in the market. And second, in the context of the Kelly Criterion (see my old article on this topic, here), rising volatility combined with decreased liquidity in general means that at every level of the market, investors should hold more cash than they otherwise would.

I don’t know how far the market will go down, and I don’t really care. I am prepared for “down.” What I care about is how fast.

Back From the Moon

January 6, 2016 2 comments

Economics is too important to be left to economists, apparently.

When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!

Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.

A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.

It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.


Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”

In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”

Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.

Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:

  • Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
  • As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
  • Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.

Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.

And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.

A Good Time to Remember

December 16, 2015 7 comments

Some days make me feel so old. Actually, most days make me feel old, come to think of it; but some days make me feel old and wise. Yes, that’s it.

It is a good time to remember that there are a whole lot of people in the market today, many of them managing many millions or even billions of dollars, who have never seen a tightening cycle from the Federal Reserve. The last one began in 2004.

There are many more, managing many more dollars, who have only seen that one cycle, but not two; the previous tightening cycle began in 1999.

This is more than passing relevant. The people who have seen no tightening cycle at all might be inclined to believe the hooey that tightening is bullish for stocks because it means a return to normalcy. The people who have seen only one tightening cycle saw the one that coincided with stocks’ 35% rally from 2004-2007. That latter group absolutely believes the hooey. The fact that said equity market rally began with stocks 27% below the prior all-time high, rather than 32% above it as the market currently is, may not have entered into their calculations.

On the other hand, the people who dimly recall the 1999 episode might recall that the market was fine for a little while, but it didn’t end well. And you don’t know too many dinosaurs who remember the abortive tightening in 1997 in front of the Asian Contagion and the 1994 tightening cycle that ended shortly after the Tequila crisis.

Moreover, it is a good time to remember that no one in the market today, or ever, can remember the last time the Fed tightened in an “environment of abundant liquidity,” which is what they call it when there are too many reserves to actually restrain reserves to change interest rates. That’s because it has never happened before. So if anyone tells you they know with absolute certainty what is going to happen, to stocks or bonds or the dollar or commodities or the economy or inflation or anything else – they are relying on astrology.

Many of us have opinions, and some more well-informed than others. My own opinion tends to be focused on inflationary dynamics, and I remain very confident that inflation is going to head higher not despite the Fed’s action today, but because of it. I want to keep this article short because I know you have a lot to read today, but I will show you a very important picture (source: Bloomberg) that you should remember.


The white line is the Federal Funds target rate (although that meant less at certain times in the past, when the rate was either not targeted directly, as in the early 1980s, or the target was represented as a range of values). The yellow line is core inflation. Focus on the tightening cycles: in the early 1970s, in the late 1970s, in 1983-84, in the late 1980s, in the early 1990s, in 1999-2000, and the one beginning in 2004. In every one of those episodes, save the one in 1994, core inflation either began to rise or accelerated, after the Fed began to tighten.

The generous interpretation of this fact would be that the Fed peered into the future and divined that inflation was about to rise, and so moved in spectacularly-accurate anticipation of that fact. But we know that the Fed’s forecasting abilities are pretty poor. Even the Fed admits their forecasting abilities are pretty poor. And, as it turns out, this phenomenon has a name. Economists call it the “price puzzle.”

If you have been reading my columns, you know this is no puzzle at all for a monetarist. Inflation rises when the Fed begins to tighten because higher interest rates bring about higher monetary velocity, because velocity is the inverse of the demand for real cash balances. That is, when interest rates rise you are less likely to leave money sitting idle; therefore, investors and savers play a game of monetary ‘hot potato’ which gets more intense the higher interest rates go – and that means higher monetary velocity. This effect happens almost instantly. After a time, if the Fed has raised rates in the traditional fashion by reducing the growth rate of money and reserves, the slower monetary growth rate comes to dominate the velocity effect and inflation ebbs. But this takes time.

And, moreover, as I have pointed out before and will keep pointing out as the Fed tightens: in this case, the Fed is not doing anything to slow the growth rate of money, because to do that they would have to drain reserves and they don’t know how to do that. I expect money growth to remain at its current level, or perhaps even to rise as higher interest rates provoke more bank lending without and offsetting restraint coming from bank reserve scarcity. By moving interest rates by diktat, the Fed is increasing monetary velocity and doing nothing (at least, nothing predictable) with the growth rate of money itself. This is a bad idea.

No one knows how it will turn out, least of all the Fed. But if market multiples have anything to do with certainty and low volatility – then we might expect lower market multiples to come.


Subtle Clues: Not Everyone Thinks the Fed Will Win

December 8, 2015 Leave a comment

The illiquid trading of December is already well in evidence – and we haven’t even reached the bad part yet. One we are past the CPI report and the Fed meeting, there will be a few days where serious traders are squaring up based on what they now believe after those data points. After that, it will get truly quiet for the last couple of weeks.

A little quiet is what the energy market needs. On Monday front Crude broke to new six-year lows. Not since oil bottomed at $32.40 in December 2008 have prices been this low. Prior to that, the last time we saw sub-$40 oil was in July 2004. Ditto with gasoline prices, which are averaging just a touch above $2/gallon nationwide. This is truly amazing, and is causing all sorts of carnage in energy and energy service companies as has been widely reported.

What is interesting, though, and has been widely unreported has been the impact these recent price declines have had on inflation expectations as impounded in the price of inflation derivatives and TIPS breakevens. In short: not very much.

In prior episodes, such as last year at about this time, plunging energy quotations affected not only near-term inflation expectations but also long-term inflation expectations. The reason that near-term breakevens, or say 1-year inflation swaps, respond to energy prices is very simple: these contracts are pegged to headline inflation, which includes energy; while the market tends to overreact to the energy effect it tends to price fairly efficiency the near-term effect of movements in gasoline on actual inflation outturns.

But it makes very little sense that even very large moves in gasoline prices should be reflected in long-term­ inflation expectations. This is for two reasons: first, energy prices are mean-reverting, so declining prices in one year are more likely to see appreciating prices the following year (or, at least, big declines tend not to be followed by big declines). Second, even a significant change in energy prices, amortized over ten years for example, ends up not being a very big movement per year when you then also take into account how low the pass-through is from energy prices to inflation swap prices.

A bunch of this is sort of “inside baseball” talk to inflation traders, which I know isn’t my audience for the most part. But you can readily understand, I think, that if gasoline prices drop 50% in one year – and if we don’t expect them to continue to drop 50% in every year – then that’s only around a 5% movement per year in energy prices, averaged over ten years. That’s like saying gasoline prices rise a dime per year for ten years. Do you think that would have, or should have, a big effect on your overall inflation expectations?

In practice, it turns out to affect the market. The chart below (source: Bloomberg) shows the national average gasoline price (in white) from the American Automobile Association versus the 10-year breakeven (that is, the difference in the 10-year Treasury yield minus the 10-year TIPS yield, a number that approximates the inflation required to break even between these two investments). You can see that this is a fairly tight relationship in the grand scheme of things. When gasoline prices fell from $3.60 to $2.00 in 2014-15, breakevens plunged from 2.20% to 1.60%. As I have just pointed out, that’s larger than makes sense but the direction makes sense.

bei and gasoline

This phenomenon, incidentally, is why we (meaning me, and my company when we are doing analysis) strip out the implied energy effect by using futures quotes, so as to come up with an implied core inflation curve. (And you can actually hedge, so you can create something that looks very much like core inflation rather than headline inflation). By doing this, we can often see when the inflation market is overpricing the energy effect or underpricing it, and indeed this can be traded as part of an institutional investment strategy.

But recently, we haven’t really needed to be so fine with the calculation. Notice on the right side of the chart above that over the last couple of months inflation expectations (breakevens) have risen even as crude and gasoline prices have continued to slide. The chart illustrates how unusual this is. What this means is that expectations for long-term core inflation have been rising – investors are actually looking past the near-term energy washout and saying “we don’t believe this will be sustained, and even if it is we don’t believe that core inflation will average 1.25% for five years.” That’s what was being priced in late October; now that figure is a still low but much more-sensible 1.5%.

Will investors be right? I must say that we have been aggressive in saying that being long at these breakeven levels leaves few ways to lose, at least for investors who can hold through the bumps. And inflation has long upper tails, so that even if you think 1.50% for five years is fair, you should be willing to pay a bit more simply because a miss on the high side is likely to be a worse miss than a miss on the low side.

Sadly, the only way for retail investors to position explicitly for this is through the ETF RINF, which is the Proshares 30y breakeven spread, and the bid/offer is intimidating as is the expense ratio. But it’s something.

What I find fascinating is that this is happening at all. Everyone professes to believe that the Fed is ahead of the curve and will surely squash inflation. But that isn’t how they’re positioning.

Categories: Federal Reserve, Theory, TIPS

Median Inflation vs Mediocre Growth

November 5, 2015 3 comments

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.”


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