The big story of the weekend was that a meeting of OPEC and non-OPEC producers, at which an agreement was supposed to be signed to freeze oil production at recent levels, ended without an agreement being signed. This was not an enormous surprise, since Iran didn’t even attend the conference and the Saudis had said they wouldn’t sign unless Iran agreed, but oil prices initially took a significant hit before recovering some later in the day.
The economic significance of the lack of agreement is fairly small; most producers are producing near their maximum output, except for important non-attendees like the United States and Iran. (The Saudis claim to be able to put 1mm barrels per day online in short order, too). But the psychological significance was thought to be important.
I’m not so sure about the importance of mind-games in an efficient global market for a commodity product. The market is oversupplied, by a significant amount, and no amount of posturing will change that. However, basic economics may.
Overlooked by many is the fact that OPEC’s problem is one that automatically diminishes over time even if OPEC does nothing. This is because the demand for oil is short-term inelastic, but long-term elastic.
The elasticity of demand describes how quickly the quantity demanded responds to price. If demand is very elastic, then changes in price cause large changes on the quantity demanded. On the other hand, inelastic demand curves indicate that the quantity demanded changes very little when the price on offer changes.
The elasticity of demand has a very significant consequence for the question of how revenues change when prices change. Revenue is simply price times quantity. So, if a small change in price causes a large change in quantity (that is, an elastic demand curve), it is a good strategy (for example, as an individual company) to cut one’s price: the company will sell lots more product and give up only a little revenue on each one, so that total revenues rise with price declines if a producer faces an elastic demand curve. On the other hand, if demand is inelastic, then a price cut doesn’t change the quantity sold very much, but decreases revenue on each unit. If a producer faces an inelastic supply curve, total revenues decline with price decreases. And, conversely, total revenues increase with price increases in such a case. This is the reason that cartelization of the oil industry is an apparently attractive strategy: oil demand is, at least in the short-run, price inelastic. If gasoline prices rise $1 per gallon next week, you will still drive almost as much as before.
But static equilibria cannot fully describe dynamic markets! It turns out that for most products, demand elasticity in the long-run is higher, and often much higher, than in the short run. Consumers adjust to changing prices by adjusting their consumption mix! This is also true with energy markets: while you won’t drive a lot less next week if gasoline prices are much higher, if they stay higher you will start to carpool, buy more energy-efficient vehicles, and so on. This is one reason that cartelization ends up failing. In the short run, it makes sense to band together and hike prices, raising overall revenue, but this has deleterious effects on long-run revenue and creates incentives to cheat to grab more of the (diminishing) demand.
Analysis of the energy markets tends to focus on supply, but as prices increase and decrease over extended periods of time, it is important to remember that demand eventually responds. From 2011 until mid-2014, retail gasoline averaged about $3.50 per gallon (see chart, source Bloomberg). But it has been below that level for almost two years, and averaged more like $2.30 per gallon since then.
Similarly, WTI crude oil averaged around $100/bbl in 2011-mid2014, but only about $60 since then. And most of that was well below $60. The picture for Brent is of course very similar.
In the short run, with inelastic demand, these large declines represent a very large drop in OPEC producer revenues. But in the long run – and after two years, we are much closer to the long run – demand will increase even if the global economy doesn’t grow at all because there is a demand response to lower prices. OPEC, in other words, initially sold the same amount of oil at lower prices, but as time passes they will sell larger amounts of oil at these lower prices. While that’s not as good as selling those larger amounts of oil at higher prices, it is better than what it had been after the initial, sharp decline.
So oil producers will have more total revenue over the next year, even if price doesn’t change and even if the global economy stops growing, than they did last year. The need for a production freeze becomes less urgent all the time.
Of course, the supply overhang is huge, and it won’t go away overnight and probably won’t go away from demand response alone. But, as we are dealing with the long run, we shouldn’t neglect the demand response, either.
Following is a concatenation of my post-CPI tweets. You can follow me @inflation_guy. Due to scheduling issues, I don’t have any further development of the observations highlighted below.
- OK, 4 minutes until CPI. If I had to guess what a theme, I would say the question of whether apparel and medical care trends continue.
- Is apparel the canary in the coal mine from recent jumps? And is CPI or PPI right about medical care? The latter has been softer.
- Weak CPI number! 0.1%/0.1% and y/y core slipped to 2.2%!
- even weaker than that…+0.07%, 2.20% exactly y/y on core. That’s a really big surprise.
- first glance – medical care y/y slipped, and apparel y/y plunged. getting more detail
- core services slipped to 3.0% from 3.1%; core goods dropped to -0.4% from +0.1%
- while i’m waiting for more detail…this CPI doesn’t mean it’s done going up; just that we can’t reject the hypothesis that it’s not.
- have to remember these are experiments – underlying inflation rate not knowable so we can only reject hypotheses.
- my suspicion: we may be able to lean more to the “apparel was seasonal” hypothesis but jury is out on medical care normalization.
- ok – apparel -0.64% from +0.89% y/y. medical care 3.29% from 3.50%. housing up small, recreation, education/comm, other all up small.
- within apparel: Mens suits/sportcoats/outerwear -7.6% from -4.6%. Mens furnishings -1.2% from +2.2%. Mens pants/shorts -5.8% from +2.4%
- but WOMENS outerwear 5.5% from 3.2%; suits & separates +0.2% from -0.3%. Dresses down though, -6.3% from -4.3%.
- so could be seasonal…but we will have to wait to know for sure. weird, anyway.
- in housing: Primary rents 3.66% vs 3.68%; OER 3.12% vs 3.16%. lodging away from home 2.27% v 4.19%. so rise in housing was HH energy.
- In Medical: drugs 2.49% v 2.34%. Prof svcs 2.27% vs 2.54%. hospital 4.33% v 4.90%. Insuance 6.20% v 5.97%. Similar read to PPI.
- PPI and CPI don’t have much overlap, or we would rely more on the earlier PPI. So hard to read much.
- does mean core PCE not likely to converge as quickly with core/median CPI.
- ok last tweet: early estimate on median still looks like +0.17%, 2.39%, down vy slightly from 2.43% y/y.
None of this changes the underlying focus: median at 2.4% and core converging upward to it. And there’s still no sign that housing is about to weaken. Core goods had been strengthening; this has been arrested but it may be a function of the early Easter (however, Easter occurred for men, too…). As I suspected early – this is a holding-pattern number, certainly weaker than inflation bulls expected but it doesn’t dash the underlying trends…yet. This makes the April number, released next month, more important!
And none of this changes the underlying points I made in a Marketwatch opinion article that appeared yesterday. You can read that article here.
Last week I mentioned something about what Keynes said in the General Theory, and promised to expand on that a bit this week. I will do so, in the form of a book review.
I can’t remember who it was, and I’m sorry, but one of the people who read my articles suggested a book to me a year or so ago published in 2009 and called Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts by Hunter Lewis, and I finally got around to reading it. I am very glad I did – this book is terrific, and is a must-read if you are either pro-Keynes or anti-Keynes.
Of course, readers will know from my articles that I am anti-Keynes, although more precisely I am anti-Keynesian in the modern sense of that word. I never read very much of the General Theory, because honestly it is poorly written in the sense of its prose, and I always assumed that Keynes probably had some great insights and it was the later Keynesians that screwed up what he said.
Oh, I was so wrong. Keynes was looney tunes. A bona fide lunatic. He proved masterful in manipulating the cult of personality that existed at the time he was writing, however; he was adept at destroying his opponents in ways that sounded erudite and like certain later personalities the media adored him. All of this is well-documented by Mr. Lewis, although the looney tunes conclusion is my own.
The book is put together brilliantly. The author quotes passages from Keynes, using actual quotes interspersed with paraphrasing – which is necessary because, as I said above, the General Theory is poorly written and opaque. But it isn’t the paraphrasing that is damning. When Mr. Lewis wants to indict Keynes, he does it with his own words. For example, in unraveling the absurd (and often self-contradictory) prescriptions that Keynes had for managing the macro economy, Mr. Lewis declares that Keynes thought government should never raise interest rates. That’s right, never. But you needn’t take Lewis’ word for it. Here’s Keynes, cited in the book:
“The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”
If you are anything like me, that sent a shiver down your spine right now. Does that sound at all familiar? Keep in mind that Lewis wrote this book in 2009. He could not possibly have anticipated that interest rates would not move away from zero for seven years (and counting, in some countries). And yet this quote sounds to me so much like what the Mount Rushmore of Fed speakers seemed to be suggesting last week. “It worked,” Bernanke was saying. “We’re not in a bubble economy,” said Yellen. None of them saw any signs of serious imbalances, except Volcker (and he was fairly circumspect about how worrisome they were).
In my own book, I indict Keynesianism in the simplest way: I simply point out that the prescription of the Keynesians hasn’t only not worked, it also has failed in every major prediction since, basically forever. But Lewis attacks Keynes himself, with his own words, from the original source. He explains, very clearly, where Keynes went wrong. If you wonder why world governments keep screwing up economies…you should read this book.
 Apparently elsewhere Keynes said different things but in the General Theory he was consistent on this point.
 Keynes, General Theory, p. 322; quoted on page 20 of Where Keynes Went Wrong by Hunter Lewis.
In yesterday’s article, I neglected to mention one remark by a former Fed chair that bothered me at the time. However, I didn’t mention it because I thought the reason it bothered me was that it was vacuous – the sort of throw-away line that someone uses to stall while thinking of the real answer to the question. Since then, I’ve realized what specifically annoyed the subconscious me about the remark.
When Bernanke was asked about whether a recession is coming at some point; he glibly replied “Expansions don’t die of old age,” as if that was obvious and the questioner was being a dolt. Like so much of what Bernanke says, this statement is both true, and irrelevant.
Human beings, also, don’t die of old age. There is a cause of death – something causes a person to die; it isn’t that their library card of corporeality became overdue and they expired. The cause may be a heart attack, a slip-and-fall in the bathtub, cancer, pneumonia, complications from surgery, or the flu, but death is the result of a cause. It just happens that as a person gets older, the number of potential causes multiplies (a newborn rarely has a heart attack) and the number of causes that become fatal to an old person, where they would be merely inconvenient to a hale person, increases as well. As we age, parts of our bodies and immune systems weaken – and that’s where death sneaks in.
Think of those weaknesses as…let’s call them imbalances that have accumulated.
The statement that expansions don’t die of old age is literally true. Something causes them to die. It may be monetary error, but as Volcker pointed out last night in answer to a different question, there were recessions long before there was a Federal Reserve. Expansions also can die from a diminution of credit availability, from energy price spikes, from malinvestment, from an overextension of balance sheets that leads to bankruptcies…from a myriad of things that may not kill a young, vibrant expansion.
The parallel is real, and the point is that while this expansion was never very vibrant the current imbalances are legion. The Fed may not see them, or may believe them to be small (like Bernanke’s Fed felt about the housing bubble and Greenspan’s Fed felt about the equity bubble). But the Fed has a fantastic record on one point: they are nearly flawless at misdiagnosing a patient who is sickening.
Thursday evening’s public discussion between Fed Chairman Janet Yellen and former chairmen Volcker, Greenspan, and Bernanke – these last three in order of gravitas and effectiveness and (perhaps not unrelatedly) reverse order of academic accomplishment – was a first. Never before, apparently, have four current and former Fed chairmen appeared on the same stage. This is less amazing than it seems: prior to Alan Greenspan it was the practice of the Federal Reserve to remain out of the limelight.
Honestly, we all probably would have been better off had they stayed there.
Still, it was a fascinating event. The International House, which hosted the event, called it the “Fabulous Four Fed chairs,” but since they did not serve contemporaneously a better image is probably Mount Rushmore…if Mount Rushmore had the faces by Nixon, Hoover, Carter, and Andrew Johnson instead of Washington, Lincoln, Teddy Roosevelt, and Thomas Jefferson.
Okay, all bond guys have a soft spot for Paul Volcker, who was the last Fed Chairman to try monetarism and managed to break the back of inflation using its common-sense prescription. But he should have stayed retired. The Volcker Rule has sucked a tremendous amount of liquidity out of the market (in conjunction with other Dodd-Frank rules) and is clearly a stain on his resumé.
Everyone was hoping that this collection of experienced policymakers would give us some clear consensus about what the Fed should do now – raise rates as per the original path that was implied? Raise rates more slowly? Maintain rates? Keep on adding liquidity? Instead, there was almost nothing useful to be gleaned from the conversation. The three ex-chairmen seemed to be competing to make the funniest statement (some intentionally, and some unintentionally like Bernanke’s statement that “unwinding the balance sheet is very straightforward”) without saying anything constructive, challenging, or even useful about current and future Fed policy; Yellen seemed to want to say useful things but it isn’t clear she has anything useful to say.
One overwhelming consensus was that the economy is doing just fine, but isn’t a “bubble economy.” Volcker did allow that “there are aspects of the financial world that are overextended.” Oh, do you think so? Maybe something like the chart below, which is an updated version of Figure 9.7 from my book?
Here are two other interesting snippets:
- Bernanke, asked “how will you unwind” the extraordinary measures he instituted, wisecracked “Fortunately, I don’t have to,” which considering the scale of what he did is a clever witticism that I am sure Dr. Yellen appreciated. After expressing, as I noted earlier, that unwinding is really easy, he pointed out languidly that the Fed’s balance sheet, relative to GDP, is “about the same size of most other central banks.” Does he really think no one was paying attention since 2008? The reason all central banks have huge balance sheets is that the Fed did it first and they all followed. If you consider “most other central banks” to include others throughout history…no, it’s not even close.
- Yellen didn’t address the elephant in the room, but went so far to pat its rump and then pretend it wasn’t there. She described the criteria the Fed had had for the December increase in interest rates (substantial progress towards employment goal, and inflation heading back up), but didn’t feel like explaining that when even more progress had been made on employment, and inflation was even higher, at the next two meetings the Fed decided to pass. She noted that “headwinds” in the “legacy of the financial crisis” and “weak global growth” meant that “the neutral rate is very low,” but unless that neutral rate happens to be 0.25%-0.50% such a comment begs the question. Those headwinds haven’t gotten any worse since December! As such, she left completely unanswered the $64,000 question which is “what the heck would make you tighten again?”
In short, all of these notable central bankers (which is a little like saying “these notable hobos”) seemed to agree that everything is just fine and there is no urgency with respect to anything right now. I’ve spent the last quarter-century deciphering three of these four speakers, and I must say I can’t decide whether “everything is fine” means “the Fed can go ahead and tighten now, because everything is fine,” or “there’s no reason for the Fed to tighten now, because easing forever doesn’t seem to be a problem.”
So, markets remain suspended from the pendulum of complacency, which right now seems to be quite a bit on the “complacent” side but will, I suspect, shortly swing the other way to “disturbed and uncomfortable”. I must say that nothing I heard tonight suggests further Fed tightening is imminent. However, that point in itself makes me disturbed and uncomfortable and at some point the market will oscillate around to that view – perhaps next Thursday when I think there is a good chance that core CPI rises to 2.4% y/y.
Administrative Note: On Friday at 4pm ET, I will be on Bloomberg TV’s “What’d You Miss?” with Joe Weisenthal, Alix Steel, and Scarlet Fu.
 In keeping with my usual tilt to keep focused on inflation and real values, it should be noted that the $64,000 question would today be the $523,277 question. The quiz show ended in November 1958 with the CPI price index at 29; it is now at 237.111.
 Interestingly, this last point directly echoes some of Keynes’ points in the General Theory. I will revisit that point next week.
A longtime reader (and friend) today forwarded me a chart from a well-known technical analyst showing the recent correlation between TIPS (via the TIP ETF) and gold; the analyst also argued that the rising gold price may be boosting TIPS. I’ve replicated the chart he showed, more or less (source: Bloomberg).
Ordinarily, I would cite the analyst directly, but in this case since I’m essentially calling him out I thought it might be rude to do so! His mistake is a pretty common one, after all. And, in fact, I am going to use it to illustrate an important point about TIPS.
The chart shows a great correlation between TIPS and gold, especially since the beginning of the year. But here’s the problem with drawing the conclusion that rising inflation fears are boosting TIPS – TIPS are not exposed to inflation.
Bear with me, because this is a key point about TIPS that is widely misunderstood. Recall that nominal interest rates represent two things: first, an amount that represents the return, in real terms, that the lender needs to realize in order to defer consumption and instead lend to the borrower. This is called the real interest rate. The second component of the nominal interest rate represents the compensation the lender demands for the fact that he will be paid back in dollars that (in normal times) will be able to buy less. This is the inflation compensation. Irving Fisher said that nominal interest rates are approximately equal to the sum of these two components, or
n ≈ r + i
where n is the nominal interest rate, r is the real interest rate, and i is the inflation compensation.
In a world without TIPS, you can only trade nominal bonds, which means you can only access the whole package and nominal interest rates may change when real rates change, expected inflation changes, or both change. (And when interest rates are negative, this leads to weird theoretical implications – see my recent and fun post on the topic.) Thus changes in real interest rates and changes in expected inflation affect nominal bonds, and roughly equally at that.
But once you introduce TIPS, then you can now separate out the pieces. By buying TIPS, you can isolate the real interest rate; and by trading a long/short package of TIPS and nominal bonds (or by trading an inflation swap) you can isolate the inflation expectations. This is a huge advance in interest rate management, because an investor is no longer constrained to own a fixed-income portfolio where his exposure to changes in real rates happens to be equal to his exposure to changes in inflation expectations. Siegel and Waring made this argument in a famous paper called TIPS, the Dual Duration, and the Pension Plan in 2004, although it should be noted that inflation derivatives books were already being managed using this insight by then.
Which leads me in a roundabout way to the point I originally wanted to make: if you own TIPS, then you have no exposure to changes in inflation expectations except inasmuch as there is a (very unstable) correlation between real rates and expected inflation. If inflation expectations change, TIPS will not move unless real rates change.
So, if gold prices are rising and TIPS prices are rising, it isn’t because inflation expectations are rising. In fact, if inflation expectations are rising it is more likely that real yields would also be rising, since those two variables tend to be positively correlated. In fact, real yields have been falling, which is why TIP is rising. The first chart in this article, then, shows a correlation between rising inflation expectations (in gold) and declining real interest rates, which is certainly interesting but not what the author thought he was arguing. It’s interesting because it’s unusual and represents a recovery of TIPS from very, very cheap levels compared to nominal bonds, as I pointed out in January in a piece entitled (argumentatively) “No Strategic Reason to Own Nominal Bonds Now.”
Actually (and the gold bugs will kill me), gold has really outstripped where we would expect it to go, given where inflation expectations have gone. The chart below (source: Bloomberg) shows the front gold contract again, but this time instead of TIP I have shown it against 10-year breakevens.
No, I don’t hate gold, or apple pie, or America. Actually, I think the point of the chart is different. I think gold is closer to “right” here, and breakevens still have quite far to go – eventually. The next 50bps will be harder, though!
 I abstract here from the third component that some believe exists systematically, and that is a premium for the uncertainty of inflation. I have never really understood why the lender needed to be compensated for this but the borrower did not; uncertainty of the real value of the repayment is bad for both borrower and lender. I believe this is an error, and interestingly it’s always been very hard for researchers to prove this value is always present and positive.
 It’s technically (1+n)=(1+r)(1+i), but for normal levels of these variables the difference is minute. It matters for risk management, however, of large portfolios.
 I expanded this in a much less-famous paper called TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans in 2011.
 What the heck, one more footnote. I had a conversation once with the Assistant Treasury Secretary for Financial Markets, who was a bit TIPS booster. I told him that TIPS would never truly have the success they deserve unless the Treasury starts calling ‘regular’ bonds “Treasury Inflation-Exposed Securities,” which after all gets to the heart of the matter. He was not particularly amused.
Had a great interview with Chuck Jaffe on MoneyLife today! Interview is streamed at moneylifeshow.com/upcomingGuests… Look for me in the Wednesday, April 6th edition – about halfway down. Or click directly to the stream here.