What if ‘Excess Reserves’ Aren’t Really Excess?

March 4, 2019 1 comment

One intriguing recent suggestion I have heard recently is that the “Excess” reserves that currently populate the balance sheet of the Federal Reserve aren’t really excess after all. Historically, the quantity of reserves was managed so that banks had enough to support lending to the degree which the Fed wanted: when economic activity was too slow, the Fed would add reserves and banks would use these reserves to make loans; when economic activity was too fast, the Fed would pull back on the growth of reserves and so rein in the growth of bank lending. Thus, at least in theory the Open Markets Desk at the New York Fed could manage economic activity by regulating the supply of reserves in the system. Any given bank, if it discovered it had more reserves than it needed, could lend those reserves in the interbank market to a bank that was short. But there was no significant quantity of “excess” reserves, because holding excess reserves cost money (they didn’t pay interest) – if the system as a whole had “too many” reserves, banks tended to lend more and use them up. So, when the Fed wanted to stuff lots of reserves into the system in the aftermath of the financial crisis, and especially wanted the banks to hold the excess rather than lending it, they had to pay banks to do so and so they began to pay interest on reserves. Voila! Excess reserves appeared.

But there is some speculation that things are different now because in 2011, the Basel Committee on Banking Supervision recommended (and the Federal Reserve implemented, with time to comply but fully implemented as of 2015) a rule that all “Systematically Important Financial Institutions” (mainly, really big banks) be required to maintain a Liquidity Coverage Ratio (LCR) at a certain level. The LCR is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) by a number that represents its stress-tested 30-day net outflows. That is, the bank’s liquidity is expressed as a function of the riskiness of its business and the quantity of high-quality assets that it holds against these risks.

In calculating the HQLA, most assets the bank holds receive big discounts. For example, if a bank holds common equities, only half of the value of those equities can be considered in calculating this numerator. But a very few types of assets get full credit: Federal Reserve bank balances and Treasury securities chief among them.[1]

So, since big banks must maintain a certain LCR, and reserves are great HQLA assets, some observers have suggested that this means the Fed can’t really drain all of those excess reserves because they are, effectively, required. They’re not required because they need to be held against lending, but because they need to be held to satisfy the liquidity requirements.

If this is true, then against all my expectations the Fed has, effectively, done what I suggested in Chapter 10, “My Prescription” of What’s Wrong with Money? (Wiley, 2016). I quote an extended section from that book, since it turns out to be potentially spot-on with what might actually be happening (and, after all, it’s my book so I hereby give myself permission to quote a lengthy chunk):

“First, the Federal Reserve should change the reserve requirement for banks. If the mountain will not come to Mohammed, then Mohammed must go to the mountain. In this case, the Fed has the power (and the authority) to, at a stroke, redefine reserves so that all of the current “excess” reserves essentially become “required” reserves, by changing the amount of reserves banks are required to hold against loans. No longer would there be a risk of banks cracking open the “boxes of currency” in their vaults to extend more loans and create more money than is healthy for an economy that seeks noninflationary growth. There would be no chance of a reversion to the mean of the money multiplier, which would be devastating to the inflation picture. And the Open Markets Desk at the Fed would immediately regain power over short-term interest rates, because when they add or subtract reserves in open market operations, banks would care.

“To be sure, this would be awful news for the banks themselves and their stock prices would likely take a hit. It would amount to a forcible deleveraging, and impair potential profitability as a result. But we should recognize that such a deleveraging has already happened, and this policy would merely recognize de jure what has already happened de facto.

“Movements in reserve requirements have historically been very rare, and this is probably why such a solution is not being considered as far as I know. The reserve requirement is considered a “blunt instrument,” and you can imagine how a movement in the requirement could under normal circumstances lead to extreme volatility as the quantity of required reserves suddenly lurched from approximate balance into significant surplus or deficit. But that is not our current problem. Our current problem cries out for a blunt instrument!

“While the Fed is making this adjustment, and as it prepares to press money growth lower, they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise.

“Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. It is possible that, as this happens, reserve requirements could be edged incrementally back to normal as well. But those decisions are years away.”

If, in fact, the implementation of the LCR is serving as a second reserve requirement that is larger than the reserve requirement that is used to compute required and “excess” reserves, then the amount of excess reserves is less than we currently believe it to be. The Fed, in fact, has made some overtures to the market that they may not fully “normalize” the balance sheet specifically because the financial system needs it to continue to supply sufficient reserves. If, in fact, the LCR requirement uses all of the reserves currently considered “excess,” then the Fed is, despite my prior beliefs, actually operating at the margin and decisions to supply more or fewer reserves could directly affect the money supply after all, because the reserve requirement has in effect been raised.

This would be a huge development, and would help ameliorate the worst fears of those of us who wondered how QE could be left un-drained without eventually causing a move to a much higher price level. The problem is that we don’t really have a way to measure how close to the margin the Fed actually is; moreover, since Treasuries are a substitute for reserves in the LCR it isn’t clear that the margin the Fed wants to operate on is itself a bright line. It is more likely a fuzzy zone, which would complicate Fed policy considerably. It actually would make the Fed prone to mistakes in both directions, both over-easing and over-tightening, as opposed to the current situation where they are mostly just chasing inflation around (since when they raise interest rates, money velocity rises and that pushes inflation higher, but raising rates doesn’t also lower money growth since they’re not limiting bank activities by reining in reserves at the margin).

I think this explanation is at least partly correct, although we don’t think the condition is as binding as the more optimistic assessments would have it. The fact that M2 has recently begun to re-accelerate, despite the reduction in the Fed balance sheet, argues that we are not yet “at the margin” even if the margin is closer than we thought it was previously.

[1] The assumption in allowing Treasuries to be used at full value seems to be that in a crisis the value of those securities would go up, not down, so no haircut is required. Of course, that doesn’t always happen, especially if the crisis were to be caused, for example, by a failure of the government to pay interest on Treasuries due to a government shutdown. The more honest reason is that if the Fed were to haircut Treasuries, banks would hold drastically fewer Treasuries and this would be destabilizing – not to mention bad for business on Capitol Hill.


Summary of My Post-CPI Tweets (February 2019)

February 14, 2019 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

I usually post these the day of CPI but I was traveling and didn’t get to do so. These were my tweets in the immediate aftermath of the CPI report.

  • About 15 minutes to CPI. Today’s stream-of-consciousness will be a little more relaxed since I’m at a conference in Florida at the moment!
  • As for the number today, here are some thoughts.
  • We’ve recently begun to see some reduction in pressure from truckload rates upstream. Not down, but rising more slowly. Bottlenecks in overland are easing somewhat. Higher prices are still passing through but less alarm about it.
  • Housing price increases have also been slowing. Again, we’re talking second-derivative stuff; they aren’t falling nationwide. Rents are loosely related to prices, so I don’t think we’ll see much downward pressure there yet, but it’s a meme at the moment.
  • Wage growth remains strong, but wages lag inflation so that’s not much illumination.
  • There is decent momentum in some other categories, and…tariffs. Remember we don’t need tariffs to get worse growth/inflation outcomes than the last 20 years; we just need less forward progress on trade. And we have that for sure! (Again with the second derivatives??)
  • I’ve been expecting an interim peak in median CPI later in 2019. It’s not here yet, and I might still be wrong about that and see it climb further. Inflation after all is a process with momentum. But that’s my current expectation.
  • However, I ALSO don’t expect that when median CPI eventually turns lower that it will fall anywhere close to the prior lows. I think we’ve begun a long-term cycle of higher highs and higher lows in inflation.
  • Now, money growth is picking up again, and higher rates over the last year imply higher velocity going forward. But globally we have more negative-rate debt, so that’s dampening. But the macro pressures on inflation remain to the positive side.
  • For today, the Street sees 0.2% on core, dropping y/y to 2.1% because drop off a difficult +0.3% comp from last January. The January figure sees a number of interesting cross currents. I suspect there’s a smidge of upside risk to this number, but I have low confidence on that.
  • We will see, in 5 minutes.
  • ok, 0.24% on core CPI, a bit higher than expected and BARELY kept core from rounding lower to 2.1%, even dropping off the strong Jan 2018

  • 15% is core to 2 decimal places y/y.
  • Primary rents 0.31% m/m after 0.21%, but y/y still declined to 3.43% vs 3.47%. As I said, rents only loosely related to prices and rent slowing has still been only at the margin.
  • Owners’ Equiv Rent was 0.27% vs 0.22% last, with y/y unchanged at 3.21%. So the big chunk of housing was reasonably strong. Actually Lodging Away from Home, which had a very large jump last month, had another decent rise this month. It’s only 0.9% of CPI but no “AirBnB” effect.
  • So the macro interesting thing is that core services declined to 2.8% y/y, thanks to the gradually slowing housing I think, while core goods rose to 0.3%.
  • That’s the highest core goods since 2013. Our models think this is headed up to 0.5% before flattening, but … tariffs. Our models don’t include them. This is the underlying pressure.

  • OK, so Apparel is 0.11% y/y, basically unchanged. Jump this month, but that looks seasonal. Medical care declined to 1.90% y/y vs 2.01%. Recreation rose to 1.36% vs 1.14%.
  • There was some chatter that a change the BLS made in how it accounts for quality change in some communications categories could drag down the CPI like cell phones did last year, but it’s a much smaller effect. Education/Communication was 0.31% y/y vs 0.21% last month.
  • Sorry for the interlude…some tech glitch. Anyway…picking up. Education was 2.72% y/y vs 2.62% last month; Communication was -1.68% vs -1.76%. So the rise in Education/Communication was from both parts.
  • Not so in Medical Care. Medical Care Commodities were -0.28% vs -0.50%; Med Care Services 2.45% vs 2.64%. So the overall small decline in Medical Care (1.90% vs 2.01% y/y) was basically entirely from the “Hospital and Related Services” category (2.44% vs 3.64%).
  • The other Medical Care categories – medicinal drugs, Professional Services, and Health Insurance – all rose. But they were counterbalanced by the Hospital part.
  • Median this month might be really interesting. Rough calculation suggests that a housing sub-category that Cleveland Fed calculates might be the median category so it’s hard to tell. But I think Median y/y will drop from 2.77% to 2.64%. Might even be worse.
  • Core ex-housing fell to 1.39% from 1.51%. So, there’s definitely some signs of softness here even though Core Goods is providing upward pressure. Working on the 4-pieces breakdown now.
  • Core ex housing chart. Sorry not too many charts today. Little harder to do remotely.

  • OK the four pieces. For those new to this analysis, I break CPI into these four pieces, each roughly 1/4 of CPI (19%-33%).

  • Here are the four pieces, from most-volatile to least-volatile. Part 1 is Food and Energy. Clearly holding down headline CPI but this is why we look through it. Look at that y axis!

  • Part 2 is Core Goods. With the trade frictions, this is presently the most interesting piece. Even if the tariffs implemented by the Administration are dropped, we’ve still stopped the forward trade momentum of the last quarter century. So this bears watching.

  • Core Services less Rent of Shelter. A lot of this is Medical Care, and while it looked like we might be breaking the long downtrend recently…maybe not so much.

  • Finally, rent of shelter. Off the highs, but our models don’t have it dropping seriously. Housing prices still rising, albeit more slowly. And rents, while high relative to wages, are now getting a following wind from rising wages. I suspect this will meander.

It seems, from reading the other post-mortems, that some people saw this as a very strong number. It really wasn’t…slightly stronger than expected. But I guess it depends on your state of mind coming in. I’ve thought the underlying run rate of core CPI was something like 0.22% per month, and with seasonal issues in January thought we’d be a touch higher than consensus. I suppose if you thought inflation was falling off a cliff you might have expected something much weaker. The composition, too, was solid but unspectacular. Again, if you thought rents were about to collapse then you were surprised that it was only down a little on a y/y basis. The core goods rise is important, but again – not unexpected.

So is inflation running “hot”? Well, if you think 2.2% is hot, I suppose so. But Median CPI also declined on a y/y basis, as have wages recently. Don’t get me wrong, I think inflation is still rising and probably will for most of this year. But it’s not shooting higher and if I were at the Fed and if I believed what they believed, I wouldn’t be alarmed by this number (I am not at the Fed and I don’t believe what they believe, for the record).

Categories: CPI, Tweet Summary

The Downside of Balancing US-China Trade

January 18, 2019 Leave a comment

The rumor today is that China is going to resolve the trade standoff by agreeing to balance its trade with the US by buying a trillion dollars of goods and services over the next four years. The Administration, so the rumor goes, is holding out for two years since that will look better for the election. They should agree to four, because otherwise they’re going to have to explain why it’s not working.

I ascribe approximately a 10% chance that the trade balance with China will be at zero in four years. (I’m adjusting for overconfidence bias, since I think the real probability is approximately zero.) But if it does happen, it is very bad for our financial markets. Here’s why.

If China buys an extra trillion dollars’ worth of US product, where do they get the dollars to do so? There are only a few options:

  1. They can sell us a lot more stuff, for which they take in dollars. But that doesn’t solve the trade deficit.
  2. They can buy dollars from other dollar-holders who want yuan, weakening the yuan and strengthening the dollar, making US product less competitive and Chinese product more competitive globally. This means our trade deficit with China would be replaced by trade deficits with other countries, again not really solving the problem.
  3. They can use the dollars that they are otherwise using to buy financial securities denominated in dollars, such as our stocks and bonds.

The reality is that it is really hard to make a trade deficit go away. Blame the accountants, but this equation must balance:

Budget deficit = trade deficit + domestic savings

If the budget deficit is very large, which it is, then it must be financed either by running a trade deficit – buying more goods and services from other countries than they buy from us, stuffing them with dollars that they have no choice but to recycle into financial assets – or by increased domestic savings. So, let’s play this out and think about where the $500bln per year (the US trade deficit, roughly, with the rest of the world) is going to come from. With the Democrats in charge of Congress and an Administration that is liberal on spending matters, it seems to me unlikely that we will see an abrupt move into budget balance, especially with global growth slowing. The other option is to induce more domestic savings, which reduces domestic consumption (and incidentally, that’s a counterbalance to the stimulative growth effect of an improving trade balance). But the Fed is no longer helping us out by “saving” huge amounts – in fact, they are dis-saving. Inducing higher domestic savings would require higher market interest rates.

The mechanism is pretty clear, right? China currently holds roughly $1.1 trillion in US Treasury securities (see chart, source US Treasury via Bloomberg).

China also holds, collectively, lots of other things: common equities, corporate bonds, private equity, US real estate, commodities, cash balances. Somewhere in there, they’ll need to divest about a trillion dollars’ worth to get a trillion dollars to buy US product with.

The effect of such a trade-balancing deal would obviously be salutatory for US corporate earnings, which is why the stock market is so ebullient. But it would be bad for US interest rates, and bad for earnings multiples. One of the reasons that financial assets are so expensive is that we are force-feeding dollars to non-US entities. To the extent that we take away that financial inflow by balancing trade and budget deficits, we lower earnings multiples and raise interest rates. This also has the effect of inducing further domestic savings. Is this good or bad? In the long run, I feel reasonably confident that having lower multiples and more-balanced budget and trade arrangements is better, since it lowers a source of economic leverage that also (by the way) tends to increase the frequency and severity of financial crack-ups. But in the short run…meaning over the next few years, if China is really going to work hard to balance the trade deficit with the US…it means rough sledding.

As I said, I give this next-to-no chance of China actually balancing its trade deficit with us. But it’s important to realize that steps in that direction have offsetting effects that are not all good.

RE-BLOG: Britain Survived the Blitz and Will Survive Brexit

January 14, 2019 Leave a comment

Since tomorrow is a big day in the saga of Brexit, I thought I’d re-post the article I wrote on June 24, 2016, when the UK first decided to leave. (You can find the original post here). Two and a half years on, and civilization has not yet collapsed, and in fact the forecasts of immediate and unavoidable disaster have turned out to be somewhat overblown. No matter; people have just rolled the forecasts forward to the actual date of hard Brexit. Buy your canned goods now! My opinion is unchanged – seen from the perspective of a few years, a hard Brexit is not going to be the cataclysm that some predict.

So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?

As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.

Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.

But Britain survived the Blitz; they will survive Brexit.

Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.

As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.

These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.

A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.

Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.

Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!

Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.

One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.

We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.

Categories: Euro, Re-Blog, UK

Summary of My Post-CPI Tweets (January 2019)

January 11, 2019 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • A few minutes to CPI. Consensus 0.2%, 2.2% y/y on core, pretty much on the dot. That’s slightly lower on core than last month, which ALMOST rounded to 2.3%, but dropping off a strong Dec ’17. Remember Median is 2.82%, near the highs.
  • it will be hard to get a ‘handle surprise’ on core CPI today. But watch Apparel, which has been weirdly weak despite tariff tensions. Used cars/trucks has been strong for a couple months and is due to be back normal, but not to “retrace” as it was too low before.
  • In general, look at core goods, which last month went flat after a long time in deflation. And keep an eye on core-ex-shelter, which is near multi-year highs.
  • 21% on core, 2.21% y/y. Basically a consensus number.
  • Pretty stable last few months of core.

  • Core goods 0.1% y/y, down from 0.2% y/y last month. Core Services unch at 2.9% y/y.
  • Core goods right on schedule.

  • OER 0.23% m/m, dropping y/y because of base effects back to 3.22%. Had been a y/y bounce last year because of those base effects but now pretty much back to trend. Primary rents 0.20%, 3.48% y/y, also down.
  • Inflation bears will point at “Lodging Away from Home,” +2.74% m/m, and say that is an aberration. But it’s really just reversing a very weak recent aberration. Y/y up to 0.91%; had been -1.37%. So ignore those people.
  • Pharma was weak, at -0.43% m/m and -0.58% y/y.

  • Doctors services also remains fairly low. Hospital Services however accelerated to 3.67% y/y from 3.52% y/y. Overall, Medical Care was roughly steady at 2% y/y.

  • Used Cars and Trucks was -0.18%, dropping y/y to 1.43% vs 2.30%. It was due to decelerate, and that’s roughly in line.

  • Apparel is back to positive y/y, at +0.3% vs -0.6%, but that’s mostly base effects. Only very small rise this month. That continues to be a head-scratcher. I’d expect to see trade frictions show up in apparel quickly. But this is a Dec number, and so maybe stockpiling pre-xmas.
  • Core ex-housing was 1.50% y/y, down slightly from 1.53% y/y last month. That remains near 5-year highs, but still waiting for the break higher.
  • Core ex-shelter chart.

  • By the way, if you have kids I hope they’re girls. In apparel, Boys’ apparel is +13.1% y/y…Men’s footwear is +4.3%…nothing else is over +0.5%.
  • Recreation is a pretty small part of CPI (5.7%), but rose from 0.61% y/y to 1.16% y/y. Inflation in Cable and Satellite Services, Pets and Pet Products, and “Admissions” were the main culprits. Pets are “recreation?” I think of them more as Transportation. Or Food.
  • Just kidding.
  • College Tuition and Fees +2.7% y/y, up a small amount but continuing to run ahead of headline and core.
  • Looks like a regional housing index will be the median category this month, which means my median guess isn’t as sharp. My estimate is 0.23% m/m, making the y/y 2.80% down from 2.83%. Median is a better measure of inflation trend since it ignores outliers.
  • This is an important chart. It shows Median CPI (without today’s number, not out yet) vs 10-year inflation swaps. You can see how bearish the market has gotten recently. Some of this is oil but these are 10y swaps so that shouldn’t matter much.

  • I almost forgot to mention that Wireless telephone services weakened again to -3.19% from -3.03% y/y. More interestingly, Land-line went to -0.02% from 0.46%. Even more interesting, land-line spending is only about a third as large as wireless. Here’s a chart of landline.

  • Let’s wrap this up with the four-pieces charts. First piece is food & energy. Weirdly linear deceleration.

  • The piece I think is a very important story going forward: core goods. Out of deflation and I think it’s going higher. This is where trade tensions are most important.

  • Core services less Rent of Shelter…still look to be in a downtrend, mostly thanks to medical. If we’re going to have an inflation accident, it should also show up here.

  • Rent of Shelter. Going nowhere fast. And that means you’re not getting deflation any time soon.

  • Final thought: next month we drop off a +0.35% m/m from core (from Jan ’18), which means it is pretty likely we see a drop in core towards 2%. That makes a Fed hike harder. But then the comparisons get easier, as my 12-month m/m core CPI chart showed.
  • Core is unlikely to drop below 2% any time soon, and in my view we’re likely to see 2.5% before 1.9%, and median inflation above 3% before long. But the Fed has a couple months’ reprieve before the choices get tougher.
  • That’s all for today. Thanks for tuning in.

Today’s CPI number is an acceptable one for the Fed. Right on the screws, showing no unanticipated accelerations. But also, no decelerations! Next month, core should decelerate, but that is likely to be the last good news for a while on inflation. Now, there are some reasons to think that the upward trend on inflation might be ending sooner than I have thought, and I’ll get into those reasons over the next week or two. But for now, the story is that the Fed has some breathing room to stop and watch for a while, and avoid some critical Presidential tweets while seeming to be principled. The difficult test will come in a few months when inflation starts heading higher even while growth, and stock markets, head lower. It may well be that we have seen the last tightening for a while – if the Fed Chair were Bernanke or Yellen, they’d already be easing, but Powell seems to be made of sterner stuff (but read my prior post about whether there is a Powell put). However, it has been easy up until now, with growth strong enough to take some hikes, inflation heading the wrong direction, and rates below any semblance of neutral. The next year or two is where the Fed’s job gets difficult as they have to navigate crosscurrents.

Categories: CPI, Tweet Summary

What’s Bad About the Fed Put…and Does Powell Have One?

January 8, 2019 3 comments

Note: Come hear me speak this month at the Taft-Hartley Benefits Summit in Las Vegas January 20-22, 2019. I will be speaking about “Pairing Liability Driven Investing (LDI) and Risk Management Techniques – How to Control Risk.” If you come to the event I’ll buy you a drink. As far as you know.

And now on with our irregularly-scheduled program.

Have we re-set the “Fed put”?

The idea that the Fed is effectively underwriting the level of financial markets is one that originated with Greenspan and which has done enormous damage to markets since the notion first appeared in the late 1990s. Let’s review some history:

The original legislative mandate of the Fed (in 1913) was to “furnish an elastic currency,” and subsequent amendment (most notably in 1977) directed the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” By directing that the Federal Reserve focus on monetary and credit aggregates, Congress clearly put the operation of monetary policy a step removed from the unhealthy manipulation of market prices.

The Trading Desk at the Federal Reserve Bank of New York conducts open market operations to make temporary as well as permanent additions to and subtractions from these aggregates by repoing, reversing, purchasing, or selling Treasury bonds, notes, and bills, but the price of these purchases has always been of secondary importance (at best) to the quantity, since the purpose is to make minor adjustments in the aggregates.

This operating procedure changed dramatically in the global financial crisis as the Fed made direct purchase of illiquid securities (notably in the case of the Bear Stearns bankruptcy) as well as intervening in other markets to set the price at a level other than the one the free market would have determined. But many observers forget that the original course change happened in the 1990s, when Alan Greenspan was Chairman of the FOMC. Throughout his tenure, Chairman Greenspan expressed opinions and evinced concern about the level of various markets, notably the stock market, and argued that the Fed’s interest in such matters was reasonable since the “wealth effect” impacted economic growth and inflation indirectly. Although he most-famously questioned whether the market was too high and possibly “irrationally exuberant” in 1996, the Greenspan Fed intervened on several occasions in a manner designed to arrest stock market declines. As a direct result of these interventions, investors became convinced that the Federal Reserve would not allow stock prices to decline significantly, a conviction that became known among investors as the “Greenspan Put.”

As with any interference in the price system, the Greenspan Put caused misallocation of resources as market prices did not truly reflect the price at which a willing buyer and a willing seller would exchange ownership of equity risks, since both buyer and seller assumed that the Federal Reserve was underwriting some of those risks. In my first (not very good) book Maestro, My Ass!, I included this chart illustrating one way to think about the inefficiencies created:

The “S” curve is essentially an efficient frontier of portfolios that offer the best returns for a given level of risk. The “D” curves are the portfolio preference curves; they are convex upwards because investors are risk-averse and require ever-increasing amounts of return to assume an extra quantum of risk. The D curve describes all portfolios where the investor is equally satisfied – all higher curves are of course preferred, because the investor would get a higher return for a given level of risk. Ordinarily, this investor would hold the portfolio at E, which is the highest curve he/she can achieve given his/her preferences. The investor would not hold portfolio Q, because that portfolio has more risk than the investor is willing to take for the level of expected return offered, and he/she can achieve a ‘better’ portfolio (higher curve) at E.

But suppose now that the Fed limits the downside risk of markets by providing a ‘put’ which effectively caps the risk at X. Then, this investor will in fact choose portfolio Q, because portfolio Q offers higher return at a similar risk to portfolio E. So the investor ends up owning more risky securities (or what would be risky securities in the absence of the Fed put) than he/she otherwise would, and fewer less-risky securities. More stocks, and fewer bonds, which raises the equilibrium level of equity prices until, essentially, the curve is flat beyond E because at any increment in return, for the same risk, an investor would slide to the right.

So what happened? The chart below shows a simple measure of expected equity real returns which incorporates mean reversion to long-term historical earnings multiples, compared to TIPS real yields (prior to 1997, we use Enduring Investments’ real yield series, which I write about here). Prior to 1987 (when Greenspan took office, and began to promulgate the idea that the Fed would always ride to the rescue), the median spread between equity expected returns and long-term real yields was about 3.38%. That’s not a bad estimate of the equity risk premium, and is pretty close to what theorists think equities ought to offer over time. Since 1997, however – and here it’s especially important to use median since we’ve had multiple booms and busts – the median is essentially zero. That is, the capital market line averages “flat.”

If this makes investors happy (because they’re on a higher indifference curve), then what’s the harm? Well, this put (a free put struck at “X”) is not costless even though the Fed is providing it for free. If the Fed could provide this without any negative consequences, then by all means they ought to because they can make everyone happier for free. But there is, of course, a cost to manipulating free markets (Socialists, take note). In this case the cost appears in misallocation of resources, as companies can finance themselves with overvalued equity…which leads to booms and busts, and the ultimate bearer of this cost is – as it always is – the citizenry.

In my mind, one of the major benefits that Chairman Powell brought to the Chairmanship of the Federal Reserve was that, since he is not an economist by training, he treated economic projections with healthy and reasonable skepticism rather than with the religious faith and conviction of previous Fed Chairs. I was a big fan of Powell (and I haven’t been a big fan of many Chairpersons) because I thought there was a decent chance that he would take the more reasonable position that the Fed should be as neutral as possible and do as little as possible, since after all it turns out that we collectively suck when it comes to our understanding of how the economy works and we are unlikely to improve in most cases on the free market outcome. When stocks started to show some volatility and begin to reprice late last year, his calculated insouciance was absolutely the right attitude – “what Fed put?” he seemed to be saying. Unfortunately, the cost of letting the market re-adjust is to let it fall a significant amount so that there is again an upward slope between E and Q, and moreover let it stay there.

The jury is out on whether Powell does in fact have a price level in mind, or if he merely has a level of volatility in mind – letting the market re-adjust in a calm and gentle way may be acceptable to him, with his desire to intervene only being triggered by a need to calm things rather than to re-inflate prices. I’m hopeful that is the case, and that on Friday he was just trying to slow the descent but not to arrest it. My concern is that while Powell is not an economist, he did have a long career in investment banking, private equity, and venture capital. That might mean that he respects the importance of free markets, but it also might mean that he tends to exaggerate the importance of high valuations. Again, I’m hopeful, and optimistic, on this point. But that translates to being less optimistic on equity prices, until something like the historical risk premium has been restored.

Spinning Economic Stories

January 4, 2019 5 comments

As economists[1] we do two sorts of things. We do quantitative work, and we tell stories.

One of the problems with economics is that we aren’t particularly regimented about how we convert data into stories and about how we look at stories to decide how to interrogate the data. So what tends to happen is that we have a phenomenon and then we look at what story we like and decide if that’s a reasonable way to explain the data…without asking if there isn’t a more reasonable way to explain the data, or at least another way that’s equally consistent with the data. I’m not saying that everyone does this, just that it’s disturbingly common especially among people being paid to be storytellers and for whom a good story is really important.

So for example, there is a well -known phenomenon that inflation tends to accelerate after the Fed begins raising interest rates.[2] Purporting to explain this phenomenon, here is a popular story that the Fed is just really smart, so they’re ahead of inflation, and when they seeing it moving up just a little bit they can jump on it real quick and get ahead of it and so inflation goes up…but the apparent causality is there because we just knew it was going to go up and acted before the observation of the higher inflation happened. This is basically Keynesian theory combined with “brilliant person” theory.

There is another theory that is consistent with this, of course: monetarism, which explains that increasing interest rates actually causes inflation to move higher, by causing velocity to increase. But, because this isn’t the popular story, this doesn’t get matched up to the data very frequently. In my mind it’s a better theory, because it doesn’t require us to believe that the Fed is super brilliant to make it work. (And, not to get snarky, but the countervailing evidence versus Fed staff economist genius is pretty mountainous). Of course, economists – and the Fed economists in particular – like theories that make them look like geniuses, so they prefer the prior explanation.

But again, as economists we don’t have a good and rigorous way to say that one way is the ‘preferred’ story or to look at other stories that are consistent with our data. We tend to look at what part of the data supports our story – in other words, confirmation bias.

Why this is relevant now is that the Fed is in fact tightening and inflation is in fact heading higher, and the story being pushed by the Fed and some economists is “good thing the Fed is tightening, because it looks like inflation was going up!” The story on the other hand that I have been telling for quite some time (and which I write about in my book) is that it’s partly because the Fed is tightening and interest rates are going up that that inflation is rising, in a feedback loop that is missed in our popular stories. The important part is the next chapter in the story. In the “Fed is getting ahead of it” story, inflation comes down and the Fed is able to stop tightening, achieving a soft landing. In the “rate increase is causing velocity to rise and inflation to rise” story, the Fed keeps chasing the dog which is only running because the Fed is chasing it.

There is another alternative, which really excites the stock market as evidenced by today’s massive – although disturbingly low-volume – rally. That story is that the Fed is going to become more “data dependent” (Chairman Powell suggested something along these lines today), which is great because the Fed has already won on inflation and growth is still okay. So the Fed can stop the autopilot rate hikes. This story unfortunately does require a little suspension of disbelief. For one thing, today’s strong Employment report (Payrolls 370k, including revisions, compared to 184k expectations) is unfortunately a December figure which means it has huge error bars. Moreover, the Unemployment Rate rose to 3.9% from 3.7%, and while a higher Unemployment Rate doesn’t mean the economy is definitely slowing (it could just be that more people are looking for jobs because the job market is so robust – another fun story), it is certainly more consistent with the notion that the economy is slowing at the margin. The fact that the Unemployment Rate went up, while Hourly Earnings rose more than expected and Jobs rose more than expected, should make you suspect that year-end quirkiness might have something to do with the figures. For the decades I’ve watched economic data, I always advise ignoring the January and February Employment Reports since the December/January changes in payroll are so large that the noise swamps the signal. But professional storytellers aren’t really content to say “this doesn’t really mean anything,” even if that’s the quantitative reality. They get paid to spin yarns, so spin yarns they do.

Yeah, about those wages: I’m not really sure why economists were expecting hourly earnings to decelerate this month. All of the anecdotal data, along with other wage measures, are suggesting that wages are rising apace (see chart, source Bloomberg, showing the Atlanta Fed Wage Tracker vs AHE). Not really a surprise, even given its compositional challenges, that AHE is also rising.

The thing about all of these stories is that while they can’t change the actual reality, they can change how reality is priced. This is one of the reasons that we get bubbles. The stories are so powerful that trading against them, with a ‘value’ mindset for example, is quixotic. Ultimately, in the long run, the value of the equity market is limited by fundamentals. But in the short run, it is virtually unlimited because of valuation multiples (price as a speculative multiple of fundamental earnings, e.g.) and those valuation multiples are driven by stories. And that’s a big reason that bullish stories are so popular.

But consider this bearish footnote on today’s 3.4% S&P rally: volume in the S&P constituents today was lower than the volume was on December 26! To be fair, the volume yesterday, when the S&P declined 2.5%, was even a bit lower than today’s volume. It’s typical thin and whippy first-week-of-the-year trading. Let’s see what next week brings.

[1] People occasionally ask me why I didn’t go on for my MA or PhD in Economics. I reply that it’s because I learned my Intermediate Microeconomics very well: I stopped going for a higher degree when the marginal costs outweighed the marginal benefits. When you look at it that way, it makes you wonder whether the PhD economists aren’t just the bad students who didn’t absorb that lesson.

[2] It’s referred to as the “price puzzle”; see Martin Eichenbaum, “Interpreting Macroeconomic Time Series Facts: The Effects of Monetary Policy: Comments.” European Economic Review, June 1992. And Michael Hanson, “The ‘Price Puzzle’ Reconsidered,” Journal of Monetary Economics, October 2004.

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