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.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link).
I am often critical of central banks these days, and especially the Federal Reserve. But that doesn’t mean I think the entire institution is worthless. While quite often the staff at the Fed puts out papers that use convoluted and inscrutable mathematics to “prove” something that only works because the assumptions used are garbage, there are also occasionally good bits of work that come out. While it is uneven, I find that the Atlanta Fed’s “macroblog” often has good content, and occasionally has a terrific insight.
The latest macroblog post may fall into the latter category. Before I talk about the post, however, let me as usual admonish readers to remember that wages follow inflation; they do not lead or cause inflation. That reminder is very important to keep in mind, along with the realization that some policymakers do think that wages lead inflation and so don’t get worried about inflation until wages rise as well.
With that said, John Robertson and Ellyn Terry at the Atlanta Fed published this great macroblog article in which they present the Atlanta Fed’s Wage Growth Tracker. Here’s the summary of what they say: most wage surveys have significant composition effects, since the group of people whose wages you are surveying now are very different from the group you surveyed last year. Thus, measures like Average Hourly Wages from the Employment report (which has been rising, but not alarmingly so) are very noisy and moreover might miss important trends because, say, high-wage people are retiring and being replaced by low-wage people (or industries).
But the Atlanta Fed’s Wage Growth Tracker estimates the wage growth of the same worker’s wage versus a year ago. That is, they avoid the composition effect.
It turns out that the Wage Growth Tracker has been rising much more steadily and at a higher rate than average hourly earnings. Here is the drop-the-mic chart:
With this data, the Phillips curve works like a charm. Higher employment is not only related, but closely related to higher wage growth. (For the record, Phillips never said that broad inflation was related to the unemployment rate. He said wage inflation was. See my post on the topic here.) The good news is that this doesn’t really say anything about future inflation, and what it means is that the worker who is actually employed right now is still keeping pace with inflation (barely) thanks to relatively strong employment dynamics.
The bad news, for Yellen and the other doves on the FOMC, is that if they were hiding behind the “tepid wage growth” argument as a reason to be suspicious that inflation will not be maintained, the Atlanta Fed just took a weed-whacker to their argument.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
I was surprised in December when the most dovish central banker ever to lead the Fed allowed the body to implement a tightening, so perhaps I shouldn’t be surprised now that she is staunchly resisting an increasingly-raucous chorus of hawks. Prior to the Fed’s last meeting, I noted that if there was ever an excuse for tightening, unemployment being around 5% with core CPI above 2% while emergency measures still remain in place from the last crisis was probably a pretty good one. When the Fed eschewed action at the meeting, I scratched my head even though I wasn’t totally shocked. Yellen is a dove, and an unrepentant one at that. Despite all efforts to rehabilitate her image in that regard, the truth remains.
But her arguments are getting increasingly weak. Her argument seems to be that if domestic growth is weak, then even if inflation is rising the Fed will maintain the extraordinary measures as long as inflation is not yet at disturbing levels, or if the inflation is believed to be transient. Okay, fair enough – I believe it’s the wrong tine of the fork to focus on, since in the long run growth is maximized when inflation is low, stable, and predictable (as Greenspan once was fond of reminding us) and because the Fed can actually control inflation through monetary policy while there is little evidence they can control real growth. But still, it’s a point that many at the Federal Reserve would agree with.
However, in her remarks on Tuesday Yellen went further and pointed to weakness in other parts of the world where the Fed clearly has no direct mandate but also where it isn’t clear the weakness isn’t a net positive for the US in terms of our growth/inflation tradeoff. Lower energy prices due to weak growth in Europe and China, for example, has a positive impact on the United States which almost certainly outweighs the decline in our exports to those countries.
Yellen’s argument sounds a lot like what you will sometimes hear around bonus time at a large company (and perhaps here I will reveal lingering frustrations of my own!). In some companies, what you hear at bonus time if your group or your particular project did really well is “you did well, but we can’t pay you as much as it deserves because the firm/the division/the group came in below plan.” At the same organization, if your group or your project did poorly while the overall firm had a banner year, the bonus time discussion will begin with “well, as you know you didn’t perform well…”
Growth will always be weak somewhere in the world. Soon enough, it will probably be weak here. But even when it weakens here it is not likely to be so weak that we continue to need extraordinary liquidity provision such as that which is currently in place.
Yes: to me, the bigger issue is the size of the Fed’s balance sheet and the global pile of excess reserves. Higher interest rates from the central bank are not only not a cure, they make the problem worse by causing money velocity to increase. But I would be somewhat less uncomfortable if there was any indication that the Fed had some sense of urgency on the inflation front.
In any event, if the Fed does not raise rates in April then it means it will be at least 6 months between 25bp rate increases. At that rate, it would be about six years until the short rate returned to something like a normal level. But that’s irrelevant – because a change in rates every six months cannot be seriously called a tightening “campaign.”
The Fed’s credibility erodes further with every passing day. The good news is that there isn’t much left to erode.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
In the long list of nightmares that market risk managers have to wrestle with on a daily basis, some have gradually receded. For competently-run banks and large trading institutions, the possibility of a rogue trader making undiscovered trades or mis-marking his own book – another Nick Leeson – is increasingly remote given the layers of oversight. But one nightmare in particular has been increasing in frequency since 2009, especially as Volcker Rule and Dodd-Frank restrictions have been implemented.
The concern is market illiquidity. Every year that goes by, liquidity in the financial markets is declining. This is not apparent to the casual observer, or casual investor, who faces a tight market for his hundred- or thousand-lot. But probably every institutional investor has a story of how his attempt to hit a bid on the screens resulted in his trading the minimum size while the rest of the bid fled with sub-millisecond dispatch. And so the question is: if your mutual fund is hit by redemptions at the same time that its market (equities, emerging markets, credit?) is falling apart – and that is the normal time that redemptions swell – then at what price will it be able to get out? And what if there is no bid at all that is big enough?
Banks and other dealing institutions have responded to both the new regulatory restrictions themselves, and to the effects of the restrictions, by decreasing the size of their balance sheet dedicated to trading. Much of the apparent ‘liquidity’ in the market now is provided by the algos (the algorithmic trading systems) who as we have seen can be there and gone in an eyeblink. I am not aware of anything that has been done in the wake of the various “flash crashes” we have seen that would lead me to have great confidence that in the next big market discontinuity markets will function any better than they did in 2008. In fact, public liquidity is quite a bit smaller and I would expect them to function a fair bit worse.
Yes, many institutions have begun to access “dark pools” where they face anonymous counterparties in crossing large trades, rather than chasing hair-trigger algos for a fraction of the size they need. But nothing is particularly soothing about the dark pools, either (starting with their name). The whole point of a market discontinuity is that flow traders end up all on the same side of the flow; in these times we want the speculative traders with big balance sheets to take the other side of trades at a price that reflects a reasonable return on their capital. Those spec traders, or at least the big-balance-sheet banks, aren’t providing extra liquidity in dark pools either.
Banks have also responded to the beat-down regularly administered by socialists like Bernie Sanders and by sympathetic ears in the press (and among the populist splinters of the right as well) – by cutting the experienced and expensive traders who have more experience in pricing scarce liquidity, and perhaps finding it sometimes. Again, none of this makes me optimistic about how we will handle the next “event.”
None of this rant is new, really. But what is interesting and new is that the illiquidity is starting to show up in very visual ways. Regular readers know that my primary area of domain expertise is in rates, and specifically in inflation. Consider the chart below (source: Enduring Investments), which I would consider strong evidence that market liquidity in inflation is worse now than it was two years ago. The chart shows 1-year inflation forward from various points on the inflation curve. That is, the point on the far left is 1 year inflation, 0 years forward (in other words, today’s 1-year inflation swap). The next point is 1 year inflation, 1 year forward. And so on, so that the last point is 1 year inflation, 29 years forward.
Ignore the level of inflation expectations generally – that isn’t my point here. Obviously, inflation expectations are lower and that is not news. But the curve from two years ago shows a nice, smooth, “classic rates derivatives” shape. Inflation is priced in the market as rising in smooth fashion. This doesn’t mean that anyone really expects that inflation will rise smoothly like that; only that such is the best single guess and, moreover, one that has nice characteristics in terms of derivatives pricing and transparency.
The blue curve shows the curve from last Thursday. Now, I could have chosen any curve in the last month or two and they would have been similarly choppy. You can see that the market is evidently pricing in that inflation will be 1.72% over the next year, and then decline, then rise, then decline, then rise irregularly until 9 years from now when it will abruptly peak and descend.
That’s a mess, and it is an indication that liquidity in the inflation swaps market is insufficient to pull the curves into a nice, smooth shape. This is analogous to one important characteristic of a planet, from an astrophysicist’s point of view: any body that is not sufficiently massive to pull itself into a sphere is not a planet, by definition. I would argue that the inability of the market to pull the inflation curve into a nice and smooth “derivatives” shape is an early warning sign that the “mass” of liquidity in this market – and in others – is getting worse in a visually-apparent way.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
Last week, one of the curious parts of the CPI report was the large jump (1.6% month/month, or nearly 20% annualized) in Apparel. At the time, I dismissed this rise with a hand-wave, pointing out that it Apparel is only 4% of core and so I don’t worry as much about Apparel as I do, say, Medical Care or Housing.
But a Twitter follower called to my attention the words of @IanShepherdson, one of the real quality economists out there (and one whom I read regularly when he was with High Frequency Economics, and I was at Natixis). He hasn’t always been on top of the inflation story, but he nailed the housing bubble story in 2008 and I have great respect for him. Ian apparently said of Apparel that it could be the proverbial “canary in the coal mine” when it comes to inflation, since apparel tends to respond more quickly to inflationary pressures since it is a very competitive and very homogeneous category.
So I figured it was worth taking a longer look at inflation.
Now, I should point out that I probably have a bias about getting over-excited about inflation. Back in 2011-12, Apparel prices started to accelerate rapidly for the first time in a generation- and that’s no hyperbole. As the chart below (Source: Bloomberg) shows, the price index for seasonally-adjusted apparel prices went sideways-to-down-to-sideways between 1992 and 2012.
You can see from this why I may have gotten excited in 2012. Between 1970 and 1992, apparel prices rose at a very steady rate. Then, as post-Cold War globalization kicked into high gear, apparel manufacture moved from being largely produced in the US to being largely produced outside of the US; the effect on prices is apparent on the chart. But in 2011-2012, the price index began to move higher at almost the same slope as it had been moving prior to the globalization dividend. My thought back then was that the dividend only happens once: at first, input costs are stable or declining because high-cost US labor is replaced with low-cost overseas labor – but eventually, once all apparel is produced overseas, then the composition effect is exhausted and input prices will rise with the cost of labor again. In 2012, I thought that might be happening.
And then Apparel flattened out.
You can see, though, from the right side of the chart the latest spike that has Ian (and maybe me) so excited. The month/month rise was the third largest in the last 30 years, exceeded only by February 2009 and February 2000. As an aside, the fact that the three largest monthly spikes were all in February ought to make you at least a little suspicious that some of what is going on may be a seasonal-adjustment issue, but let’s leave that aside for now because I’m rolling.
What about the assertion that Apparel may be the ‘canary in the coal mine,’ giving an early indication on inflation? The chart below (source: Bloomberg, and Enduring Investments calculations) shows the year-over-year change in Apparel prices (on the right-hand scale) versus core CPI (on the left-hand scale).
I do have to admit, there is something suggestive about that chart although it is at least somewhat visual since I can’t find a consistent lag structure in the data. But the clear turns do seem to happen first in Apparel, often. Ah, but here is the fun chart. For the next chart, I’ve also taken out Shelter from core inflation, since Shelter especially in recent years has been largely driven by pretty crazy monetary policy, as I have pointed out before many times. (And if you want to read what I think that’s likely to lead to, read my book.) To make it fair, I also removed Apparel itself since once Shelter and Food and Energy are all removed, Apparel is starting to matter.
In this chart, you can start to see a pretty interesting tendency for Apparel to perhaps lead, slightly – and so, perhaps, Ian is right. In this case, I certainly wouldn’t want to bet against him since I think that’s where inflation is going too. I just wasn’t sure that Apparel was a strong part of the argument. (But at the same time, notice the big spike in Apparel inflation in 2012 preceded a rise in ex-housing core, but not a large or sustained rise in ex-housing core).
The table below shows the breakdown of Apparel into its constituent parts. The first column is the category, the second column is the weight (in overall CPI), the third column is the current y/y change, and the fourth column is the previous y/y change.
|Category||Weights||y/y change||prev y/y change|
|Boys’ and girls’ footwear||0.17%||2.506%||-0.046%|
I look at this to see whether there’s just one category that is having an outsized move; if there were, then we would worry more about one-off effects (say, the rollout of a new kind of women’s blouse that is suddenly all the rage). It is interesting that Men’s apparel and Boys’ apparel decelerated, while most everything else accelerated, but this happens all the time in the Apparel category. Actually, this is a pretty balanced set of sub-indices, for Apparel.
Now, I’m still not 100% sure this isn’t a seasonal-adjustment issue. It could be related to weather, or day count (29 days in February!), or some bottleneck at a port that caused a temporary blip in prices. I want to see a few more months before getting excited like I did in 2012! But we have had a couple of bad core CPI prints, and we also saw pressure in Medical Care so it is fair to say the number of alarm bells has broadened from one (Housing) to several (Housing, Medical Care, Apparel). It is fair to be concerned about price pressures at this point.