Brexit and Trump and Free Options

November 9, 2016 1 comment

As the evening developed, and it began to dawn on Americans – and the world – that Donald Trump might actually win, markets plunged. The S&P was down 100 points before midnight; the dollar index was off 2%. Gold rose about $70; 10-year yields rose 15bps. Nothing about that was surprising. Lots of people predicted that if Trump somehow won, markets would gyrate and move in something close to this way. If Clinton won, the ‘status quo’ election would mean much calmer markets.

So, we got the upset. Despite the hyperbole, it was hardly a “stunning” upset.[1] Going into yesterday, the “No Toss Ups” maps had Trump down about 8 electoral votes. Polls in all of the “battleground” states were within 1-2 points, many with Trump in the lead. Yes, the “road to victory” was narrow, requiring Trump to win Florida, Ohio, North Carolina, and a few other hotly-contested battlegrounds, but no step along that road was a long shot (and it wasn’t like winning 6 coin flips, because these are correlated events). Trump’s victory odds were probably 20%-25% at worst: long odds, but not ridiculous odds. (And I believe the following wind to Trump from the timing of Obamacare letters was underappreciated; I wrote about this effect on October 27th).

And yet, stock markets in the two days prior to the election rose aggressively, pricing in a near-certainty of a Clinton victory. Again, recall that pundits thought that a Clinton victory would see little market reaction, but a violent reaction could obtain if Trump won. Markets, in other words, were offering tremendous odds on an event that was unlikely, but within the realm of possibility. The market was offering nearly-free options. The same thing happened with Brexit: although the vote was close to a coin-flip, the market was offering massive odds on the less-likely event. Here is an important point as well – in both cases, the error bars had to be much wider than normal, because there were dynamics that were not fully understood. Therefore, the “out of the money” outcome was not nearly as far out of the money as it seemed. And yet, the market paid you handsomely to be short markets (or less long) before the Brexit vote. The market paid you handsomely to be short markets (or less long) before yesterday’s election results were reported. And, patting myself on the back, I said so.

capture

This is not a political blog, but an investing blog. And my point here about investing is simple: any competent investor cannot afford to ignore free, or nearly-free, options. Whatever you thought the outcome of the Presidential election was likely to be, it was an investing imperative to lighten up longs (at least) going into the results. If the status-quo happened, you would not have lost much, but if the status quo was upset, you would have gained much. As I’ve been writing recently about inflation breakevens (which was also a hard-to-lose trade, though less dramatic), the tail risks were really underpriced. Investing, like poker, is not about winning every hand. It is about betting correctly when the hand is played.

At this hour, stock markets are bouncing and bond markets are selling off. These next moves are the difficult ones, of course, because now we all have the same information. I suspect stocks will recover some, at least temporarily, because investors will price a Federal Reserve that is less likely to tighten and the knee-jerk response is to buy stocks in that circumstance. But it is interesting that at the moment, while stocks remain lower the bond market gains have completely reversed and are turning into a rout. 10-year inflation breakevens are wider by about 9-10bps, which is a huge move. But there will be lots of gyrations from here. The easy trade was the first one.

[1] And certainly not “the greatest upset in American political history.” Dewey Defeats Truman, anyone?

Why Are Inflation Expectations Rising?

November 2, 2016 5 comments

A persistent phenomenon of the last couple of months has been the rise in inflation expectations, in particular market-based measures. The chart below (source: Bloomberg) shows that 10-year inflation swap quotes are now above 2% for the first time in over a year and up about 25-30bps since the end of summer.

usswit10

The same chart shows that inflation expectations remain far below the levels of 2014, 2013, and…well, actually the levels since 2004, with the exception of the crisis. This is obviously not a surprise per se, since I’ve been beating the drum for months, nay quarters, that breakevens are too low and TIPS too cheap relative to nominals. But why is this happening now? I can think of five solid reasons that market-based measures of inflation expectations are rising, and likely will continue to rise for some time.

  • Inflation itself is rising. What is really amazing to me – and I’ve written about it before! – is that 10-year inflation expectations can be so low when actual levels of inflation are considerably above 2%. While headline inflation oscillates all the time, thanks to volatile energy (and to a lesser extent, food) markets, the middle of the inflation distribution has been moving steadily higher. Median inflation (see chart, source Bloomberg) is over 2.5%. Core inflation is 2.2%. “Sticky” inflation is 2.6%.

medcpia

Moreover, as has been exhaustively documented here and elsewhere, these slow-moving measures of persistent inflationary pressures have been rising for more than two years, and have been over the current 2% level of 10-year inflation swaps since 2011. At the same time inflation expectations have been declining. So why are inflation expectations rising? One answer is that investors are now recognizing the likelihood that the inflation dynamic has changed and inflation is not going to abruptly decelerate any time soon.

  • It is also worth pointing out, as I did last December in this article, that the inflation markets overreact to energy price movements. Some of this recovery in inflation quotes is just unwinding the overreaction to the energy swoon, now that oil quotes are rising again. To be sure, I don’t think oil prices are going to continue to rise, but all they have to do is to level off and inflation swap quotes (and TIPS breakevens) will continue to recover.
  • Inflation tail risk is coming back. This is a little technical, but bear with me. If your best-guess is that inflation over the next 10 years will average 2%, and the distribution of your expectations around that number is normal, then the fair value for the inflation swap is also 2%. But, if the length of the tail of “outliers” is longer to the high side than to the low side, then fair value will be above 2% even though you think 2% is the “most likely” figure. As it turns out, inflation outcomes are not at all normal, and in fact demonstrate long tails to the upside. The chart below is of the distribution of overlapping 1-year inflation rates going back 100 years. You can see the mode of the distribution is between 2%-4%…but there is a significant upper tail as well. The lower tail is constrained – deflation never goes to -12%; if you get deflation it’s a narrow thing. But the upper tail can go very high.

longtailsWhen inflation quotes were very low, it may have partly been because investors saw no chance of an inflationary accident. But it is hard to look at what has been happening to inflation over the last couple of years, and the extraordinary monetary policy actions of the last decade, and not conclude that there is a possibility – even a small possibility – of a long upside tail. As with options valuation, even an improbable event can have an important impact on the price, if the significance of the event is large. And any nonzero probability of double-digit inflation should raise the equilibrium price of inflation quotes.

  • The prices that are changing the most right now are highly salient. Inflation expectations are inordinately influenced, as noted above, by the price of energy. This is not only true in the inflation markets, but in forming the expectations of individual consumers. Gasoline, while it is a relatively small part of the consumption basket, has high salience because it is a purchase that is made frequently, and as a purchase unto itself (rather than just one more item in the basket at the supermarket), and its price is in big numbers on every corner. But it is not just gasoline that is moving at the moment. Also having high salience, although it moves much less frequently for most consumers: medical care. No consumer can fail to notice the screams of his fellow consumers when the insurance letter shows up in the mail explaining how the increase in insurance premiums will be 20%, 40%, or more. While I do not believe that an “expectations anchoring” phenomenon is important to inflation dynamics, there are many who do. And those people must be very nervous because the movement of several very salient consumption items is exactly the sort of thing that might unanchor those expectations.
  • Inflation markets were too low anyway. When 10-year inflation swaps dipped below 1.50% earlier this year, it was ridiculous. With actual inflation over 2% and rising, someone going short inflation markets at 1.50% had to assess a reasonable probability of an extended period of core-price disinflation taking hold after the first couple of years of inflation over 2%. By our proprietary measure, TIPS this year have persistently been 80-100bps too cheap (see chart, source Enduring Investments). This is a massive amount. The only times TIPS have been cheaper, relative to nominal bonds, were in the early days when institutions were not yet investing in TIPS, and in the teeth of the global financial crisis when one defaulting dealer was forced to blow out of a massive inventory of them. We have never seen TIPS as cheap as this in an environment of at least acceptable liquidity.

tipscheap

So, why did breakevens rally? Among the other reasons, they rallied because they were ridiculously too low. They’re still ridiculously too low, but not quite as ridiculously too low.

What happens next? Well, I look at that list and I see no reason that TIPS shouldn’t continue to outperform nominal bonds for a while since none of those factors looks to be exhauster. That doesn’t mean TIPS will rally – indeed, real yields are ridiculously low and I don’t love TIPS on their own. But, relative to nominal Treasuries (which impound the same real rate expectation), it’s not even a close call.

How Obama Helped Trump Win the White House

October 27, 2016 8 comments

At this writing, Presidential Candidate Donald Trump is trailing Hillary Clinton in most assessments of the political map. While it is much closer than the 6-point spread in the national polling indicates (if all of the “toss-up” states on Real Clear Politics flip to Trump, rather than to Clinton as they now lean, then Trump scores a fairly easy victory), the winner-take-all betting markets put Clinton’s chance of victory near 90%. To be fair, though, let’s remember that the betting markets had the Brexit vote failing with similar certainty, even though the polls were similarly close.[1]

The October surprises, which by now are no surprise, have had essentially no effect. The jaded and cynical US public yawned at tales of Trump’s peccadilloes and the shocking, shocking tale that Clinton may have padded her pockets by selling influence while in office. And so…it’s over?

Well, not so fast. While the public now dismisses as normal behavior the sorts of things that we would fire an employee for (or divorce a spouse for) if they happened to people around us, and seems content to elect a flawed candidate regardless of the outcome on November 8th, there is something that they do care about, and deeply: their own money.

It is incredible to me, since I am just as cynical as the rest of the electorate, that when the Affordable Care Act was passed the open enrollment date was systematically placed just a few days before Election Day. That was either great confidence (“this is going to be great! They’ll love us and vote for us!”), great hubris (“it doesn’t matter whether this works, the sheeple will vote for us anyway”) or great carelessness (“oh, rats, didn’t think of that”). Because we now know that over the next several days, millions and millions of Americans will receive letters explaining to them that their existing plan will be outrageously more expensive in 2017 – in some cases, premiums will double – or may not be available at all.

I suspect that a taxpayer in North Carolina, who sees his premium jump 40%, is going to suddenly take notice of the Presidential election and wonder which candidate is more likely to solve that problem. Now, before you write your hate mail to me, let me note and acknowledge a few facts:

  1. I am not voting for either of the two major party candidates. I’m no Trump stooge. I think they’re both awful candidates. This article is just a commentary on what I think will happen, not cheerleading for an outcome I want to happen.
  2. Some voters will not see any change in their premiums because their subsidies will rise an equivalent amount to the premium. But,
    1. Most people who are squarely in the middle class will not get these subsidies. On the calculator at https://www.healthcare.gov, I can see that a family of four in New Jersey, earning $45,000, should not expect to be eligible for a premium tax credit or other savings. According to the Pew Research Center, a family of four with a $45,000 pre-tax income is in the lowest 25% of New Jersey residents arranged by income.
    2. Furthermore, someone who continues to get a subsidy is not likely to be as motivated to go out and vote for a continuation of the status quo as a person who is seeing a 40% rise is motivated to go out and vote for change. So, this is likely to cause a major change in the degree of motivation for one party compared with the other.
  3. Many voters will, instead, get a letter that their existing plan will no longer be offered, and this too will cause angst and anger.
  4. Voters who are covered by an employer plan are not immune just because the “employer pays.” When an employer’s cost for employee insurance rises 40%, that employer will either lay off workers, make them cover more of their own premium costs, or hold down other costs…such as salary increases.

Simply put, unless you are living under a rock you are aware of these dramatic changes in insurance costs and coverage. If you’re one of the few lucky ones to be subsidized (and even more if you’re lucky to have a cheap plan that you wouldn’t have had to get at all before the ACA passed), then you’re probably going to like the current regime. You may even be grateful, and go out to vote your thanks. But this is a small (and expensive!) minority of the electorate. The vast majority is going to see painful and drastic changes in the health care landscape. And they’re going to see it right about now. Again, what is really amazing to me is that the program designers made November 1st the notification deadline for re-enrollment letters.

Aside from the effect on the election, which I think might be dramatic, we need to also think about the effect on the economy. The good news is that while medical care inflation is likely to keep rising, the large jump this year is possibly a one-off effect because the ACA is removing subsidies of insurance companies that previously caused insurance to look cheaper than it really was. But that won’t help this year’s politicians.

The large rise in premiums, incidentally, is also going to have a depressing effect on economic growth next year because it hits the middle of the income distribution the hardest. If Bill Gates sees his insurance costs go up 40%, it’s no big deal. But if Fred the plumber from Poughkeepsie sees his insurance costs go up 40%, he’s going to be buying less of something else that is discretionary. Cars, clothes, meals out perhaps?

The election is mere days away. If Trump wins, despite his every effort to make himself unelectable, he will have one person to thank most profusely: President Obama.

[1] Remember that the betting markets work like options – as time to maturity goes to zero, gamma at the strike price goes to infinity. That is, with no time left the value of the Clinton option – which, since it’s a binary option, is the same as its delta – goes from 100% if she wins by 1 vote in a state that puts her 1 electoral vote over Trump, to 0% if she loses by 1 vote in that same state. Six months ago, one vote would have no effect on option price; but if we are around the strike as we are now even small changes can have large effects on price.

Categories: ACA, Politics

Summary of My Post-CPI Tweets

October 18, 2016 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. Plus…buy my book about money and inflation, published in March 2016. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI coming up in 14 minutes. Consensus on core is for a barely 0.2% print, (more like 0.15%). That would keep the y/y barely at 2.3%.
  • Remember to join me at 9am for a (FREE) live interactive video event at http://events.shindig.com/event/tmenduringinvestments
  • okay, core 0.1%, y/y to 2.2%. Yayy! And by the way it was only 0.11% so not close. y/y to 2.21%.
  • core rate is only 1.8% over last 3 months, vs 2.0% over last 6 and 2.2% over last 9. November tightening is wholly out.
  • Housing accelerated, Medical care roughly unch. Educ/Communication dropped. Getting breakdown now.
  • Headline was also soft. Market was 241.475 bid before the number and 241.428 was the print. Still rounded to 0.3% m/m though.
  • Bonds don’t love this as much as I thought they would. 10y note up about 4 ticks after the data.
  • 10y inflation swaps also didn’t do much. Close to 2% for first time in a long, long time.
  • Primary rents 3.70% from 3.78%, I was reading last month. But OER still up, 3.38% from 3.31%.
  • New and used cars -1.16% vs -0.95%, so more weakness there.
  • In Med care: Drugs 5.38% vs 4.59%, ouch. But prof svcs 3.22% vs 3.35%, and hospitals 5.64% vs 5.81%, and insurance 8.37% vs 9.10%.
  • But those are all retracements within trend.
  • Tuition ebbed to 2.32% vs 2.53%, and “information and info processing” -1.98% vs -0.90%. Those two add up to 7% of CPI.
  • I can see why bonds aren’t super excited. This isn’t a trend change. It looks like a pause.
  • ok, have to go get ready for the video event. See you at http://events.shindig.com/event/tmenduringinvestments … in about 10.
  • Probably good news from Median as well. I see 0.17%, bringing y/y down to 2.54% vs 2.61%. But hsg is median category so I may be off.

I covered some stuff in the Shindig event, but it’s worth showing a couple of charts. Here is health insurance. You can see the little drop this month isn’t exactly something that would make you say “whew! Glad that’s over!”

medins

This next chart, also in medical care, is the year/year change in the cost of medicinal drugs (prescription and non-prescription). Also, not soothing. And these are where the important things are happening in CPI right now.

medicinaldrugs

Finally, the big momma: Owners’ Equivalent Rent. This is not looking like it’s rolling over! And if it’s not rolling over, it’s not likely that inflation overall is rolling over.

oer

In short, the monthly weakness was enough to sooth the Fed and take them off the table for November. And, unless the next figure is really, really bad – like over 0.3% – then they’ll still say “two of the last four are soft.” The December Fed meeting, for what it’s worth, is the day before the CPI is released. The Fed won’t know that number in advance, although nowadays with “nowcasting” they’ll have a clue. But at this point, unless next month’s CPI is very high and/or the Payrolls number is very strong, I think a rate hike in December is also unlikely.

That’s good for markets in the short run. But inflation is rising, and that’s bad for markets in the medium-run!

Inflation Dogma Dies Hard

October 14, 2016 Leave a comment

It has been a busy week, if short. We found out this week that there is pressure on the doves at the Federal Reserve, the biggest of which is Chairman Yellen, to raise interest rates. To some extent we already knew this, based on the dissents in favor of immediate hiking at the latest FOMC meeting. But the minutes this week provided evidence that the support for such a move is broadening, and even normally-dovish Fed speakers have lately been conceding the argument that it “may” soon be time to raise rates again. Notably, and critically, the Chairman is not among those turncoats. I continue to believe that Dr. Yellen will look for any and all excuses to skip a rate hike at coming meetings. Most observers don’t expect an increase to happen immediately before the US election, but the market is putting a pretty heavy weight on December. According to Bloomberg, Fed funds futures are implying a 2/3 chance of a hike at one of the next two meetings.

But lots can change before December 14th, and it will not take much to constitute an excuse to remain sidelined. It is an absurdly high hurdle that Yellen has set. But it makes sense if you remember that Yellen believes that monetary policy is an important and useful tool for increasing employment, that inflation has been so low for so long that it can run “a bit hot” for a while and not be worrisome, and that it can be reined back in at will.

Some of her insouciance is shared by many at the Fed (and described in this Bloomberg article from August). The article is delicious, because some of the quotes suggest confusion about certain notions that have been long held at the Fed but don’t seem to be working any more. They’re not working because they never did, but there was correlation without causation that confused them, and an embraced dogma about inflation that was simply wrong and ignored everything we had learned about inflation in the 1970s and early 1980s. For example, the Fed has long believed that inflation expectations play an important role in anchoring inflation. They have believed this since the 1990s, when a role for expectations was inserted in economists’ models to explain the break to low inflation around 1993. Now, however, “movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations.”

It isn’t clear why anyone ever believed that the shopkeeper will set his prices based on what his customers expect to pay, rather than on what his input costs are, but there was a lot of math and some spurious correlations and poof! let there be dogma.

So here’s a thought: maybe inflation is caused by changes in money float and money velocity? And maybe…just maybe…changing the amount of the measurement stick (money) in circulation doesn’t change the amount of stuff (real GDP) being measured? Call me crazy, but these ideas have worked for decades, and they might be useful even if there isn’t as much math.

multicountrym2

For fun, I did the chart above with both US and Eurozone money supply growth, versus US inflation. Even though I am ignoring the things the orthodoxy considers causal, like unemployment rates and inflation expectations, the fit is pretty good. MV=PQ still outperforms the output-gap based models easily. Of course, now that the unemployment rate is back to being low, the rising inflation that we are seeing will be attributed by the economic high priests to the closing of the output gap, despite the fact that inflation started accelerating in earnest long before that gap closed. Dogma dies hard.

Ironically, Yellen has the right stance but for the wrong reason: higher rates will cause higher money velocity, which will cause higher inflation; without any attempt to restrain reserves money supply growth will not roll over and squelch that inflation. So, if rates start to rise – Fed induced, or not – in earnest, the vicious cycle (higher rates cause higher velocity, which causes higher inflation, which causes higher rates, etc…) is going to kick into gear and it could be a long decade ahead. Go to our website and play with the MVPQ calculator. Starting velocity is 1.45. Remember that is an all-time low, and that the average velocity for 1960-1990 was 1.72 (and the average for 1980-2010 was 1.94). Current M2 growth is about 7.5%. It’s October. Go scare yourself.

On Tuesday, we will get another CPI and another chance to turn up the heat on the doves. In three of the last eight months, core CPI has been above 0.25%. If that happens again, then the year-over-year figure will rise to 2.4%. The Cleveland Fed’s Median CPI is already at 2.6%; the Atlanta Fed’s “Sticky” CPI is 2.72%. After the report, at 9am ET I will be doing a (free) live interactive virtual video event; you can sign up at this link. I will summarize what the inflation report said and what effect it should have on Fed and markets, and I will take audience questions. You need to RSVP, so get in there while you can!

Why Does the Fed Focus on a Flawed PCE?

On Friday, I was on Bloomberg TV’s “What’d You Miss?” program to talk about the PCE inflation report from Friday morning. You can see most of the interview here.

I like the segment – Scarlet Fu, Oliver Renick, and Julie Hyman asked good questions – but we had to compress a fairly technical discussion into only 5 or 6 minutes. As a result, the segment might be a little “wonky” for some people, and I thought it might be helpful to present and expand the discussion here.

The PCE report itself was not surprising. Core PCE came in as-expected, at 1.7%. This is rising, but remains below the Fed’s 2% target for that index. I think it is interesting to look at how PCE differs from CPI to see why PCE remains below 2%. After all, core PCE is the only inflation index that is still below 2% (see chart, source Bloomberg). And, as we will see, this raises other questions about whether PCE is a reasonable target for Fed policy.

fourmeasuresThere are several differences between CPI and PCE, but the main reasons they differ can be summarized simply: the CPI measures what the consumer buys, out-of-pocket; the PCE measures not only household expenditures but also spending on behalf of consumers, including such things as employer-purchased insurance and some important government expenditures. As pointed out by the BEA on this helpful page, “the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.”

This leads to two major types of differences: weight effects and scope effects.

Weight effects occur because the PCE is a broader index covering more economic activity. Consider housing, which is one of the more steady components of CPI. Primary rents and owners’-equivalent rent constitute together some 32% of the CPI and those two components have been rising at a blended rate of about 3.4% recently. However, the weight of rent-of-shelter in PCE is only 15.5%. This difference accounts for roughly half of the difference between core CPI and core PCE, and is persistent at the moment because of the strength in housing inflation.

However, more intriguing are the “scope” differences. These arise because certain products and services aren’t only bought in different quantities compared to what businesses sell (like in the case of housing), but because the two surveys include and exclude different items in the same categories. So, certain items are said to be “in scope” for CPI but “out of scope” for PCE, and vice-versa. One of the places this is most important is in the category of health care.

Most medical care is not paid for out-of-pocket by the consumer, and therefore is excluded from the CPI. For most people, medical care is paid for by insurance, which insurance is usually at least partly paid for by their employer. Also, the Federal government through Medicare and Medicaid provides a large quantity of medical care goods and services that are different from what consumers buy directly – at least, purchased at different prices than those available to consumers!).

This scope difference is enormously important, and over time accounts for much of the systematic difference between core CPI and core PCE. The chart below (source: BEA, BLS) illustrates that Health Care inflation in the PCE essentially always is lower than Medical Care inflation in the CPI.

pceandcpiMoreover, thanks in part to Obamacare the divergence between the medical care that the government buys and the medical care consumers buy directly has been widening. The following chart shows the spread between the two lines above:

pceandcpispreadIt is important to realize that this is not coincidental, but likely causal. It is because Medicare and other ACA control structures are restraining prices in certain areas (and paid by certain parties) that prices to the consumer are rising more rapidly. Thus, while all of these inflation measures are likely to continue higher, the spread between core CPI and core PCE is probably going to stay wider than normal for a while.

Now we get to the most interesting question of all. Why do we care about PCE in the first place? We care because the Fed uses core PCE as a policy target, rather than the CPI (despite the fact that it has ways to measure market CPI expectations, but no way to measure PCE expectations). They do so because the PCE covers a wider swath of the economy. To the Fed, this means the PCE is more useful as a broader measure.

But hang on! The extra parts that PCE covers are, substantially, in parts of the economy which are not competitive. Medicare-bought prices are determined, at least in the medium-term, by government fiat. The free market does not operate where the government treads in this way. The more-poignant implication is that there is no reason to suspect that these prices would respond to monetary policy! Ergo, it seems crazy to focus on PCE, rather than CPI (or one of the many more-useful flavors of CPI), when setting monetary policy. This is one case where I think the Fed isn’t being malicious; they’re just not being thoughtful enough.

Every “core” inflation indicator, including the ones above (and you can throw in wages and the Employment Cost Index as well!), is at or above the Fed’s target even accounting for the typical spread between the CPI and PCE. Not only that, they are above the target and rising. The Fed is most definitely “behind the curve.” Now, as I have noted before in this space I don’t think there’s anything the Fed can do about it, as raising rates without restraining reserves will only serve to accelerate inflation further since it will not entail a slowing of money supply growth. But it seems to me that, for starters, monetary policymakers should focus on indices that are at least in principle (and in normal times) more responsive to monetary policy!

 

Even With a Crisis, No Deflation Coming

September 28, 2016 2 comments

Recently I’ve been thinking a lot about what might happen in the event of a banking crisis redux. While I’m not very concerned about US banks these days, there is a ‘developing situation’ in China that could well eventually lead to crisis (although the state might prevent outright collapses), and of course ongoing gnashing of teeth over Deutsche Bank’s capital situation if it is fined as heavily as some have suggested they will be.

I am not yet really worried about the banking side of things. But there are plenty of sovereign issuers who are clearly heading down unsustainable paths (not least of these is the US, especially if either of the leading Presidential candidates really implements the high-cost programs they are declaring they will), and when sovereigns tremble it is often banks that bear the direct brunt. After all, you can’t form a line outside of the sovereign to withdraw your money.

But, in a spirit of looking forward to anticipate potential crises, let us pretend we are confronting another banking crisis. The question I often hear next is, “how deflationary would it be to have another crisis when inflation is already low?”

Unpeeling the onion, there are several reasons this doesn’t concern me much. First, inflation is stable or rising in most developed nations. Yes, headline inflation is still sagging due to energy prices, but median inflation is 2.6% in the US and core inflation is 0.8% in Europe and 1.3% in the UK. To be sure, all of those are lower than they were in mid-2008. But remember that in 2009 and 2010, median (or core) inflation never got below 0.5% in the US, 0.8% in Europe, and 2.7% in the UK. Japan of course experienced deflation, but that wasn’t the fault of the crisis – as I’ve pointed out before, Japan has been in long-running deflation due to the BOJ’s inability or unwillingness to grow the money supply.

So, if the worst crisis in 100 years didn’t take core inflation negative – a major, major failure of Keynesian predictions – then I’m not aflutter about it happening this time. Heck, in 2009 and 2010 core inflation wouldn’t even have been as low as it was, had the cause of the crisis not been the bursting of the housing bubble. The chart below (source: Bloomberg) shows the Atlanta Fed’s “sticky” CPI (another way to measure the underlying inflation trend) ex-shelter. Note that in 2010, the low in this measure was about 1.25%…it was actually lower in 2014 and 2015.

stickyexshelter

But we can go further than that. One reason that inflation decelerated in 2009 and 2010 was because money velocity dropped sharply. As I’ve shown before, and argued in my book, the decline in money velocity was not particularly unusual given the decline in interest rates. That is, if you had known what was going to happen to interest rates, you would have had a very good forecast of money velocity and, hence, core inflation.

Back in 2008, I never dreamed that interest rates would go so low, or stay so low for so long. Few of us did! But the outcome, in the event, was consistent with the monetarist model while being completely inconsistent with the Keynesian model. And here’s the point, when thinking about the next crisis: interest rates are already at incredibly low levels, lower even than the 36-year downtrend channel would have them (see chart, source Bloomberg).

log10s

With the wisdom of experience, I would never be so cavalier as to say that interest rates cannot go lower from here! But in 2008, 10-year rates were around 3.80% and they’re 1.60% now (in the US, and lower elsewhere). Real rates were around 2% at the 10-year point; they are at 0% now. It is difficult to imagine how rates can have another dramatic move as they did in 2008-09.

It is important to understand, that is, just why inflation tends to fall in recessions. It is not, as the Keynesians would have it, that a growing “output gap” reduces the pressure on resources and relieves price increases. It is because slack demand for credit causes interest rates to decline, which leads to lower money velocity and hence, lower inflation. If the central bank responds in a timely manner to increase money supply growth by increasing reserves, then inflation doesn’t fall very far. In the last crisis, the Fed and other central banks added enough liquidity to ramp up M2 growth, and that kept the decline in money velocity from causing outright deflation (then, they kept adding reserves for a few more years, which led to the situation we are in now – too many reserves in the system, so that central banks no longer control the marginal dollar that goes into the money supply).

So, in the next crisis I expect central banks will add still more reserves to the pile of excess reserves, which will be meaningless but will make them feel better. Interest rates will decline, but not by as much as they did in the last crisis, and money velocity will fall. So, in a real serious crisis, inflation will decline – however, it will not decline very much.

That is the world we are now living in: higher highs to inflation on each subsequent peak, and higher lows in each subsequent trough. The vicious cycle counterpart to the virtuous cycle we have enjoyed for 35 years. This is true, I think, whether or not we get a crisis or just a garden-variety recession.

I should be clear that I think that such a crisis would be horrible for growth. That is, our current weak growth in global GDP would turn negative again, and possibly even more painful. And times would be truly bad in the stock market. But inflation will not follow, just as it didn’t follow in 2009-2010, and turn into deflation.

%d bloggers like this: