Tag: Inflation

Inflation revisited, Bailouts, and Base Cases

In late 2020, I wrote about my views on inflation and why I thought inflation as measured by PCE and CPI had been so consistently low for so many years, while noting that asset price inflation had been simultaneously much higher due to monetary policy. Looking back, I am quite happy with what I published then in most regards, with the exception that I only briefly touched on how asset price inflation affected the rapidly disappearing middle classes of developed economies:

“Viewed in this way, it makes sense why the central banks who ‘tamed inflation’ cannot seem to hit their own two percent target rates, unfazed by even unprecedentedly aggressive and sustained interventions. They never were the predominant driver of inflation in the first place (unless they turned so extreme that they fell into hyperinflation like Venezuela, Zimbabwe, Turkey et al). The low interest rates drive little marginal capital formation and instead only serve to balloon financial assets and real estate – the former of which is not a part of PCE and the latter of CPI measures, respectively. Instead, cheap credit has warped security pricing of public and private markets, driven leveraging in risky and fragile areas and slowly hollowed out real incomes of middle classes and substituted them with growth-constraining dependence on consumer credit in the form of student loans, mortgages and other lifestyle related borrowing.”

What I failed to make fully explicit is just how destructive this hollowing out of the middle classes has been and will be, and quite how the ‘preferred’ inflation measures’ exclusion of asset prices allowed for several decades of artificially cheap credit post 1987 (with savage acceleration after 2008 and during the pandemic).

Put simply, CPI and PCE by design exclude capital goods as they are meant to capture changes in the cost of consumer goods and services.

[Yes, both CPI and PCE encompass components meant to proxy the cost of shelter. However, Owner’s Equivalent Rent does not reflect changes in real estate prices accurately for many reasons. For one, the peak correlation coefficient of 0.75 between US house price growth and OER is reached at a time lag of a full 16 months, according to this Dallas Fed analysis. Similarly, rents and measures thereof do not always move with increases in house prices, especially when falling rates cause increased homeownership demand. Neither CPI nor PCE contain even remote proxies for financial asset prices or deposit yields.]

However, societal expectations for members of the middle class have long entailed meaningful ownership of capital — in the form of ownership of a house (tellingly, U.S. homeownership rates definitionally include mortgaged homes, with only 37% of households being mortgage-free), retirement savings invested in stocks and bonds, and plain old cash which, in theory, should be yielding a steady risk-free return in an FDIC-insured bank account.

As the off-shoring of manufacturing and supply chains has kept consumer goods inflation low and even periodically negative, overall CPI looked deceptively low for many years. Meanwhile, interest rates plummeted, private and public equity skyrocketed, real estate soared higher than the boldest of bald eagles (importantly also as compared to median income), and savings accounts became cash incinerators in real terms. All of them remained unaccounted for by the conventionally accepted definitions of inflation which remained unchallenged by the economic orthodoxy. After all, why bother when ‘inflation’ was so low and the ivy league technocrat elite derived supreme legitimacy and unrestrained power from their ‘victory’ over the 08 crisis and inflation! To those young and less fortunate pursuing the dream of a ‘middle class’ life, the graduality and obscuring complexity of these enormous wealth transfers, excessively cheap consumer credit, and the propaganda suggesting that their lack of progress was due simply to lack of grit and hustle eventually became like water to the starving. The essential backbone of democratic stability and compromise, now afflicted with a Kwashiorkor promoted but simultaneously denied by a progressively narrower and intellectually homogenous political elite, became cheap to buy with premises of change of any kind, no matter from which end of the political spectrum. Alas, populism, once again, has revealed itself to be not the promise of genuine partnership, but the tenuous bond between client and supposed patron. The implicit social contract that has been supporting societal trust in what one might term liberal democracies is now viewed by large groups of people as fundamentally broken, with predictable consequences. I doubt that the decline in birth rates is solely attributable to the secularization of ‘richer’ countries, rather than growing pessimism about coming generations’ future prospects, for one.  

Nevertheless, supposedly low inflation statistics and the manifold temptations of Keynesian stimulus masked the slow transition of emancipated citizens to neo-feudal serfs well enough to continue with unsustainable monetary (and, through deficit monetization, fiscal) policy. Indeed, perversely, the disenfranchisement of the economically most vulnerable has made them all the more prone to suggestions that negative real rates and QE were part of the solution to their problems, rather than their very cause. Amazing really, that with such high energy prices and economic fragility the likes of the ECB’s Lagarde, the BoE’s Bailey, and the BoJ’s Kuroda get such massive budgets for gaslighting.

But I digress.

Even with such low inflation indicators unrepresentative of what they were supposedly measuring — namely, the decline in spending power as experienced by regular people due to aggregate price rises — such crude measures as the Taylor rule (itself relying on these deceptively understated definitions of inflation!) have shown massive divergence between policy and theoretically appropriate rates of interest for many years at both regional and global levels. Of course, once the absurdity of 0% and even negative rates became too difficult to ignore, some regimes, such as that of the United States, chose to use QE, a tool pioneered in modern times (2001) by the BoJ (after they themselves had introduced negative rates in 1999) to push more credit into the system than ordinary mechanisms would allow.

Note the Shadow Policy Rate translating the effect of QE into percentage changes in the FFR
Source: https://www.hoover.org/sites/default/files/14110_-bordo–exiting_from_low_interest_rates_to_normality-_an_historical_perspective.pdf

Fast forward to 2023, and we can see what massive costs it would/will entail to normalize rates and central bank balance sheets. The (in relative terms small, but highly unusual) contraction in aggregate money supply in 2022 as a result of a very minor reduction in the Fed balance sheet, has led to deposit outflows across basically all banks, the consequent failure of Silvergate and Silicon Valley Bank, and the ensuing loss of faith that ultimately felled the G-SIB that was Credit Suisse. For reasons that should be obvious, I will not comment on the regulatory actions taken in the context of these bank failures. In an abstract hypothetical scenario that by complete coincidence happened to resemble current goings-on but de facto bore no relations imagined or otherwise whatsoever, someone resembling my person but most definitively not me, might be tempted to suggest that these were bailouts of less-than-optimal structure that will exacerbate the longstanding buildup of moral hazard and dumbing down of financial market participants drastically. That person who is distinctly separate from mine, as I really cannot emphasize enough, would not be alone in that assessment.

Where to go from here?

In my estimation there are three different paths the developed economies could take in this context.

The first is to tighten monetary policy harshly (including some QT) and hence cause a recession with the corresponding increase in unemployment which would be politically unpopular but normalize asset valuations. I believe this is not likely take place for political and academic orthodoxy reasons (as evidenced by ECB and Fed officials implying neutral rates that are far too low, real interest rates continuing to be negative in US and Europe/UK, de Guindos calling for tools to limit core-peripheral EU government debt yield dispersion – I was in the audience that day and he seemed rather serious about the idea).

The second is to pursue long-term financial repression and keep real interest rates negative. To make this work, the European economies, the UK, and the US would need to introduce strict capital controls, as global capital flows would inevitably destabilize and make moot the attempted financial repression. I do not believe this to be particularly likely, but it certainly looks much more likely than it has in 30 or so years.

The third is to attempt financial repression/the tightening of monetary policy to levels insufficient to quell inflation without the introduction of effective capital controls. This would lead us into a stagflationary environment similar to the one pre-Volcker. This is my current base case. Naturally, there will likely be important differences to the late 60s and 70s of the previous century on the way there. I am not entirely certain what they will be. In fact, I am certain of perhaps only two things.

1. The real area of concern in the financial sector are not banks (and that is not to say banks will be completely unaffected), but shadow banks (that is, non-bank lenders). We will see the failure of many fintechs, Buy-Now-Pay-Laters, private equity funds, public funds, real estate firms, financial exchanges, hedge funds, venture capital outfits, family offices, factoring businesses, and whatever other vehicles have a business model that one way or the other relies on leverage.

2. We are now genuinely past the point of no return, and even the wisest policy must now focus on damage mitigation rather than avoidance. That is a pretty scary thought, even for me.

Let us hope we come out the other side renewed and primed for a better future, rather than ever more divided.

Tom

Ps: It sure looks to me as though regulators are aggressively backstopping banks because they know there will be many more illiquid but potentially solvent entities knocking about in the near future (as they are less willing to cut rates than market participants seem to think). Setting a precedent of successful orderly resolution of bank runs and financial institution failures without depositors being adversely affected would be a shrewd move… if state capacity were sufficient in the West to credibly handle these subsequent restructurings. Unfortunately I do not believe that to be the case and we will instead see more of a worst of both worlds outcome when inevitably the powers of the Fed are used too inefficiently and unwisely to keep the monetary pressure cooker going.

Central *anking, or the Underpass to Serfdom

Fair warning: The following is a highly political and somewhat pessimistic rant on a ‘dry’ subject. You may not enjoy it. In fact, you are a weirdo if you do.

I first became interested in central banking in a serious manner during my time as an undergrad at uni (and yes, I was fun at parties, why do you ask?). Naturally, I had been dimly aware of the existence of central banks since at least 08 and in a very superficial sense, grasped that interest rates were kind of important and had even heard of quantitative easing. Nevertheless, there was this lingering sensation that there was more to that particular story that I did not appreciate, something I just did not get about these systems that had such a powerful influence on financial markets, economies and the polis. Being a curious fellow, I went from furrowing my brow at Buffett talking about low interest rates pushing up equity valuations to reading Princes of the Yen (good book by the almost as crazy as he is sharp Richard Werner) and brooding over the Wikipedia entries of Gosbank, Gosplan and Gossnab to devouring Lords of Finance by Liaquat Ahamed (a fantastic book if you manage to ignore the unbecoming and, in my opinion, ahistorical level of idolization of Keynes). After not too long, it became pretty apparent to me that my ignorance of central banks had been a major blind spot and I all of a sudden felt many of the pieces that connected my knowledge of history with my growing literacy of economics fall into place in an almost uncanny fashion. Perhaps most impressive to me was just how political it all turned out to be. Perhaps that makes me naïve, but when Bernanke and Yellen, the very epitome of technocrats, talked about their rigorously data-driven approach and how well they managed 2008, I previously had not mustered the necessary context and critical thought to go, you know, ‘hang on how can something that drives level of employment, housing costs, FX, borrowing costs, bank capitalization regulations and asset prices simultaneously on national and global levels with minimal accountability to the electorate not be political?’. I am a little slow that way, I suppose.  

Be that as it may, by the time I graduated I had been stewing long enough in the Keynes-Hayek-Friedman Goulash for matters of central banking to have by far eclipsed climate change in my short list of greatest concerns. In fact, the consequences of the present brand of central banking are one of the few things that manage to make me anxious, the others being neurodegenerative disease, stroke, fatal cancers and death. You can imagine that I have been observing global response to the pandemic with immense dismay.

Why? Because it really emphasized just how much consensus there is behind the path we are going down as a global society. Sure, people may be intensely divided all over on the Brexits, the Trumps & Bidens, the BoJos – but if you look at the field of monetary policy, the differences between factions are not qualitative but at best whether the next stimulus package should be measured in the single digit percentages of 2019 GDP or double digits. To be clear, I do not mean to suggest that there are no contexts in which these transfers will have merit, particularly in the United States, where helicopter money is a way to expand welfare without experiencing immediate political deadlock and public infrastructure is crumbling, or in selectively alleviating some of the pain of quarantines. But all this is not free, despite what the MMT people (it amazes me they can breathe independently) would have you believe.

There was almost zero opposition to taking the toolset quasi-pioneered in late 90s/early 00s Japan and escalated in the West in 2008 as an exceptional emergency response and making it the de facto new modus operandi at ever greater scale. What was supposed to be a last resort has become undeniably chronic. Interest rates have in some countries been negative for years and globally suppressed for decades (making traditional saving impossible), quantitative easing, which was meant to be long reversed by now, commonplace, and massive monetization of government debt accepted as though it were war time. Speculation is rampant and prices of every asset class distorted. But do not worry guys, we will totally raise taxes on the rich. Definitely not net regressive. Pinky promise.

This state of affairs is already absolutely toxic but I fear that the worst lies still ahead. As systemic fragility increases thanks to bloated valuations, dumb leverage and even dumber pricing (aka excessive momentum), the stakes grow higher and higher, guaranteeing a brutal recession if any major central bank should tilt even slightly hawkish. I am afraid that we have already passed the point of no return and I do not see any Volcker-like figure on the horizon, not without CPI inflation and certainly not among the peers of Powell and Yellen. They will continue to be more and ever more ‘accommodative’ and when the crashes become more frequent and more violent, they will turn more aggressively interventionist yet. The rhetoric that markets have become unhinged and need stronger government guidance will accelerate. And most people will believe it. It is twisted that arsonists should masquerade as firefighters, but it is sickening that most will give them credence.

Maybe it is just that I frequent the wrong public fora, but I think that present discourse is for the most part utterly imbecilic. People who cannot read the simplest of financial statements are drowning in FOMO, while lecturing on crypto and Tesla. Hundreds of thousands are gleefully gambling with their life savings and college funds (incidentally tuition inflation is also just another side effect of the status quo) on margin and derivatives they overtly do not understand. How does any of this make for a desirable society? Social mobility is beneficial when it is merit based, not when it rewards those who have excess capital merely for having it and the odd speculator for taking boneheaded risks they can ill-afford. Stocks only go up is a daft maxim, but it is orders of magnitude dafter that it will hold broadly true for as long as excess credit is pushed into the system. What a mess.

The funny thing is that I am not anti-government. Hell, I would wager that I consider the SEC far more important than Jay Clayton (admittedly not a high bar) does. But it is not a question of more or less government or regulation. The regulatory framework would have been sufficient, were it effectively and intelligently enforced! While I believe 100% that government plays an important role in the economy and society, I equally believe government should not be the economy and society. Some circles of intelligentsia may deride the cliché and people are free to think me a trite libertarian capitalist, but centrally planned economies and financial systems eventually collapse for good reason.

Further, I even notionally benefit from these developments, with over 95% of my net worth in equity. On the face of it I should embrace all this. But what point is there in being rich in a beggared global community? Were growth rates not low enough in the West to begin with, so that we now need to suppress productivity for political ends? The socioeconomic shifts that these policies constitute will only reinforce the demographics that are causing this polarization of politics the world over. I cannot see how drifting towards a China-style system (but even less efficient) is in the interest of anyone, least of all European and American middle-classes’.

Should real estate be appreciating significantly in real terms? 🤔
Source: http://www.econ.yale.edu/~shiller/data.htm

…

As you can see, I am ever so slightly frustrated. Just a tiny bit. At this point, significant consumer inflation would probably be the best turn of events, if it forced central banks to change course. But it might be too little too late. My best guess is that we will experience further asset price inflation, particularly in stocks but also in crypto, maybe even in some precious metals (though I do not advise buying or shorting either) and real estate (personally loathe the real estate people) for at least a few more years. Governments and particularly central banks will acquire a more authoritarian bend than they already have. Direct taxes will likely go up some but not offset the massive regressive redistribution. There will be many more nominal millionaires and billionaires. Classism and political segmentation will strengthen. Yet more trade conflicts. Lower real growth for the foreseeable future. Just peachy.

Hope that you do not feel too crestfallen after reading my perspective

Tom

On Inflation

Inflation! What a word, what a concept! Even in circles free from the burden of practical or theoretical knowledge of finance and economics, it is possible to receive a lecture on hyperinflation, printing money, and, if one is particularly… lucky…, how blockchain technology experiences none of it. Unfortunately, it seems to me that many professional economists and commentators themselves struggle to attain a firm grasp of the phenomenon significantly superior to the above mentioned. And, to my dismay, this includes my not quite so humble self! Hence it is high time for a first step on the path to remedy and redemption. While in this post I will not make the popular error of attempting to forecast short-term inflation or deflation, I will disaggregate some of the aspects of the concept and perhaps even demystify some of them.

The very first thing to note, is that of course the rate of inflation is not caused by just one convenient factor but many messy interrelations and, much like body temperature, can be symptomatic of many different conditions but is sufficient to definitively diagnose at best only those situations where it has turned so extreme as to become a problem unto itself (i.e. hyperinflation, sustained deflation) and at worst none at all. And why should it? It is an incredibly broad measure, defined as the fall in purchasing power of currency or, equivalently, the rise of general price levels over time. As such, there are many different measures of inflation available over which to argue. What goods and services should be included in the basket of comparison, how should they be substituted as goods and services evolve over time, how ought they be weighted, how and where should real economic data be collected and accounted for, over what period should inflation be studied and so on and on. It is what one might diplomatically call an active area of discussion.

While these particulars are important and interesting, I am at present much more concerned with the question of the nature and origin of inflation, rather than its precise magnitude – much as one might ask why an organism’s body temperature is rising or falling over time rather than what its precise quantity is at any given instance. But enough tattle, onto the subject at hand.

Inflation, as it is measured and defined in units of currency, is naturally a monetary phenomenon. But – and I believe this is one of the reasons for the broad fascination it elicits – it equally relates to real productive output. In other words, it is the interface between the otherwise quite disparate worlds of money, and stuff, respectively. It is inflation that exposes the excessive issuance of currency to enable greater consumption as alchemy. Obviously, if there are three sandwiches in the global economy each costing a doubloon, producing more doubloons by itself will not allow you to eat four until someone makes another one of those baked prisons for charcuterie. Inflation therefore, is simply an aggregated measure of how much less one gets of a selection of goods and services, as a result of the relative rates of growth of the quantity available of that selection of goods versus the quantity of currency in circulation (that is, available to induce that transaction). If that mix of goods grew at the same rate as the relevant money supply, inflationary pressure would be zero. If money supply growth exceeded output growth you would get inflationary pressure equivalent to the gap and deflationary pressure in the converse scenario. Human-made stuff is finite, and the laws of physics cannot be swayed to allow otherwise, not even in exchange for some crisp bank notes still warm from the press (yes, I know, most money supply is digital,  but that simply is not as evocative an image).

From this simple set of rules emerge more complicated expressions when looking at systems in motion and more representative of our world. Since the industrial revolution, all nations have experienced dramatic and continual increases to their productive capacity. The most successful of them have further seen another important transition away from manufacturing and turned into economies predominantly reliant on service and information-based activities. Since these changes materially concern the key inputs determining inflationary pressure (money supply and output) and the balance between them, it should not come as a surprise that they have also an important role in explaining inflation and the various proxies we choose to heed or ignore.

In an industrializing economy, one of the chief constraints of the growth of productive output is financial capital. In other words, the financing of the laying of railroad track, the construction of massive factories and machines and the turning to stone and steel of some seriously sexy bridges pulled from the late-night wet dreams of starchitects sucks up capital, making it scarce and expensive. Yet on balance these investments pay off immensely and the (autocatalytic) formation of more capital in the guise of machines, steel, concrete, labor and access to credit manifests in astonishing growth numbers and societal shifts. Each such investment also impacts inflation in a cyclical fashion over its lifetime. At the beginning, during the planning and funding phase, the investment absorbs scarce physical resources (in effect occupying some of the present capacity for output) and, being typically financed with credit, expands money supply. Aside from crowding out other possible investments, this causes inflationary pressure also and it is quite evident why: It widens the gap between available output and the supply of money chasing said output.

This pressure remains the same or levels off throughout construction and the phases of turning the investment productive (say bringing a factory online and reaching its cruising working capacity) based on the timing of financing and resource consumption. Yet, once the investment is starting to bear fruit, the initial phase reverses! Suddenly the factory/bridge/bank ceases to be a net consumer of the capital needed for further investments and turns net producer. It also starts repaying the credit once extended for the purpose of its creation, causing a contraction of money supply actively in circulation until the repaid money is once more extended to a new investment. Clearly, this is the opposite of our initial phase, reversing the inflationary pressure of the start and causing a deflationary force instead. So, over its lifetime, is the investment inflationary or deflationary? It depends. If the investment exactly pays for itself, it causes neither net inflation nor deflation over its lifetime. N.b. it still causes inflationary pressure in the beginning and deflationary pressure in its senescence, yet these offset in aggregate over its lifetime!

If, however, the investment is terrible and does not end up paying for itself, it then becomes clear that it is a net inflationary force. What though if it is a great investment? Then it simply causes net deflation in the long run. Should we therefore expect that economies in the process of successfully industrializing also are wracked by terrible bouts of deflation? Well.

Not necessarily.

You see, this is where it is important to once again look at the creature in motion. There is a reason why so far, I have carefully emphasized de/inflationary pressure rather than de/inflation, period. Because the deflationary pressure may be offset by the inflationary pressure of subsequent new investments (or simple consumption) and their phases overlap! If the economy keeps continuously reinvesting aggressively the returns of its prior investments and/or consuming them, the deflation may never self-evidently manifest as such and there may well be a sustained and positive rate of inflation, depending on the balance between successful mature investments’ return and the costs of new investments over time. A little bit like adding vectors of opposing forces in the Newtonian sense; the motion is an aggregate and determined by the net of the forces. The individual magnitudes of the forces are not readily apparent and only the resultant acceleration visible.

This explains, in my estimation, why inflation over the 20th century has been markedly positive. In any economy exhibiting positive real growth, aggregate investment has been productive by definition and caused significant deflationary pressures over time. Yet, victims of their own success, earlier investments’ high returns fund more and more subsequent investments and drive down the cost of capital by virtue of increasing its supply on steady or declining demand, while the returns of each subsequent generation of investment slowly diminish, as the obvious opportunities are made use of and the opportunity set becomes gradually less attractive. In this manner, deflationary pressure eases off at a faster pace than resource allocators choose to reduce growth in investment and consumption. With chronically low interest rates and a societal imperative for more growth without concern as to its longevity or substance, inflationary pressure ends up chronically dominating the deflation caused by productive stewardship of resources.

This framework also helps contextualize what common sense already dictates: the waves of growing household consumerism and appetite for radio, microwave, fridge, car, computer and so on are not coincidental but play an important part in absorbing the newly available productive capacity.

US PCE Index, Source: Federal Reserve Bank of St. Louis

Further, it also now helps us make sense of the recent past and present. With investments becoming less productive in aggregate in post-industrialized economies, net lifetime deflationary pressure slows almost simultaneously as inflationary pressures from new big projects, now less attractive due to lower expectations of returns, decline. The balance looks remarkably stable, as the magnitudes of the inputs experience lower variance. I think this is a crucial realization.

Viewed in this way, it makes sense why the central banks who ‘tamed inflation’ cannot seem to hit their own two percent target rates, unfazed by even unprecedentedly aggressive and sustained interventions. They never were the predominant driver of inflation in the first place (unless they turned so extreme that they fell into hyperinflation like Venezuela, Zimbabwe, Turkey et al). The low interest rates drive little marginal capital formation and instead only serve to balloon financial assets and real estate – the former of which is not a part of PCE and the latter of CPI measures, respectively. Instead, cheap credit has warped security pricing of public and private markets, driven leveraging in risky and fragile areas and slowly hollowed out real incomes of middle classes and substituted them with growth-constraining dependence on consumer credit in the form of student loans, mortgages and other lifestyle related borrowing.

Clearly, I am not a fan of the path central banking has been taking us down since the latter half of the 20th century. But more on that in a future post.

I hope the above has been of interest to you

Tom