The Inflation Trader

Registered investment advisor, bonds, etf investing, forex
The Inflation Trader
Registered investment advisor, bonds, ETF investing, forex
Contributor since: 2010
Company: Enduring Investments LLC
I think we need the Fed to police the soundness of the banks, and to be able to orderly wind them down (not prop them up!) when they go bust. I think that they've proven that they are no good at the original purpose.
Having said that, since velocity and money growth are somewhat controllable, the Fed *could* serve a useful purpose if they only targeted inflation (along with the bank supervision aspect that I suspect we all agree on). And in fact, the successes the Fed has had in the past have been when they focused mainly on that variable (e.g., reining in inflation under Volcker). But I think with the size of the institution, there's no chance for them to believe so narrowly in their mandate.
Thanks for that vote of agreement!
For the first year I made them roughly equal to the uncertainty in core inflation over a 1-year term; increased them linearly thereafter. No science to it...I was merely illustrating what error bars ought to look like, not exactly what they would be. So they're 0.75% in 2016, 1.50% in 2017, and 2.25% in 2018. Again, no real science although I suspect they're not far off from the true error bars.
What is amazing to me is that I had to stumble on that. A few years ago I was desperately looking for a way to forecast velocity and trying all sorts of things. And I happened to, at the time, be trying to read everything Milton Friedman ever wrote on the subject and jeez, he couldn't have stated it more plainly.
Now, I went to school and was at the top of my class in a high-quality economics program. And I had never heard a whisper of this, either at school or in a couple decades on the Street as a formal or informal rates strategist.
The economics profession has more or less forgotten this, either intentionally or unintentionally. And it's really, really amazing to me because it's hugely important (I can find only two exceptions in major central bank policy circles, and I mention them both in my book. And one of them recently retired). It sort of re-writes my beliefs on how almost anything is forgettable, no matter how important. And that's scary.
I don't disagree. I think all bonds are expensive, and stocks are much worse. My observation here is aimed at people (and institutions) that MUST own some bonds, either for risk diversification or for other reasons. The only argument I can see for owning fixed-rate Treasuries is that you have some nominal liabilities that you are defeasing with the specific fixed maturities on your bonds. For example, with life insurance companies hedging annuity streams. But in most cases, it makes very little sense to own Treasuries over TIPS right now.
well, it's the actual figure so I am not sure how you mean it's wrong.
I think you're confusing a few things, but we agree on the fact that changing interest rates, rather than changing the quantity of money, should be ineffective (at best).
However, I don't think changing MV affects Q hardly at all, while I think you believe it has a large effect.
So, I think we are in for a more or less garden-variety recession in terms of depth although probably not length since there are too many imbalances to be unwound. But there will be no banking collapses this time around, at least in the US.
Not really...inflation has been doing just about exactly what monetarism predicts, and not at all what keynesians have predicted. Excess reserves aren't involved in the equation...only transactional money is. So adding excess reserves is meaningless, except inasmuch as it makes the Fed impotent to operate on the margin by restricting reserves banks require.
It may make sense, but history says that when interest rates rise people choose to invest money for longer (in bonds, not bank CDs), which is not savings. The correlation between the 5y Treasury rate and money velocity for the last 35 years is about 0.9. Which is exactly what Friedman suggested would happen, more than 50 years ago.
raising interest rates does not cause money growth to dampen; restricting reserves causes interest rates to rise AND money growth to dampen. The Fed has this backwards; raising rates without restricting reserves (which is what they are doing) will not change money growth appreciably but it WILL raise money velocity. That is, if they actually succeed in raising interest rates appreciably, which they have not so far.
Well, today they tried the dovish-talk route, by letting one of the hawks muse that lower oil prices might mean inflation goes up more slowly and so tightening might not be as necessary. That will be stage 1.
In 2008 they also banned short-selling at times, for some equities. Of course, that only works if the market is being pushed lower by evil short sellers, and not if it's just people saying "GET ME THE HECK OUT!"
Ultimately, how can the Fed force asset prices higher? The only real instrument they have is the blunt instrument of buying OTHER assets (the ones they are allowed to buy, like government bonds) so that you have no choice but to buy risky stuff. That's what the Fed calls the "portfolio balance channel" and the rest of us call "trying to manipulate the stock market so that prices stay permanently high." The Fed cannot buy stocks and while some people think they can order banks to buy stocks, they can't (and indeed, the Volcker Rule means banks cannot hold stocks as a prop trade any more, even if they wanted to).
It didn't work in 2008. In 2000-2003 they didn't really try any of the really crazy stuff like in 2008. Bottom line is that if investors decide they're paying too much for corporate growth prospects, prices will fall. Even China can't do it.
That's a reasonable speculation, but we track value on these commodities going back to the 1970s and they're all out-of-whack on the very-long-term. OK, they aren't ALL out of whack; Live Cattle, Feeder Cattle, Copper, and Silver are all roughly fair value relative to long term trends (which is for a small negative real return over time, exclusive of collateral and roll returns). But Nickel, for example, is priced at a level that historically has produced 8% per annum real returns looking forward. Nat Gas 12% (although I concede the technological advances in Nat Gas may make that number too high). Whatever bubble the Fed created, it has entirely deflated and then some. (Whereas, on the other hand, the deflating stock and real estate bubbles only reached fair value or slightly below; those asset classes never got particularly cheap.)
So I think it's plausible that the removal of QE helped the stampede for the exits even though by then commodities had already been in a 4-year bear market...but the stampede seems far overdone.
Moreover, the Fed's powers derive from those given it by Congress. Fed governors are appointed by the President. While regional Fed bank presidents are elected/appointed by private institutions, practically speaking the power is entirely federal. The FOMC consists of the (appointed) Fed Governors plus five (rotating, with the exception of the NY Fed which always has a seat on the FOMC) Presidents of the regional Federal Reserve Banks.
And it bears repeating that the Fed only exists and has powers because of authorizing Congressional legislation, which can be revoked at any time. And some in Congress would like to.
They aren't. The primary driver is money. Inflation always shows up in some product, because we are not used to thinking of the declining value of money and instead think of the increasing price of a product.
Not only can the Fed control inflation, it is the ONLY thing they can control. They cannot control growth except in the presence of significant money illusion, which probably exists at some level but not nearly in the concentration needed for monetary policy to be efficacious in terms of affecting real growth.
Of course, the Fed can also police the safety and soundness of financial institutions, which doesn't require that they play God with the economy.
Bring a team of engineers who know how to build models, test them, reject ones that don't work, and remember the lessons of history. Their models don't work - even THEY say so - but there are models which do. The forecasting record of the monetarist model is virtually flawless. NO significant inflation or deflation has ever occurred which did not have a monetary root.
The problem is that they want to be relevant, and it's also the case that money is inert with respect to real growth. Simply put, they CAN'T have much effect on growth.
I get into much more depth in the book I have coming out in March, and include my prescription for what I would do now. There is no chance they will implement my suggestion, which is one reason I'm pretty sure it would work.
You are all so kind, and thank you all for your generous comments - not only on the content of my articles, but for your comments that contribute to the discussion (and to my own understanding of the issues, as we hash it out collectively). Merry Christmas and Happy New Year, everyone.
Money illusion is when people see more money in their pocket and mistake that for more wealth, and therefore spend more money. That would lead to more growth and less inflation for any given amount of money growth.
It is unclear whether consumers actually operate under much money illusion. Experiments have shown that in fairly contrived circumstances, money illusion can operate but it hasn't been demonstrated convincingly outside of the lab.
It may be that in this case, if the Fed is correct about the importance of an 'inflation anchor', it means that investors behave as if there is much more money illusion because the Fed is credible and so they mistake the significant rise in M2 to be wealth in their pockets, and so real growth booms while inflation stays low.
I am skeptical, however.
Monetary policy does nothing for growth, except in the presence of money illusion. But it most certainly raises prices - always has, without exception, and will this time. The only question is whether the upswing in inflation is arrested at some reasonable level or whether we approach double-digits.
No, but it's what happens to market rates. Overnight rates do nothing to anything. Watch 5-year rates. They are low, but near the top of the range for the last several years. If they stay here, then money velocity probably inches up and inflation rises but doesn't leap. But if the Fed is going to tighten more than once, 5-year rates at 1.70% don't make any sense and they will go higher. THAT will cause higher velocity.
TBD!
I don't really follow the question. The question is who wants to hold the money in the bank; when there are low opportunities outside of cash then the answer is 'almost everyone.' When there are lots of investment or more lucrative lending opportunities, then the answer is 'almost no one.' It doesn't have much to do with the volume of those opportunities, unless it's really true that no one is trying to borrow money. If I buy a bond, I give the money to someone else who buys something else, or I give the money to the borrower who needs it for something else. The question is how long is the lag between when I buy the bond and give the money to him, and he does something with the money. Consider how corporations hoard cash - at higher interest rates, they certainly do not but at low interest rates, it is cheap liquidity. Once interest rates rise that cash will start moving again. If there are fewer borrowers it just means the bonds will change buyers more often.
true statement. she is not aware of one.
It turns out the problem is that since the debt is so large and so much of it matures so often that if interest rates adjust it is hard to inflate your way out of debt UNLESS you do it really quickly (or run a primary surplus so that you don't have to roll your debt at higher rates, or anyway not as much debt) and surprise everyone. So if you crawl to 4% inflation, pretty soon your interest rates are 2% higher than they are when you're at 2% inflation and the interest catches up with you. But if you pop to 20% for a couple of years, you can make a dent. I don't think the Fed is really trying to do this. Although politicians would love to be able to blame them for it. :-)
...because I don't recommend specific stocks and that's what drives eyeballs.
Thank you for the compliment!
I think Bernanke would have liked to see a quick spurt of inflation, but I think Yellen really worries a lot about the little guy and inflation kills the little guy. That being said, I also think she doesn't understand the inflation dynamic and thinks it is easy to catch up because "inflation is anchored." She'll let it get to 3% before she worries very much. And then it will be too late.
Heck, it's already too late.
I never understood why people thought of repos as derivatives. They are derivatives in the same sense as any collateralized loan (which is what they are) is a derivative. Nonsense. Now, you can get pretty good leverage with them, and Citron had some leverage, but in general what I mean is that it was naive to think of these things as being some fancy-schmancy Wall Street concoction. Try synthetic CDO-squareds on for size.
No, I don't think the Fed will tighten very much. And whatever they do, they will do slowly even as inflation starts to move ahead of them. But there are a whole lot of firms that are dependent on an interest rate of zero, and industrial firms that need zero plus a small credit spread. It's especially these latter folks I worry about, because when rates go from zero to 0.25%, spreads might triple from here as defaults rise. I agree with Dalio that the Fed, no matter what they do this month, will abort the takeoff as soon as the economy looks a bit shaky.
no worries. And thanks for posting the 3% number, which helps answer the commenter above who suggests the government's TIPS factors are biased low. As you point out, in 2011 they were biased high because the figure you're looking at is headline inflation, which includes food and energy.
I use median CPI, which is produced by the Cleveland Fed and does not exclude food or energy but rather focuses on the median of the distribution (which isn't affected by wild swings in energy). Right now that's at 2.5%; in 2011 it rose and rose and rose from a very low level in 2010, but it peaked at 2.38%.
The Cleveland Fed's median CPI is released on its website roughly mid-day on the day the regular CPI is released, although I always estimate it in my CPI-day tweets.
Money velocity is the inverse of the demand for real cash balances. Here's how to think about it: suppose you have a bunch of money sitting in cash. If interest rates are at zero, you might leave the cash sitting there waiting for an opportunity. But if the 5-year Treasury rate is 6%...you are less likely to leave cash sitting there for long. The opportunity cost of a real cash balance is higher.
Of course, when you buy the Treasury bond it becomes someone else's cash balance, so this doesn't change the amount of money in the system...it just changes the speed with which money is moving. Cash becomes a hot potato at higher interest rates. You will tend to spend it or invest it (which means giving the money to someone else who wants to spend it) more quickly.
Make sense?
Yep, and inflation has been rising over that time and is at 6-year highs. Hopefully you will eventually see the risks.
That's not a disparity. CPI for Social Security relies on headline figures since food and energy are most definitively part of the consumption basket. And with those elements, prices were approximately unchanged over the last 12 months. Next year they will be up more than 2.5%, and above THAT if energy rebounds appreciably.
they started yesterday with Lacker saying he was crossing his fingers that they could still tighten and that it was too early to say what the effect of the French terror attacks would be (why that would affect US monetary policy is beyond me, unless you want an excuse to not tighten).
well, except that it isn't the west coast rental market - it's nationwide. And "except for half the basket" (and more than half the basket is accelerating) is not a good argument.
But this is the reason we use median. Median inflation ignores the tails, so the three-standard deviation events don't affect it inordinately. The fact that median is above core implies that most of the tail events, contrary to Mr. Low's belief, are on the DOWNside, not the upside.
I don't know...I was wee high when this was all happening. :-)