Wednesday, November 19, 2014

Inflation expectations are just fine

The minutes of the October 2014 FOMC meeting released today showed that policy makers "should remain attentive to evidence of a possible downward shift in longer-term inflation expectations." Members also worried that "if such an outcome [a downward shift of inflation expectations] occurred, it would be even more worrisome if growth faltered."

The charts that follow illustrate the market's inflation expectations as implied by the pricing of TIPS and Treasury notes and bonds. They all show that although inflation expectations have declined somewhat of late, they are not unusually low. It's notable that inflation and inflation expectations have remained solidly above 1-1.5% for the past 5 years, despite this being the slowest recovery on record—that suggests that the Fed's concern about slow growth leading to deflation are overblown. It's also notable that inflation hasn't been a lot higher despite the Fed's unprecedented experiment with massive Quantitative Easing—that suggests that the Fed hasn't really been printing money, but rather just supplying the world with risk-free assets (i.e., bank reserves) that have been in high demand.

The chart above compares the nominal yield on 5-yr Treasuries with the real yield on 5-yr TIPS. The difference between the two (the green line on the chart) is the market's expected average annual inflation rate (CPI) over the next 5 years, which is currently about 1.6% That is lower than the 2.3% average inflation rate we've had over the past 10 years, but it is consistent with the fact that oil prices have fallen by about 30% in recent months and CPI inflation ex-energy has been running 1.5-2% for the past few years. With big declines in gasoline prices we should expect to see headline inflation fall somewhat. Moreover, there's no reason for the Fed to worry about a somewhat lower rate of inflation that is the by-product of falling energy prices, since cheaper energy should bolster economic growth.

In short, I don't see anything to be concerned about on the inflation or monetary policy front at the present time.

The chart above shows the 10-yr version of the first chart, and the green line represents the market's expected average annual CPI inflation rate over the next 10 years, which is currently about 1.8%. That too is consistent with our inflation experience in recent years and the behavior of energy prices.

The chart above effectively links the first two. It shows the implied forward-looking inflation rate five years from now (i.e., what the average annual inflation rate is expected to be from 2019 through 2024). For years 1-5, as the first chart shows, inflation is expected to be about 1.6% a year. For years 6-10, as the second chart shows, inflation is expected to be faster, about 2.2% per year. Over the next 10 years, inflation is expected to average 1.8%. That's just fine in my book, although I'd be a little happier if inflation were closer to zero. Low and stable inflation is nirvana for supply-siders, since it fosters confidence, facilitates long-term planning (which in turn boosts investment and productivity gains), and minimizes the world's need to spend time and money looking for inflation hedges. Why the Fed is so fixated on inflation being 2% instead of 1% is a mystery that can only be explained (possibly) by the Fed bowing to the current "wisdom" that low inflation exposes the economy to the "risk" of deflation. It may be politically expedient to extoll the risks of deflation, but there is no practical reason to do so. Deflation doesn't lead to slow growth, and deflation is not incompatible with strong growth.

Nothing mysterious or scary about these numbers, in any event.

So what about falling commodity and gold prices? As I see it, commodities and gold are still trading well above the levels of 10-15 years ago. (see chart above) The next two charts look at gold and commodities in real terms, which I think is more relevant when considering whether commodity prices are likely to contribute to inflation or not.

As the chart above shows, in real terms gold is still about double what it has averaged over the past century. Today's gold prices therefore reflect a substantial premium, which in my mind means that the market still worries a lot about the possibility of the Fed making an inflationary error in the future, and the possibility of geopolitical turmoil. Gold, in other words, is still priced to a substantial risk of something going wrong. But since gold has fallen from $1900 to $1200 in the past few years, it means that the market's concerns have been alleviated to some degree. That's good. It's not a harbinger of deflation, it's a sign that the risk of high inflation has gone down.

As the chart above shows, in real terms commodity prices today are about 10% below their 45-year average. They were really cheap in 2002, and that was a time when the dollar was very strong, gold was very weak, and deflation was a definite possibility. Today, commodity prices are only somewhat lower, relative to other things, than they have been for many decades. In my view, this means commodity prices today aren't likely to impact overall inflation by much, if any.

All things considered, the near-term outlook for inflation is not worrisome at all. But I still worry that the Fed could be slow to raise short-term rates and/or withdraw excess reserves in a timely fashion should inflation begin to accelerate. In short, for now things look OK, but I still think the risk of higher inflation down the road is more worrisome than the risk of deflation.

All of this suggests that the Fed is unlikely to do anything that would shock the markets in the foreseeable future (e.g., the next 3-6 months).

Monday, November 17, 2014

Our hugely progressive tax code

A newly-released study by the Congressional Budget Office was designed to demonstrate that the inequality of income distribution in the U.S. has declined in recent years, thanks to increased transfer payments and higher tax rates on the rich. As Mark Perry notes, "Almost half of the income inequality between the highest and lowest household quintiles disappears when we adjust for government transfer payments and federal taxes. Before taxes and transfers, the average income of a household in the top 20% is 15.1 times greater than the income of a household in the lowest quintile, but that ratio drops to only 7.8 times after adjusting for transfers and taxes."

Reasonable people can disagree about whether a reduction in inequality achieved in this manner is a good thing or not (I'm in the disagree camp). In any case, the U.S. income tax code remains highly progressive, especially when one factors in the effects of income redistribution. That's illustrated in the chart above, which shows the percentage of total federal taxes paid divided by a comprehensive measure of income which includes labor income, business income, capital gains realizations, dividend income, and retirement income, plus all government transfer payments. The bottom one-fifth of income earners pay an average federal tax rate of only 2%, whereas the top 1% face an average federal tax rate of almost 30%. It's much worse in states like California, where top income earners also face a state income tax rate of 13.3%. Moreover, rates in the charts above for "the rich" would be higher today, thanks to a new top federal income tax rate of 39.6%, and an additional medicare tax of 0.9% for couples earning over $250K.

Mark also notes that because of the relatively high level of transfer payments these days (which are now at all-time highs relative to disposable income), well over half of all taxpayers receive more in transfer payments from government sources than they pay in taxes. That's illustrated in the chart above, where each bar represents the average household income in each quintile minus government transfers received. Furthermore, Mark notes that "the top 20% of American “net payer” households finance 100% of the transfer payments to the bottom 60%, as well as almost 100% of the tax revenue collected to run the federal government."

The chart above tells the same story, even though it is more narrowly focused, since it excludes employment taxes, business income, and transfer payments. It looks only at the percent of total federal income taxes paid by the 25% of income earners. Here we see that the top 25% of income earners pay almost 90% of federal income taxes.

How can anyone argue that the rich aren't paying their fair share? A great majority of the people are net recipients of the money paid by a relatively small majority. If anything, we have a potentially destabilizing situation, in which a large majority receive much more from the government than they pay in, and they can vote themselves still more of the money earned by a small minority. That's a classic "tyranny of the majority."

Supply-siders have argued for years that the steeply progressive U.S. tax code, with its myriad deductions, transfers, and subsidies, is extremely inefficient, and anti-growth. It's a major headwind to economic progress, and it most likely hurts the very people it's purportedly designed to benefit: the middle class. Why? Because the U.S. economy is arguably missing out on some $2 trillion each year in income—most of which would likely accrue to the middle class—because of, among other things, very high marginal tax rates and extremely burdensome regulations that discourage work and inhibit new business formation.

Commercial real estate is on fire

According to the Co-Star Group, the commercial real estate market is doing extremely well. As the chart above shows, a value-weighted measure of commercial property price indices has risen at a 10% annualized pace for the five years ended September 2014, and prices now exceed their pre-recession high. An equal-weighted measure is up over 14% in the past year.

Here are some of the headlines:


Both the value-weighted and the equal-weighted U.S. Composite Indices of the CCRSI made strong gains in September 2014 to close the quarter. The value-weighted index, which is heavily influenced by core transactions, advanced by 1.9% in the month of September and 3.3% in the third quarter of 2014. The value-weighted index is now 2.8% above its prerecession high and continues to make solid gains. The equal-weighted U.S. Composite Index, which is heavily influenced by smaller non-core deals, increased by 1.3% in September and 4.2% in the third quarter of 2014.





We may be in a sluggish recovery, but that does not mean that everything is sluggish. I note that since September 2009, the total return of the Vanguard REIT (VNQ) is an annualized 18.7%, almost two percentage points per year better than the annualized 16.8% total return of the S&P 500 index.