The chart above shows the 6-mo. annualized rate of inflation according to the CPI and the Core CPI (ex-food and energy). The experience of the past decade is a great example of why it pays to ignore big swings in food and energy prices. The core rate of inflation has been much more stable, and inflation according to these two indices has been exactly the same since 1986 (2.7% annualized per year). The core CPI is up 1.75% in the past year, and in the past six months it has risen at an annualized rate of 1.77%. It's very likely that the overall CPI will soon be averaging about the same rate.
If we look at the ex-energy rate of consumer price inflation (see charts above), it has averaged very close to 2% per year since 2003. The 10-yr annualized rate of ex-energy inflation currently registers 1.99%, and the year over year rate of ex-energy inflation is 1.84%.
Unsurprisingly, the bond market is very much aware of these underlying trends. As the chart above shows, the expected rate of CPI inflation over the next 5 years (as embedded in 5-yr TIPS and Treasury prices) is currently 1.89%.
The chart above shows the bond market's expected rate of CPI inflation over the next 10 years, which is currently 1.92%.
Inflation is not dangerously low. It is running just below 2%, and that's where it's been for many years and where the bond market expects it to be for at least the next decade. There is no reason for the Fed to be trying to boost inflation.
I agree with Scott Grannis! Well, half way.
ReplyDeleteI suspect in many ways the U.S. economy has become inflation-proofed in the last 50 years.
Gone are labor unions; transportation rates have been deregulated; telecommunications deregulated; gone is Reg Q and regulated stockbroker commissions; international trade has exploded; gone are Big Steel, Big Auto, Big Aluminum, big anything.
The top marginal tax rates have been cut from 90% to under 40%, and the minimum wage has declined in real terms.
The Internet has made pricing transparent and global, and created local markets for grey-market and informal goods and services (the old classified ads were too expensive).
Tell me of one business (aside perhaps from Scott Grannis' Apple) where the purveyors hint they have pricing power.
There may be some self-pity going on, but in my days in business and from what I hear today, everything is more competitive than ever.
All good!
So, the Fed probably cannot budge inflation much.
But...that means the central bank has the doors wide open to shoot for greater stimulus resulting in greater real economic growth.
In the 1970s, Fed stimulus led to very strong growth, but also inflation. Under Chairman Burns, the U.S. economy expanded 20% from 1976 through 1979, real terms. There is simply no way to explain the 1976-79 economic surge other than by monetary stimulus---the economy was rife with structural impediments, and none were seriously removed in that era. There were no supply side improvement of note. Sheesh, Jimmy Carter was president, that will tell you what a woeful administrative state we had.
But, the economy boomed.
We also got lots on inflation in the late 1970s, as the U.S. economy was inflation-prone back then.
Today, the U.S. economy in not inflation prone. The Fed can really turn up the heat.
We could have a boom to make the past look like small potatoes.
Japan has already experimented with trying to avoid deflation by keeping interest rates low, as they did for 20 years. It did not work. The yen soared.
The dollar is rising now.
The Fed needs to consider QE as conventional policy, I would hope QE would be married to tax cuts on productive behavior.
Let it rip, go for growth and prosperity.
Prices maybe stable but quantities are lower.
ReplyDeleteIn Oct. 1992, the Fed had cut the Fed funds rate from 10% to 3%.
ReplyDeleteInflation was running about 3% and real GDP growth about 4% YOY.
Milton Friedman wrote an op-ed for the Wall Street Journal that the Fed was "too tight" and should move to open market operations to stimulate.
Friedman dismissed the idea that the Fed could only push on a string.
http://0055d26.netsolhost.com/friedman/pdfs/wsj/WSJ.10.23.1992.pdf
I surmise that Friedman has gone out of style in the American right. I always liked his thinking.
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ReplyDeleteFriedman was brilliant, but not infallible. His one Achilles Heel was his assumption that the velocity of money would be relatively stable. History has shown us that is not the case.
ReplyDeleteHis warnings in 1992—that a continuation of slow M2 growth would lead to deflation and a slow economy—proved misguided. M2 growth remained very slow for the next 5 years, yet the economy grew at a respectable pace and inflation remained relatively stable and low.
If he were alive today he would arguably be calling for the Fed to tighten. Surely he would not argue for more QE, since the monetary base has exploded in size. With $2.5 trillion already in excess reserves, how could another trillion make a difference? M2 has been growing at a 6-7% rate for over six years, exactly as he would have prescribed, yet the economy is muddling along.
M2 velocity rose to record highs in the 1990s, offsetting the slow growth of M2. M2 velocity has plunged to all-time lows since 2008, offsetting the relatively rapid growth of M2. He never would have foreseen such extreme shifts in the demand for money. Consequently his policy prescriptions were wrong back in 1992 as they might have been today.
Everything Friedman argued for back in 1992 is with us today in abundance: plenty of monetary base and relatively fast growth of M2. Yet the economy is not performing well. I continue to argue that the problem today is not a shortage of money but a shortage of animal spirits, risk-taking, and confidence. No amount of money or even zero interest rates will produce faster real growth if the private sector is reluctant to invest.
Scott, refresh my memory here. Why did inflation take off in 1965? Was it just Viet Nam, Johnson tax & spend, Great Society type stuff, or was there a more underlying reason? I remember 1965 was about the 'real' top for the stock market for a number of years.
ReplyDelete1965 did mark the end of the very low and stable inflation of the early 1960s. I think most of the blame for rising inflation must go to the Fed. M2 grow was fairly rapid in the years leading up to 1965 (7-8% per year), but perhaps more importantly, the Fed was not tightening monetary policy despite outflows of gold. We were on something of a gold standard back then, which meant that gold outflows were supposed to be offset by a reduced monetary base, just as gold inflows would result in a larger monetary base. The Fed was reluctant to do its job, fearing that tighter money would slow the economy unnecessarily. They were "cheating" on the gold standard, allowing the supply of money to exceed the demand for dollars (the world wanted gold in lieu of dollars). Gold outflows intensified into the early 1970s, until Nixon famously told the Fed to devalue the dollar rather than tighten monetary policy by enough to stop the gold outflows.
ReplyDeleteScott-
ReplyDeleteObviously you make a lot of good points. But would Friedman call for no more QE today?
In the 1990s he told the Bank of Japan to buy bonds, and if that did not work, then to buy more bonds until it did.
http://www.hoover.org/research/reviving-japan
Friedman appeared to be quite an advocate for the positive effects of open market operations, (OMO), which when large enough are called large-scale asset purchases, or QE.
Friedman appears confident that even if banks sit on reserves, the other effects of QE--the ultimate bondsellers have more cash (not just the primary dealers), the portfolio rebalancing etc--will be beneficial.
Friedman anticipates both in his Japan piece, and that his 1992 WSJ piece, that banks might sit on reserves, which is amazing since at that time most people assumed banks would always lend out excess reserves.
I will say this: When the Fed started QE, there were many who said it would lead to hyperinflation. Then there were others who said it would be inert.
Now, most people seem to accept QE (as Friedman proposed 25 years ago, a quarter-century ahead of his time), but say the Fed should not do more.
Well, Friedman thought the Fed should do more, even when inflation was at 3% and the economy was growing at 4%.
If I had to place a bet, I would bet on Friedman. The guy was amazing.
Benjamin: monetary easing can help an economy if it is afflicted with a shortage of money relative to the demand for money. That does not appear to be the case today. Money supply (M2 is growing about 7% per year, a figure that Friedman would term generous. Swap spreads are at normal levels, signaling no systemic stress and plenty of liquidity. Inflation is relatively low, but at 1.5-2% not dangerously low by any stretch of the imagination.
ReplyDeleteIf there is no shortage of money, how would an increase in the supply of excess reserves (already gigantic) result in a bigger/stronger economy? That is the one question you never answer. Money doesn't create growth, only productivity does. The Fed has no control over productivity; it can foster productivity by making sure there is sufficient liquidity, but it can't create productivity.
If printing money could boost an economy, Argentina would be a powerhouse. But money can't and Argentina isn't.
Also, note that there is an important difference today which Friedman never considered: the Fed pays interest on reserves now, but it didn't back in 1992. Without IOR, banks have a real incentive to put excess reserves to work. With IOR, banks find it easier to just sit on the reserves. Going forward, the Fed is going to be using IOR as its primary policy tool, trying to find the level of IOR that keeps banks from lending too much.
Stan Druckenmiller: Zero-Interest Rates Unnecessary Now
ReplyDelete{ Druckenmiller was chief investment officer for the Soros Fund for 12 years. For several years, he has run only his family's money. }
If you want to witness a legendary investor's encyclopedic, cool, common sense mind at work watch this wide ranging Bloomberg video.
http://www.bloomberg.com/news/videos/2015-04-15/stan-druckenmiller-zero-interest-rates-unnecessary-now
Drunkenmiller's Op Ed in WSJ:"The Fed's Faulty 1937 Excuse" 4/16/2015
ReplyDelete"But is the prevailing consensus correct if emergency economic conditions are long past?
Comparisons with 1937 or with Japan in the 1990s are commonly used as examples of mistakes to avoid. Both occasions were preceded by a severe financial crisis, and years later monetary policy was prematurely tightened.
The differences between the current policy conjuncture and these historical analogues are striking, however. Eight years after the 1929 crash, consumer prices in the U.S. had fallen by a cumulative 18% and unemployment remained above 14%. And in Japan today prices are still down relative to their pre-banking crisis levels.
In contrast, since 2007, prices in the U.S. rose by an accumulated 16%, and the Fed’s favorite annual inflation measure has never been below 1%. Current unemployment is at 5.5%, the same rate prevailing in the boom years of 1996 and 2004. The U.S. is currently far from being mired in deflation and low growth as was the case in the late 1930s or in Japan in the 1990s. Therefore the initial conditions for considering the conduct of future monetary policy are radically different."
To read, Google "The Fed's Faulty 1937 Excuse"
"If there is no shortage of money, how would an increase in the supply of excess reserves (already gigantic) result in a bigger/stronger economy?"--Scott Grannis
ReplyDeleteWell, this is where you and I cannot even seem to have an argument, as we cannot agree on the basics. I am beginning to suspect we share a common ancestor somewhere.
I developed a chart and ran it past the Fed, and goes like this:
The Fed buys bonds from the 22 primary dealers, and places an equal amount of cash into the primary dealers' commercial bank accounts, commonly called "reserves."
But the primary dealers buy bonds from the market, and pay cash for those bonds (for a while there was even a Primary Dealers Credit Facility to help dealer buy bonds, but that is a complication).
The people who sell bonds to the primary dealers now have digital cash, and they must do something with it. They can literally convert it to paper cash, or deposit it into a bank, or invest in bonds, stocks and property.
The bank deposits are something of a dead end. But the other choices are not.
This results in what the Fed calls "portfolio rebalancing." I call it having $4 trillion in new cash on the investor market, and stimulus.
The stimulus does not come from increased bank reserves, like smaller OMOs pre-2008. It comes from $4 trillion in cash-fueled portfolio rebalancing.
There is another interesting side story on this, that maybe you will like. I thought this one up myself.
You have correctly pointed out a large increase in commercial and industrial loans. My experience is that banks are loath to lend on anything except collateral, and that usually is property. (I confess I was never involved in finance at a larger company, such as one with $100 mil or more in revenues).
Okay, so the Fed does QE, and property values go up, as people selling bonds reallocate to other assets, including property.
Now the banks can lend more to commercial and industrial operations, as their land is worth more.
We have seen recoveries in commercial property values, and also in C&I loans.
Anyways, I think Milton Friedman was right in 1992, and basically think he was always right.
But more importantly, I think it is also fascinating that the top monetarist in 1992, even when the economy was growing at 4% and inflation was at 3%, was calling on the Fed to be more stimulative.
Today we have such timidity that monetarist types are in white-frights over inflation above 2%, and forget about growth, it is more important that inflation be below 2%, or better yet 0%.
What ever happened to taking some risks for growth?
Benjamin: aside from your faulty understanding of how QE purchases affect the money supply (they don't create new digital cash), all you are saying is that more money would reflate asset values and that would stimulate the economy.
ReplyDeleteThe question you need to answer is: How would higher asset values stimulate the economy? How would it create a larger economy?
Scott---Well, on this one I guess we will just have to agree to disagree. I do not think my understanding of QE is faulty, as "portfolio rebalancing" is standard in Fed literature, but be that as it may.
DeleteAn interesting question: if Fed buying of more bonds would be inert, why not buy a couple trillion more T bonds and reduce taxes and the national debt?
The Fed''s QE purchases are not without impact on financial markets. At some point banks could find themselves with excess reserves they no longer want and they would ramp up their lending. This would eventually lead to a surplus of money in the system and rising inflation.
ReplyDeleteFed purchases of treasuries do not extinguish the national debt. Treasury still has to pay interest on the bonds and eventually redeem them regardless of who owns the bonds. The Fed's holdings of securities are the collateral behind the dollar money supply. If treasury walked away from its obligations the Fed's solvency would be called into question and that in turn could lead to a serious debasement of the dollar.
Scott: Yes, but the interest paid on T bonds held by the Fed flows back to Treasury. That is a better deal than taxpayers get on bonds held by the Social Security Trust Fund!
ReplyDeleteThe Treasury also has to honor bonds held by all federal agencies, but such bonds are still considered to be held by the public.
I think counting the Fed as a non-federal agency might be parsing matters a little too finely.
I understand the history of the Fed, and its sources of funding presently. But if it is not a federal agency, it sure is a close cousin.
Actually, the Fed remits to Treasury any profits it generates. The Fed receives coupon payments on the notes and bonds it holds, but it must pay out whatever the Interest On Reserves is. Currently, the yield curve is positively sloped, so the Fed is making a decent profit. But at some point in the future the curve will likely be inverted (IOR will be greater than the yield on notes and bonds), at which point the Fed will suffer losses.
ReplyDeleteScott-
ReplyDeleteYou raise some fascinating issues in your last reply.
The Fed owns $4 trillion in bonds, and forwards excess earnings to Treasury. As we know, this has been sweet money for taxpayers, a few hundred billion in last several years. Not that Congress-federal bureaucracy will cut our taxes, but....
Okay, so what is the average maturity on the Fed's bond hoard?
Bernanke recently advised the Fed not let the bond portfolio "bleed off." The Fed says it will bleed off. Suppose the Fed does let the portfolio mature, without buying new bonds.
Okay, let's suppose that $2 trillion in bonds matures in the next 10 years. The Treasury and some MBS issuers pay $2 trillion in principal to the Fed.
You think the Fed will not be able to pay IOER, when they have $2 trillion in incoming principal payments pending in next 10 years (these figures may be a little off, but you get my point).
It seems to me the Fed will be buried in money.
Of course, it is still an open question that interest rates will ever go up.
As you know, interest rates have been trending down for 35 years. Quite a track record. When interest rates hit zero in Japan 15 years ago, they just stayed there. In Europe, they got creative and went below zero.
Every year for the last three decades we hear the economics profession predict higher rates. This is worth pondering. Also, inflation is supposed to have run wild many times. Instead, right now, we are at 0% CPI YOY.
Another interesting possibility: If the Fed stopped paying IOER, I doubt the banks would lend the money out. Banks want to lend to profitable borrowers. There is a limit to that.
So, lacking the IOER, banks might start charging for deposits.That is, negative interest rates. Like Europe and Japan. Why would banks want deposits when they already have more than they can lend?
This might be the next step in the USA.