Friday, May 30, 2014

Deflation is a no-show thanks to easy money and rising wealth

We now have the CPI and the Personal Consumption Deflator for April, and they show that inflation is running comfortably in the middle to the upper half of the Fed's desired range. As evidence, I offer the following charts that compare the year over year and 6-mo. annualized rates of inflation according to these two measures, using both the total and the core (ex-food and energy) versions of each:

In the 12 months ended April, the CPI rose 1.96%, and the core CPI rose 1.83%.

In the 6 months ended April, the CPI rose at an annualized rate of 2.13% and the core CPI rose at an annualized rate of 1.94%. This suggests that inflation pressures have increased a bit of late. Which of course runs counter to the prevailing belief that weak economic growth—such as we had in the first quarter—suppresses inflation. This further suggests that the Fed's model of inflation, which is grounded in the belief that a lot of excess capacity (e.g., a relatively high rate of unemployment and a relatively large "output gap") effectively inoculates the economy against rising inflation, may be faulty. I side with the monetarists on this: inflation comes from an excess of money.

Some years ago, the Boskin Commission found that the CPI tended to overstate inflation by as much as 1% a year. The BLS has since tinkered with and improved their methods, and more recently the CPI has tended to register about one-half of a percentage point higher than the more robust and generally more accurate Personal Consumption Deflator. In line with this, we see that the PCE deflator rose 1.62% in the 12 months ended April, and the core PCE deflator rose 1.42%, both being about half a point lower than their CPI counterparts.

Over the past six months, the PCE deflator has risen at an annualized rate of 1.59%, while the core PCE deflator rose at an annualized rate of 1.46%. 

I like to round things off and generalize, so I conclude from the eight measures of inflation shown above that inflation is running somewhere in the range of 1.5% to 2.0%, and that it has picked up slightly in recent months. This is not alarming, but it does not lend much support to the Fed's aggressively accommodative monetary policy stance. Why do they have the pedal to the metal when inflation is running comfortably in the middle to upper half of their target range? 

At the very least we can conclude that deflation is nowhere to be found in the official inflation stats. Whereas some of them were flirting with sub-1% inflation last year, that is no longer the case.

The above chart is arguably the best measure of the dollar's value against other currencies. As it shows, the dollar currently is relatively weak against most of the world's currencies: about 12% below its long-term average. A weak dollar is symptomatic of an oversupply of dollars relative to the demand for dollars, and that is the equivalent to a strong anti-deflation tonic. You don't get deflation when there is a lot of extra money floating around. You're more likely to see signs of positive and/or rising inflation with a weak currency.

Steve Ballmer's shockingly large bid of $2 billion for the Clippers suggests that there is a lot of money out there chasing relatively few sports assets. Could this be a harbinger of a generalized increase in prices in the future? I wouldn't be surprised if it proves to be. Financial markets have done exceedingly well over the past 5 years. Not only is there a relative abundance of dollars, there is now a relative abundance of savings and wealth.

Despite near-zero interest rates, U.S. banks have taken in $3.3 trillion in savings deposits since late 2008. This is symptomatic of strong demand for the relative safety of money and money equivalents. Strong money demand has effectively neutralized the Fed's easy money stance to date. Put another way, the Fed has engaged in QE in order to satisfy the world's seemingly insatiable demand for money. 

As I've explained before, strong deposit inflows have provided banks the wherewithal to purchase the $2.9 trillion of bonds that they then sold to the Fed as part of its Quantitative Easing efforts. To date, it would appear that the public is content to hold $7.3 trillion in bank savings deposits yielding almost nothing, and the banks are content to sit on $2.6 trillion of excess reserves yielding only 0.25%. But if and when the demand for all that near-zero-interest paying money starts to decline, the public's desire to reduce their cash holdings could result in a significant increase in the price of things (e.g., real estate, commodities, cars, vacations) they would rather hold instead. In short, there is a lot of money sitting on the sidelines that could serve as the fuel for higher inflation and faster nominal GDP growth. All it takes is a decline in the demand to hold the huge stock of money and money equivalents that exist today.

The first chart above shows Bloomberg's calculation of the market cap of exchange-traded U.S. equities, currently about $23 trillion, up from just $8 trillion a bit over five years ago. The second chart shows the market cap of all global equities, currently $64 trillion, which is up from $26 trillion just five years ago. The third chart shows the huge gains in the net worth of U.S. households, which have been fueled almost entirely by gains in financial assets. These add up to some very impressive gains in money and wealth. Perhaps the Ballmers and near-Ballmers of the world are feeling like they'd rather have some concrete possessions instead of all that money in their brokerage account. Ballmer's aggressive bid for the Clippers may be a sign that money demand is beginning to weaken.

As the chart above shows, the bond market is anticipating that CPI inflation over the next 5 years will average 2.0% per year (expected inflation is derived by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity). That's a pretty sanguine outlook, considering that the CPI has risen at an annualized rate of 2.3% over the past 10 years, and 2.1% over the past 5 years. 

So far, so good: some signs here and there that money demand is beginning to weaken and there is a surplus of money developing, but no sign yet of any worrisome increase in inflation. But it seems to me that the pressures for higher inflation are building. It may take awhile for inflation to show up in the official statistics, but for now there are growing signs of an abundance of money and wealth, and the beginnings of a weakening in the demand for money that tip the balance in favor of higher inflation in the future.

As I noted last year, the Fed's real objective with Quantitative Easing is to destroy the demand for money. They want to weaken the public's and the banks' demand to hold on to money balances and their equivalent by making cash a poor investment compared to other assets. They don't mind seeing equity prices rise, as that ought eventually to encourage people to take on more risk. After all, this has been a recovery dominated by risk aversion. The Fed wouldn't mind seeing inflation rise above 2%, and they probably wouldn't take corrective action until it got to 3%. But that's a dangerous game, since, as Milton Friedman taught us, the lags between monetary policy and the economy are long and variable.

Don't let quiescent inflation and a weak economy lull you into a complacent view of the future of inflation, and don't worry about deflation. Think instead about the weak dollar, a weakening in the demand for money, and very strong financial markets. 


Benjamin Cole said...

Great blogging.

Not sure about the Fed's 2 percent PCE core target---one gets the sense the Fed regards the 2 percent figure as a ceiling, and maybe Scott Grannis does too, from his commentary.

I think it would be better for the Fed to operate according to stated policy, and regard 2 percent PCE core as an average target, meaning that if we now ran at 3 percent PCE core for a couple of years, then we would be back at long-term average and not at TEOTWAWKI.


For what it is worth:

News Release: May 15, 2014

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.87 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.


$2 billion for the Clippers? I have been researching art markets. People are spending $100 million for a painting from the 1960s, by Roy Lichtenstein. They look like comics.

People are paying $1 million for a painting by an artist I guarantee you never heard, that I never heard of, that no one you know or I know has ever heard of. They pay $1 million for a 1960s canvas painted red, with knife slashes in it.

For better or worse, the globe now has a large numbers of people, perhaps several hundred thousand or a few millions, with completely disposable wealth in $1 million to $2 billion range. Maybe more than $2 billion, but that is the highest number I have heard yet.

Citicorp put out some studies back in 2006 regarding the "Plutonomy."

Certainly incredible pools of wealth have been created in the last 30 years, and I think that is great. These new wealth pools can do things that government can and should not, like investigate new business platforms or commercialize technologies. There will never be shortages of investable capital again, I surmise. If you have a good technology, you can get it financed.

I am not sure than Ballmer unloading $2 billion on the Clippers means there we face any inflation. It may reflect the huge concentrations of wealth that have become common in market economies.

Or that Ballmer has lost his marbles.


I think what is lacking today is aggregate demand. A virtuous cycle could be developed if aggregate demand can be boosted, and that would unleash a lot of investing, which would boost AD even more.

The Fed, by chronically undershooting the 2 percent PCE average target, is probably asphyxiating the economy.

Call it Japan Lite.

John said...

I wonder if one positive aspect of the oligarchy is, considering that the wealth concentrated at the top is invested in globalized assets, and the oligarchs are calling the shots, politically, it may have a stabilizing affect on international affairs. In other words, there won't be a war with Russia or any other major power because there's too much money involved. Finances are thoroughly international and interdependent.

Unknown said...

Hi Scott;

I live in Irvine, so we're in the same beautiful neighborhood!Your blog is the best, I love it!Thank you.
I am a small business owner, and see wage and other inflation pressures popping up over the last year or so. How do you invest for an environment of rising inflation?



Scott Grannis said...

I think equities should do OK in a rising inflation environment, but at some point (when the Fed tightens policy in order to bring inflation down) they will suffer. Gold is a classic inflation hedge, but I think it's way too expensive today. It's already priced to lots of inflation. Real estate is another classic inflation hedge, and it doesn't look expensive. REITS are a good way to earn income and get exposure to rising property prices. Commodities should do well, but they are already expensive from an historical perspective.

theyenguy said...

1) You write, There is now a relative abundance of savings and wealth.

I respond that soon that will change as the investor, most critically the fixed income investor, will be going extinct, as investors derisk out of debt trade investments and currency carry trade investments.

2) You write, As I noted last year, the Fed's real objective with Quantitative Easing is to destroy the demand for money.

I respond that the real objective of Quantitative Easing was to birth the investor as the centerpiece of economic activity and produce a moral hazard based wealth and prosperity.

Building on the concept of economy presented by the Apostle Paul in Ephesians 1:10, Jesus Christ developed and has now matured the paradigm and age of of liberalism, which is defined as freedom from the state.

Beginning with the creation of the Creature from Jekyll Island, He perfected the Banker Regime, with its monetary policies of investment choice and schemes of credit, to produce the investor and peak prosperity and peak wealth.

Mankind’s peak economic experience has been attained, it came via the chieftain geniuses at the US Fed, the ECB, and the Bank of Japan, via their provision and enforcement of Global ZIRP beginning with QE1 and TARP. .

Now, not only is the death of currencies underway, as is seen in the Major World Currencies, DBV, such as the Euro, FXE, and the Emerging Market Currencies, CEW, trading lower in value; the failure of credit, that is failure of trust in the Banker Regime is underway, and is seen in the Floating Rate Note, FLOT, paying 0.41%, starting to trade lower in value on May 28, 2014.

Of note, European Credit, EU, has traded lower in value, as Deutsche Bank posts in PDF document concerns over European social turmoil: the eurosceptic parties increased their share substantially, but winning parliamentary representation is not equivalent to gaining actual political influence.

As currency traders force derisking out of debt trades and deleveraging out of currency carry trades, by selling the Major World Currencies, DBV, and the Emerging Market Currencies, CEW, and as the bond vigilantes force derisking out of credit investments, by calling the Benchmark Interest Rate, ^TNX, higher from 2.44%, both fiat money and fiat wealth will tumble, and being unable to underwrite safe assets, democratic nation state governance will crumble, and the Beast Regime of regional economic governance and totalitarian collectivism, will rise out of waves of Club Med sovereign, banking and corporate insolvency as foretold in Revelation 13:1-4, where authoritarianism will be mankind’s final economic paradigm and age.

William said...

ECRI Weekly Leading Index Ticks Up

The Economic Cycle Research Institute index rose 0.3 point to 135.4 in the May 24 week.

The 4-week annualized growth rate rose to 5.3% from 5%. That's the best in nearly a year.

William said...

Velocity of M2 Money Stock Continues Its Decline

M1 is the money supply of currency in circulation (notes and coins, traveler’s checks [non-bank issuers], demand deposits, and checkable deposits). A decreasing velocity of M1 might indicate fewer short- term consumption transactions are taking place. We can think of shorter- term transactions as consumption we might make on an everyday basis.

The broader M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals.

Comparing the velocities of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving.

Benjamin Cole said...

You might find the Divisia measure of the money supply interesting. It is put out by the Center for Financial Stability, online. The bad news is that this measure of the money supply is going flat....