Wednesday, October 13, 2021

Monetary policy is a slow-motion train wreck


There is no shortage of things to worry about. 

That's a phrase I have used several times over the past decade. I used it as a foil to argue that since the market was quite cautious (and nervous), then a surprise downturn or selloff wasn't a serious risk. Recessions usually happen when nearly everyone is feeling optimistic. Today there again is no shortage of things to worry about, and the market is within inches of its all-time high. Most disturbing, however, is that neither the Fed nor the administration nor Congress nor the bond market are very worried about inflation. Inflation and all its nasty consequences are, arguably, big things to worry about today.

Fed policy, as laid out in today's FOMC minutes, is amazingly blasé about the risks of higher inflation. The Fed currently plans to begin "tapering" its purchases of Treasuries and mortgages sometime next month, and to finish tapering by mid-2022. That's not a tightening of monetary policy; it's only making policy less accommodative over a prolonged period. Actual tightening—which would consist of draining reserves (i.e., selling bonds) and/or raising the interest rate it pays on reserves (i.e., higher short-term interest rates)—won't begin until sometime late next year. 

The market has apparently agreed that this is a sensible course of action. Inflation expectations embedded in bond prices are somewhat high, but still a relatively tame 2.75% per year (average) over the next 5 years. The bond market is currently pricing in one or two 25 bps "tightenings" by the end of next year (i.e., short-term interest rates of roughly 0.4% to 0.5%), and a 1.5% fed funds rate 3 years from now. By any standard, that would be a supremely gradual pace of monetary tightening. But at a time when inflation is at levels not seen in over 30 years? 

This is almost certainly an unsustainable situation. The Fed and the bond market are almost certainly underestimating the risks of higher-than-expected inflation. 

How do I know this? It's all about incentives. Today, the incentives to borrow are huge. Short-term interest rates are below the current level of inflation and will likely remain so for at least the next year. (Even 30-yr fixed rate mortgages are lower than the rate of inflation.) Smart investors and consumers won't find it hard to arbitrage these variables. In fact, the process is already underway. You simply borrow money and buy anything that is a productive asset and which also has roots in the nominal economy (e.g., commodities, equities, farms, factories, cars). Leverage is your friend and ally in a high-inflation, low-interest-rate world.

How does one place a bet on an asset (in this case the dollar) that is expected to decline in value (because of inflation eroding its purchasing power)? You sell it if you own it, or you sell it short (you borrow it and then sell it). You buy it back when inflation settles back down and/or interest rates rise to a level that is greater than inflation. One way to "short" the dollar is to simply borrow dollars. And a common way to do that is to get a loan from a bank. And when the bank lends you money, the bank can actually create the money it lends you, which in turn expands the money supply. Banks are uniquely able to create money, provided they have sufficient reserves on hand to collateralize their deposits. Since the banking system currently has upwards of $3 trillion in "excess" reserves, thanks to the Fed's gargantuan purchases of notes and bonds, banks have an almost unlimited ability to increase their lending.

So it's not surprising that the M2 money supply has expanded at an unprecedented rate over the past 18 months, a time in which the Fed has bought almost $3 trillion of notes and bonds and bank deposits have swelled by some $5 trillion. And it's also not surprising that in the past six months consumer price inflation has posted a 6-7% annualized rate of growth—a rate last seen in late 1990. 

As for Biden, his approval rating is now down to an abysmal 38%. His administration has committed a series of blunders, most notably with the Afghanistan withdrawal. His top priority now is to pass two bills chock full of new social spending and new taxes which he preposterously claims will cost the economy "zero." Meanwhile, inflation has risen to multi-decade highs, yet both the administration and the Fed keep insisting it's just transitory. Things will almost certainly get worse if trillions of new taxes and spending, additional layers of bureaucracy, and hundreds of billions of dollars of new handouts and subsidies get lavished on the middle class. My good friend and talented artist Nuni Cademartori sums it up in this cartoon:



As the battle in Congress over Biden's "Build Back Better" agenda rages, I would urge everyone who thinks this agenda will actually help the economy grow and prosper to read the recently released study by the Texas Public Policy Foundation in collaboration with my good friend, Steve Moore of the Committee to Unleash Prosperity.

The key findings:

• The cost of the Biden Build Back Better plan spread across two bills will reach $6.2 trillion over the next decade.

• The higher tax rates on corporate income, small business income, capital gains, and so on will raise the cost of capital and reduce national investment and the capital stock.

• Compared to baseline growth, the negative impact of these taxes over the next decade will result in 5.3 million fewer jobs, $3.7 trillion less in GDP, $1.2 trillion less in income, and $4.5 trillion in new debt.

While I'm on the subject of Steve Moore, whom I've known since the mid-1980s, I will once again recommend you read and subscribe to the Committee to Unleash Prosperity's free daily newsletter. I read it every day, as do more than 100,000 citizens and Washington policymakers. (One of his recent issues featured Nuni's cartoon, and another featured some of my recent charts.)

In the study mentioned above you will find details on a plethora of Biden's tax proposals (e.g., a 12.5% payroll tax on all income over $400K, a reduction in the estate tax exemption of $8 million, and an increase in the top marginal tax rate to 65%) and their likely negative impact on the economy and employment. It's frightening to think that the people who came up with these proposals apparently believe that the overall impact of BBB will be stimulative. Have they no common sense? Here's a fundamental supply-side truth: when you tax productive activity and success more, you will get less of it. And when the government borrows trillions only to redistribute the money to favored groups and industries, you get a weaker, less efficient economy. And you also risk boosting already-high inflation.

I'll wrap things up with some updated charts and commentary:

Chart #1

Nothing illustrates better the supply-chain bottlenecks that currently plague the global economy than Chart #1. Used car prices have literally skyrocketed; in inflation-adjusted terms, used car prices are higher than they have ever been. In nominal terms they are up over 50% since March '20. 

Chart #2

Chart #2 shows how almost half of small businesses in the US report paying higher prices. The last time this occurred was in the 1970s. It's hard to escape a higher inflation deja vu conclusion.

Chart #3

As Chart #3 shows, bank reserves are very near their all-time high. The vast majority of these reserves are "excess" reserves, meaning they are not required to collateralize bank deposits. Banks thus have enough reserves on hand to collateralize an ungodly increase in deposits via new lending (i.e, money creation). If the Fed doesn't increase the interest rate it pays on these reserves by enough to make them more attractive, on a risk-adjusted basis, than the interest rate banks can expect to earn on new lending, bank lending will surely continue to expand, and that will fuel a prolonged expansion of the money supply and ever-higher inflation. 

Chart #4

Chart #4 shows the 6-mo. annualized rate of growth of the CPI (including the ex-energy version). I think this is a fair way to measure what's happening now, since we are well past all the distortions of last year and the turmoil earlier this year. Inflation by this measure hasn't been this high since late 1990. 

Chart #5

Chart #5 compares the year over year growth in the CPI (I'm being conservative with this) to the level of 5-yr Treasury yields. Yields haven't been this low relative to inflation since the 1970s. Recall what happened back then: millions of households made a fortune borrowing money at fixed rates and buying houses. Negative real interest rates cannot be sustained for long, mainly because of the incentives they create to borrow and buy. 

Chart #6

Chart #6 is an updated version of the one featured in Steve Moore's newsletter. It's important to note that the multi-decade trend rate of M2 growth is 6-7% per year. This has been blown away in the past 18 months. If the public tires of holding $3.8 trillion more in bank deposits than they normally would at this time, that's a tsunami of money that could float higher prices for nearly everything in the next year or so. It's also worth noting that M2 has been growing at a 10-11% annualized rate so far this year. 

What worries me the most right now is how this all sorts out. The Fed seems determined to avoid even the semblance of tightening for the next 12 months. Yet if inflation turns out to not be transitory as they currently expect, how long will it be before policy becomes tight enough to threaten the economy's health?

Chart #7

Chart #7 provides some historical context which may help answer that question. Note that every recession on this chart (shaded bars), with the exception of the last, was preceded by 1) a flat or negatively-sloped Treasury yield curve, and 2) a very high real Fed funds rate. Both of those conditions confirm the existence of very tight monetary policy that was intended to keep inflation pressures at bay. Neither condition is in place today, however, which strongly suggests that monetary policy poses no threat to the economy at this time.

Past Fed tightenings, however, were different from what a tightening would look like today. To really tighten policy, the Fed would have to 1) start raising the interest rate it pays on reserves, and 2) start draining reserves by selling bonds. It might take years to get rid of all the excess reserves, however, and no one knows for sure how the economy will respond to higher short-term rates in the presence of abundant reserves—that's never happened before. In the past, the Fed simply drained reserves until they were in such short supply that the banks were willing to pay ever-higher interest rates in order to acquire enough of them to collateralize their deposits. A scarcity of reserves led to a liquidity shortage, and high real borrowing costs led to bankruptcies and weak investment. Eventually, economic growth ceased, and the inflation cycle was broken. 

The dilemma for investors: we might be years away from a return to these conditions, so selling risky assets right now might be premature. And, by the way, holding cash is a guaranteed way to lose money. But how long can you wait, knowing that another economic collapse looms on the horizon? 

In the meantime, the prospects for Biden's Build Back Better lollapaloosa are declining by the day, thankfully, and the spreading disarray in Washington only makes that more likely. I'm willing to bet that if any of his bills survive, it will be in greatly reduced form, and thus much less damaging to the economy. Just letting the economy sort things out on its own would be a great relief to everyone, in my view.

Nobody said investing was easy. There are a lot of things to worry about these days. But I wouldn't panic just yet. The next year or so might be likened to watching a train wreck in slow motion.

Tuesday, October 5, 2021

Important charts to watch


We're in the midst of what is so far a moderate selloff in the equity market. And as usual, in such circumstances (at least in the past decade or so) there is no shortage of bad news. China is ramping up its military threat to Taiwan, Congress is struggling to pass damaging tax hikes and massive and wasteful social spending, equities have soared by almost 550% since their March '09 bottom, 10-yr Treasury yields have jumped by 30 bps in the past two months, the Fed is about to start tapering it bond purchases, Biden's popularity is plunging, and our southern border is being overrun. In the background is the growing sense that we don't know if anyone, even Biden, is in charge. That in turn contributes to a global policy vacuum which our rivals and enemies are unlikely to ignore. 

That's an uncomfortably long list of things to worry about—no wonder the stock market is uneasy. Indeed, it's a wonder it has done so well of late.

I won't pretend to be able to predict whether now is a good time to buy or not. But I can offer some charts and thoughts which are reassuring in the sense that they offset at least some of the bad news, and also because they are not being talked about much these days (the things the market is overlooking can often be very important). Meanwhile, I'm pretty sure that inflation is going to be a lot higher for longer than the Fed currently predicts, and the eventual realization that we have an inflation problem (sometime next year?) will pose a threat to the economy because it eventually will lead to some serious Fed tightening. That just so happens to be the scenario that has preceded every recession in my lifetime save the last one (which was entirely the fault of Covid and politicians' overreactions to it). 

Chart #1

Chart #1 shows the level of M2 less currency in circulation. It's the total of all the retail bank savings deposits and checking accounts, plus a small amount of retail money market funds. This is money that the public has socked away, and it is money that is easily spendable. What we see here is a shocking and totally unprecedented increase in the money supply immediately following the Covid lockdowns. The amount of spendable money in the economy is almost $4 trillion higher than it would have been had the money supply grown at its long-term rate of about 6% a year. Notably, the Fed's three waves of Quantitative Easing in the 2009-2018 period hardly register on this chart. It's remarkable indeed that this explosion of money (a REAL BIG quantitative easing!) is hardly mentioned in the press these days.

It's hard to see the economy stumbling when liquidity is super-abundant and borrowing costs are incredibly low. It will take a looonnng time for those conditions to reverse.

Chart #2

I didn't just make up the 6% growth rate shown in Chart #1. Chart #2 shows the same 6% growth rate trend going all the way back to 1995. For the past year, M2 has grown by about 12%, and the annualized growth rate of M2 over the past three months has been about 12% as well. Money continues to grow about twice as fast as it ever has before! It's hard to imagine, given this explosion of money, that the inflation we've seen so far this year is going to prove transitory. This is a big deal that is not getting much news. For more color on how inflationary psychology works, see my post from last June on my experiences with inflation in Argentina.

Chart #3

Chart #3 is one of my all-time favorites, since it makes clear that every recession in modern times (except for the last one) has been preceded by a prolonged period of Fed tightening. The blue line is the real Fed funds rate (the Fed's policy target minus the year over year change in the Core PCE deflator). Note that it rises to at least 3-4% just prior to every recession but the last one. This is the best measure of how "tight" Fed policy is, because high real interest rates equate to very expensive borrowing costs; the Fed raises this rate in order to discourage banks from lending and to discourage the public from borrowing—this results in a shortage of liquidity and that in turn puts downward pressure on inflation. The red line is the slope of the Treasury yield curve from 1 year to 10 years. Note that it falls to zero or less just prior to every recession. A flat to negatively-sloped yield curve is the bond market's way of saying that Fed policy is so tight that it threatens the economy; that will eventually force the Fed to ease in the future—thus making long term interest rates lower than short-term rates.

In the meantime, even if the Fed finishes its tapering and starts raising its target funds rate well before anyone currently expects them to, they will still have to counteract the super-abundance of bank reserves. In the past, Fed tightening meant a shortage of bank reserves and a general lack of liquidity–conditions that proved lethal to over-extended borrowers. It would take extraordinary measures and a lot of time for those conditions to return in the future. So the threat to the economy of Fed tightening today is not nearly as imminent as one might think based on past experience. 

Chart #4

Chart #4 compares the price of gold (blue) to the 3-yr forward yield on eurodollar futures contracts. This latter is a good proxy for what the market expects the Fed's target overnight rate to be 3 years in the future. There is a strong inverse correlation between the two (I've plotted the eurodollar yield in inverted fashion). When the Fed is expected to ease in the future, gold prices tend to rise. Today, the market is pricing in future Fed tightening, and gold is declining. Gold today is not reacting to rising inflation; on the contrary, it is reacting to the expectation that the Fed will eventually have to tighten policy in order to rein in inflation. Flat to falling gold prices today suggest the gold market is pricing in a future of Fed tightening and an eventual return to lower inflation. 

Chart #5

Chart #5 shows the inflation-adjusted price of crude oil futures contracts. This price has averaged about $55/barrel for the past 47 years. Today, crude is trading just under $70/barrel. The big jump in crude prices in the early 1970s was triggered by Nixon's decision to take the dollar off the gold standard. Both gold and crude prices (and nearly all other prices) rose following this effective devaluation of the dollar. 

Chart #6

Chart #6 shows the ratio of gold prices to oil prices. This ratio has averaged about 20 (i.e., one ounce of gold tends to be worth 20 barrels of oil. Today the ratio is in the mid-20s, which suggests that oil is somewhat cheap relative to gold. In any event, gold and oil prices seem to be in rough equilibrium these days, and neither one is out of line with historical experience.

Chart #7

Chart #7 shows the level of capital goods orders in both nominal and real terms. Capital goods orders are a good proxy for corporate America's confidence in the future: more orders mean greater productivity for workers in the future. Business investment hasn't been this strong for many years (but it was even stronger in the late 1990s). Strong business investment today suggests a stronger economy in the years ahead. This is a very optimistic sign, and good evidence that we are not facing a future of stagnant economic growth. We may have a lot of inflation, but the economy is still likely to grow. High inflation is eventually destructive of an economy's growth potential, but that might take years to play out. In short: in may be premature to worry about "stagflation."

Chart #8

Chart #8 is very important, since it shows how inflation expectations are built into bond prices. The green line is the difference between the yield on nominal and real 5-yr Treasury notes, and thus it is the market's explicit expectation of what consumer price inflation will average over the next 5 years (currently 2.7%). That's near the high end of historical experience, which tells us that the bond market is only just beginning to believe that the Fed is wrong to predict that the current spurt of inflation will prove transitory. It also tells us that if future inflation expectations rise to the 4-5% level that exists currently, the bond market will have an awful lot of painful adjustment to endure (e.g., nominal yields will have to rise significantly and/or real yields will have to hold steady or fall). 

Chart #9

Chart #9 compares the level of housing starts (blue) with an index of home builders' sentiment. Sentiment tends to lead starts, not surprisingly, so the current level of sentiment points to continued strength in the housing market. One reason home prices have been so strong of late is that the nation has acquired a meaningful housing deficit after the collapse of new home building which began in 2006. It could take years to make up for this. The major risk facing the housing market today is rising mortgage rates, which are currently still incredibly low (~3% for 30-yr fixed rate mortgages). Borrowers may well be intimidated by soaring home prices, but the prospect of borrowing cheap money in a rising inflation environment is very appealing. What we are seeing today (rising housing prices and cheap borrowing costs coupled with rising inflation) is a virtual replay of what happened in the 1970s. Recall that mortgage rates eventually topped out at double-digit levels in the early 1980s. 

And by the way, it took the Fed quite a few years to break the back of double-digit inflation back in the early 1980s. 

Monday, September 27, 2021

Covid vs Spanish flu chart

Brian Wesbury publishes weekly a great and changing collection of charts that I find quite interesting. Here's a chart that really got my attention:

Note how the Spanish flu was a lot more lethal than Covid-19, especially among the younger members of the population. Note also how people under the age of 45 have face an extremely low level of risk of dying from Covid-19. Especially children of school age. I really think national media have done a terrible job of not reporting these facts. Why in the world were school kids ever forced to wear masks? Why do I still see people in their 30s and 40s walking around outside by themselves and wearing a mask? This is just crazy. People have no sense of the risks they face. We knew back in April of last year that the only portion of the population at high risk from Covid were the elderly. Yet I'll bet there are many millions of people who either do not know this or who are overlooking this. 

Friday, September 24, 2021

Your cash will lose at least 5% of its purchasing power in the next year


Earlier this week, Fed Chair Jerome Powell announced that the real yield on dollar cash and cash equivalents is likely to be -5% or less over the next 12 months. Yes, your cash balances will lose at least 5% of their purchasing power over the next year, and that's virtually guaranteed. So what are you—and others—going to do about it?

Assumptions: This forecast of mine optimistically assumes that 1) the first Fed rate hike of 25 bps comes, as the market now expects, about a year from now, and 2) the rate of inflation slows over the next 12 months to 5% from its year-to-date rate of 5.9%. Personally, I think inflation next year likely will be higher, if only because of the delayed effect of soaring home prices on Owner's Equivalent Rent (about one-third of the CPI), the recent end of the eviction moratorium on rents, and the continued, unprecedented expansion of the M2 money supply.

I'm a supply-sider, and that means I believe in the power of incentives. Tax something less and you will get more of it. Tax something more and you will get less of it. Erode the value of the dollar at a 5% annual rate and people will almost certainly want to hold fewer dollars than they do today.

I'm also a monetarist, and that means I believe that if the supply of dollars (e.g., M2) increases by more than the demand for dollars, higher inflation will be the result. We've already seen this play out over the past year: the M2 money supply has grown by more than 25% (by far an all-time record) and inflation has accelerated from less than 2% to 6-8%. Massive fiscal deficits have played an important role in this, but so has an accommodative Fed. Between the Fed and the banking system, 3 to 4 trillion dollars of extra cash were created over the past 18 months. At first that was necessary to supply the huge demand for cash the followed in the wake of the Covid shutdowns. But now that things are returning to normal, people don't need or want that much cash. Yet the Fed continues to expand its balance sheet, and they won't finish "tapering" their purchases of notes and bonds until the middle of next year. That means that there will be trillions of dollars of cash sitting in retail bank accounts (checking, demand deposits and savings accounts) that people will be trying to unload.

If we're lucky, the inept and feckless Biden administration will be unable to pass its $1.5 trillion infrastructure and $3.5 trillion reconciliation bills in the next several weeks. This will lessen the pressure on the Fed to remain accommodative, but it's not clear at all whether it will encourage the Fed to reverse course before we have a huge inflation problem on our hands. Non-supply-siders (like Powell) view an additional $5 trillion of deficit-financed spending as an unalloyed stimulus for the economy. Supply-siders view it as a virtually guaranteed way to increase government control over the economy and thereby destroy growth incentives and productivity.

Amidst all this potential gloom, there are some very encouraging signs, believe it or not. Chief among them: household net worth has soared to a new high in nominal, real, and per capita terms. Also, believe it or not, the soaring federal debt has not outpaced the rise in the wealth of the private sector. See the following charts for more details:

Chart #1

Chart #1 is a reminder of just how low today's interest rates are relative to inflation. Terribly low! In normal times, a 4-5% inflation rate would call for 5-yr Treasury yields to be at least 4-5%. yet today they are not even 1%. The incentives this creates are pernicious: holding cash and/or Treasuries implies steep losses in terms of purchasing power. That in turn erodes the demand for cash and that fuels more spending and higher inflation.

Chart #2

Chart #2 shows the growth of the non-currency portion of M2 (currency today is about 10% of M2). Currency in circulation—currently about $2.1 trillion—is not an inflation threat, because no one holds currency that they don't want. The rest of M2, just over $18 trillion, is held by the public (not institutions) in banks, in the form of checking, savings, and various types of demand deposits. For many, many years M2 has grown at an annual rate of 6-7%. But beginning in March of last year, M2 growth broke all prior growth records. As the chart suggests, the non-currency portion of M2 is about 25% higher than it would have been had historical trends persisted. That means there is almost $4 trillion of "extra" money in the nation's banks. This extra money has been created by the same banks that are holding it: banks, it should be noted, are the only ones that can create cash money. The Fed can only create bank reserves, which banks must hold to collateralize their deposits. Today banks hold far more reserves than they need, so that means they have a virtually unlimited ability to create more deposits. And they have been very busy doing this over the past 18 months. 

For most of the past year I have been predicting that this huge expansion of the money supply would result in rising inflation, and so far that looks exactly like what has happened. People don't need to hold so much of their wealth in the form of cash, so they are trying to spend it. But if the Fed and the banks don't take steps to reduce the amount of cash, then the public's attempts to get rid of unwanted cash can only result in higher prices, and perhaps some extra spending-related growth. It's a classic case of too much money chasing too few goods and services. And Fed Chair Powell has just added some incentives for people to try to reduce their cash balances. He's fanning the flames of inflation at a time when there is plenty of dry fuel lying around.

Chart #3

Now for some good news. Chart #3 shows the evolution of household balance sheets in the form of four major categories. The one thing that is not soaring is debt, which has increased by a mere 20% since just prior to the 2008-09 Great Recession. 

Chart #4

With private sector debt having grown far less than total assets, households' leverage has declined by 45% from its all-time peak in mid-2008. The public hasn't had such a healthy balance sheet since the early 1970s (which was about the time that inflation started accelerating). Hmmm....

Chart #5

In inflation-adjusted terms, household net worth is at another all-time high: $142 trillion. 

Chart #6

On a per capita and inflation-adjusted basis, the story is the same (see Chart #6). We've never been richer as a society.

Chart #7

Total federal debt owed to the public is now about $22 trillion, or about the same as annual GDP. It hasn't been that high since WWII. So it's amazing that, as Chart #7 shows, federal debt has not exploded relative to the net worth of the private sector. As I've shown in previous posts, the burden of all that debt is historically quite low, thanks to extraordinarily low interest rates. 

Chart #8

Chart #8 adds some color to my prior post, "What's wrong with gold?" What it suggests is that gold prices are weak today because the market is anticipating higher short-term interest rates. The red line shows the yield on 3-yr forward Eurodollar futures contracts (inverted), which is a good proxy for where the market thinks the federal funds rate will be in three years' time. Gold peaked when forward interest rate expectations were at an all-time low. Why? Because super-low interest rates pose the risk of higher inflation. With the Fed now talking about raising rates (albeit sometime next year, and very slowly thereafter), gold doesn't make as much sense because forward-looking investors are judging the risk of future inflation to be somewhat less than it was a few years ago.

Tuesday, September 14, 2021

Money and inflation update


With today's release of the August CPI, it looks on the surface as if inflation is moderating, much as the Fed has been hoping. Looking deeper, though, I think it still pays to be skeptical—especially since the belief that this inflation flareup is merely transitory has been fully embraced by the bond market. Witness breakeven inflation rates of 2.3% on 5-yr TIPS. 

Chart #1

At the risk of making a fool of myself, I am going to assert that Chart #1 is what really makes this time different. Never before in the monetary history of the US has there been such a huge increase in the M2 money supply. The increased M2 growth we saw in the wake of the Fed's QE1 and QE2 casings were barely perceptible, as the chart demonstrates.

Now, large and rapid growth in the money supply isn't necessarily inflationary, providing it occurs at a time when the demand for money is surging. I think that was the case a year ago, given the Covid shutdowns that virtually paralyzed economic activity and the massive increase in spending as governments worldwide attempted to keep tens of millions of displaced workers afloat. But this year, things have improved dramatically. GDP has recovered all its lost ground and then some. Corporate profits are at a new high. Nobody today wants to have as much money on his balance sheet as he had last year at this time. 

Chart #2

Chart #2 shows how the mini-surge in inflation in the sunup to the Great Recession was later reversed. That's a picture of transitory inflation, I suppose, but don't forget Chart #1. The Fed never allowed the money supply to explode back then, and they kept interest rates much higher then they are now. The Fed was tight, and that's one thing that aggravated the crisis of 2008. So it's not surprising that inflation proved transitory.

But today is different. As Chart #2 shows, the Ex-energy version of the CPI has moved well above its long-term 2% trend. For the current inflation episode to prove transitory, the blue line is going to have rise at a much slower pace in the months ahead. And the M2 money supply is going to have to do the same. So far we see no evidence of either.

Chart #3

Chart #3 shows the 6-mo. annualized growth of the ex-energy and headline versions of the CPI. This measure is much more representative, in my view, of what is happening to inflation right now. A year over year version (which shows a distinctive slowdown) is muddied by the economic chaos that occurred in the summer of last year. Better to use data from the current year. By this measure, there has been no meaningful slowdown in inflation.

Chart #4

Today also saw the release of the Small Business Optimism survey. As Chart #4 shows, small businesses reported an explosion of price increases of a magnitude not seen since the inflationary 1970s. Prices for a whole lot of things are going up. This is big. 

Chart #5

As Chart #5 shows, housing prices nationwide are up by almost 20% in the past year (blue line). The red line represents the growth rate of the CPI component called "Owner's Equivalent Rent." I have shifted the red line to the left by 18 months, in an attempt to show that big increases in housing prices are followed, about 18 months later, by big increases in the OER component of the CPI (which represents almost 40% of the CPI, by the way). According to this chart, we have only seen the first glimmerings of a pickup in OER (and the CPI as well, by inference). Robust growth in housing prices this past year already strongly suggests we'll see a significant pickup in the CPI over the next 6-9 months. 

Chart #6

Meanwhile, the real yield on Treasury notes and bonds has become deeply negative, thanks to extremely low yields and a surge in inflation, as we see in Chart #6.. This represents a stiff penalty on anyone seeking a safe haven. This penalty is discouraging people from owning safe assets. It encourages people to spend some of the extra cash they have accumulated in the Covid era. And that is what is fueling price rises everywhere. This won't stop until real yields become much more attractive. And for that to happen we need to see the Fed raise rates and we need to see inflation come down. Unfortunately, neither of those conditions are likely to occur in the next year.

Chart #7

At the suggestion of a reader, I've updated Chart #7, a chart I have been featuring for many years now. My reading of this chart is that the market is still a bit nervous about the economy going forward, because the Vix at today's level of 18-20 is still somewhat elevated. But fears have been slowly subsiding, and so money has been finding its way into equity prices, among other things. Which is logical, since equities represent ownership of tangible and productive assets, and thus are a good hedge against inflation. And anyway, corporate profits are on the moon, as I pointed out last month. Housing and the stock market are the big beneficiaries of today's money abundance. 

Thursday, September 2, 2021

What's wrong with gold?


For months now, I've been asked by friends, colleagues and readers of this blog to explain why gold hasn't moved higher on the news that inflation is rising and the Fed is sitting on its hands, doing nothing to inspire confidence in inflation returning to their 2% target.

My answer is simple: gold has already risen significantly. 


This chart shows the inflation-adjusted price of gold in today's dollars. (I've used the CPI to do the calculation.) 

In the early 1970s, just before Nixon took the dollar off the gold standard, gold was extremely cheap, which is why many of the world's central banks were demanding that the Fed redeem dollars in exchange for gold. The federal government had been ramping up social spending and deficits and monetary policy had been too accommodative—they should have been tightening in the face of declining gold reserves. Faced with a huge drain on the Fed's gold reserves, Nixon chose to devalue the dollar rather than tightening monetary policy, since he (rightly) feared it would lead to a recession. 

Gold rose significantly over the course of the next 10 years, as did inflation, oil and most commodity prices. Inflation rose from a low of 2.7% in mid 1973 to a peak of almost 15% in early 1980. Gold peaked in September 1980. Gold then fell as inflation fell, reaching a low of 1.4 % in early 1998; gold hit bottom in 1999. Gold then rose to a peak in 2011, fell to a low in 2005, only to rise again until it peaked in 2020. 

One could argue that the rise in gold which began in 2000 was driven by the expectation that the Fed was prone to be too easy (after having been demonstrably "tight" from the early 1980s) and that inflation was a potential risk. Now we are seeing the Fed validate the fears built into gold prices. It's a case of "buy the rumor, sell the fact." Gold correctly anticipated today's inflation and today's Fed error, so now gold is looking into the future to see whether things will eventually get better or worse. 

In any event, gold today is only modestly below its all-time high in real terms. It's not cheap by any stretch. 

Tuesday, August 31, 2021

Home prices and the M2 surge


The latest Case-Shiller statistics for June (which is actually the average of April, May, and June prices) show that national home prices rose almost 20% from the prior year. This is by far the most dramatic increase in home prices ever recorded. Could it be a coincidence that the M2 money supply rose by 28% over this same period, also an all-time record? If we want to understand the burst of inflation that has occurred over the past year or so, we need look no further than the money supply. For prices to rise significantly across a range of assets and markets, there must be a corresponding and significant rise in the money supply.

With the Fed assuring us that there will be no reduction in its balance sheet and no meaningful increase in short-term interest rates through the end of next year, the US economy is going to be awash in extra money for a long time. The recent burst in inflation is therefore highly unlikely to prove temporary or transient.

This is huge and very unwelcome news.

Chart #1

Chart #1 shows the nominal and real index of national home prices, as calculated by the S&P CoreLogic Case-Shiller methodology, which is widely considered to be the gold standard for home price trends. Prices are now at all-time highs, both nominally and in inflation-adjusted terms. Prices are on track for blowing away the sky-high prices we last saw in 2005-2006, which in turn were temporarily goosed by crazed lending practices.

Chart #2

Chart #2 shows the year over year change in this index, about 18%. It's a safe bet that we'll see prices continue to rise for at least the next several months. 30-yr fixed rate mortgages are going for about 3% these days, which is only modestly higher than the all-time low of 2.85% which was set in February of this year. Those same rates averaged about 6% in 2006, by the way. 

Chart #3

Chart #3 documents the virtual explosion in the M2 money supply that began in March of last year. The M2 money supply is now (as of the end of July) about $3.7 trillion above its long-term trend line. That extra $3.7 trillion can be found almost entirely in retail bank checking and deposit accounts, all of which are readily convertible into spendable cash. We have never before seen anything like this in the monetary history of the US. We have seen things like this in Argentina, however, where soaring inflation has always been preceded and accompanied by huge growth in the money supply.

Milton Friedman must be rolling over in his grave these days.

Friday, August 27, 2021

Inflation update: this is serious


We now have inflation data through July, including the CPI and the all-important PCE deflators. Here are some updated charts and commentary. This situation is developing and I plan to watch these numbers closely.

Chart #1

Energy is by far the most volatile component of the CPI. Chart #1 shows the ex-energy version of the CPI, which rose by about 2% per year for almost 20 years. It's now risen significantly above that trend line, and this suggests that the rising inflation we've seen this year is not likely to be temporary. The whole price level has been lifted by an excess supply of money, and the Fed has no plans to raise short-term rates or to withdraw excess reserves from the banking system for a very long time.

Chart #2

Chart #2 shows two versions of the CPI using a 6-mo. annualized rate of change—which is more representative of the current behavior of pricing. We haven't seen inflation like this for a very long time.

Chart #3

Chart #3 shows the consequence of rising inflation for bond investors. The real yield on 10-yr Treasuries is now deeply in negative territory. This represents a significant loss of purchasing power for anyone holding Treasuries. Caveat emptor. How much longer will bond investors tolerate a government-guaranteed loss of purchasing power? How much longer will people keep tons of money on deposit in the banking system, when it pays no interest and is losing at least 4-5% of its purchasing power every year?

Chart #4

Chart #4 shows versions of the CPI year over year back to 1982, just after inflation peaked. We may well be revisiting the painfully high levels of inflation which first surfaced in the late 1970s.

Chart #5

Chart #5 shows the 3-mo. annualized change in the Core CPI. Yikes.

Chart #6

Chart #6 shows inflation as measured by the Personal Consumption Deflator, the Fed's (and most economists') favorite inflation statistic, given that it reflects a broad basket of goods and services and is periodically updated to reflect changing tastes and markets. There's no denying that we have seen a meaningful increase in a broad range of prices. Only overly accommodative monetary policy can support such price action. If monetary policy were not so loose, a surge in durable goods prices would likely act to depress other prices (because people would not have an unlimited supply of cash).

Chart #7

Chart #8

Charts #7 and 8 show the behavior of prices for services, non-durable goods, and durable goods. I chose 1995 as the starting point of Chart #8 because 1) it was the first year when the China export machine began to impact global markets, and 2) it marked the first time in history in which we saw a sustained decline in the price of durable goods—which lasted for a remarkable 26 years. No longer: demand for "things" has been very strong, and shortages due to chip shortages are a fairly recent phenomenon. The numbers in green represent the total change for each component over the period of the chart. 

UPDATE: Thanks to reader Peter Barnes for bringing up the subject of money velocity. I've written a response and I want to add a chart to this post to illustrate my argument.

Chart #9

Chart #9 shows the demand for money (M2/GDP) which is simply the inverse of the velocity of M2 (GDP/M2). I think it's more logical to think of this in terms of people's willingness to hold on to M2 money, which predominately consists of retail bank deposits of various sorts). I think the chart shows that there is a clear tendency for money demand to rise during recessions (gray bars) and during periods of great turmoil, such as 2008-9 and the second quarter of last year. When people are scared and faced with uncertainties, it is natural to want to accumulate cash as a form of protection against the unknown. But for the past year things have been getting slowly better, and in fact the demand for money has declined by about 5% since June '20 by my calculations and estimates of current conditions. If the demand for money declines but the supply of money holds steady or increases, that is the classic prescription for a higher price level (i.e., inflation). And in fact that is what we have seen over the past year. 

Viewed in velocity terms, what has happened over the past year is that people have been trying spend their money instead of accumulating more money. Dollars are being passed around faster and faster, and that supports a growing economy and/or rising prices. 

If the demand for money were to fall back to pre-Covid levels, that would be the equivalent of unleashing a flood of $4-5 trillion into the economy (the M2 money supply is currently just under $21 trillion). And that would almost surely result in a bigger economy and much higher prices.  

Thursday, August 26, 2021

Corporate profits are impressive!

The economy could be doing a lot better, but corporate profits are about as good as they get. Which suggests that the equity market rally still has legs.

Today we received the first revision to Q2/21 GDP, which included the first estimate of corporate profits for the period. GDP was revised upwards by a modest—though still impressive—amount, posting a 6.6% quarterly annualized growth rate. Corporate profits, on the other hand, soared at a 44% annualized rate, and are now at a new, all-time high. All of this despite the fact that the unemployment rate is still quite elevated (5.4%) and there are 6 million fewer people working than at the pre-pandemic high.

If there's a silver lining to the Covid cloud, it is here, in the form of a spectacular increase in the economy's productivity. And with many of those 6 million idle workers likely to be snapped up by desperate employers starting next month (when super-generous unemployment benefits expire), the economy has plenty of room to expand in coming quarters. 

A storm still threatens on the horizon, unfortunately, in the form of the Democrats' $3.5 trillion so-called "infrastructure" reconciliation bill that just passed the House. If the spending it entails ever sees the light of day, it will result in a massive expansion of the welfare state and an equally massive and crushing new tax burden on all of us. The economy will find it very hard to thrive with so much spending, since there is almost certainly going to be many hundreds of billions of dollars wasted due to inefficiencies, perverse incentives, corruption and graft.

So if there's a silver lining to the Afghanistan cloud, it can be found in the recent and precipitous drop in Biden's popularity, thanks to his abrupt decision to surrender to the Taliban. Our ship of state is virtually rudderless, and it strains credulity to think that a seriously weakened administration can actually push through a radical expansion of the administrative state and a massive increase in income redistribution. 

The charts that follow focus on corporate profits and GDP, both of which are looking pretty good these days. I also discuss the outlook for inflation, which is not very good. Finally, I discuss equity market valuation, which by several different measures is not at all outrageous. That's a very good thing.

Chart #1

Chart #1 gives some much-needed, long-term perspective on the economy's growth trajectory. For over 40 years, the economy followed a 3.1% annual growth track. That changed dramatically, however, in the wake of the Great Recession of 2008-2009. Since then, the economy has grown at about a 2.1% rate per year.

Chart #2

Chart #2 zooms in on Chart #1, showing just the past 20 years. Today's economy is about $4.5 trillion below what it would have been had it followed a 3.1% annualized growth track. That represents a potential loss of almost 20% in real national income. What also stands out is the economy's fairly rapid recovery to its 10+ year trend growth track in the past year. 

Chart #3

Chart #2 shows the quarterly annualized rate of inflation across the entire economy (i.e., the GDP deflator). Inflation according to this broadest of measures surged at a 6.2% annualized rate in the second quarter. That's the highest rate by far since the early 1980s. 

Keynesians look at this surge in inflation as an inevitable—but likely only transitory—consequence of the massive monetary stimulus that was necessary in order to get the economy back on its feet in short order.

I agree that this surge in inflation has a monetary source, but I don't believe that expansive monetary policy is what drives a recovery. The Fed has no power to create jobs with its printing press. The most the Fed can do is to provide extra liquidity—which they did to the tune of almost $4 trillion—to satisfy the economy's desire for safety during troubling and highly uncertain times. Without that liquidity it might have been more difficult for the economy to recover. Indeed, the economy might have suffered more without an extra injection of liquidity, because markets might have seized up. 

But looking ahead, an abundance of liquidity is not necessary. As confidence returns and jobs are added and profits increase (!), the economy doesn't need an abundance of liquidity. There's way too much liquidity these days, in fact, which is why short-term interest rates are virtually zero. Yet the Fed has not reversed course; they have not withdrawn excess reserves and they have not increased short-term interest rates. As a consequence "unwanted" money and liquidity are piling up and people are trying to get ride of it. They can only do this by spending the money on "things." But of course that doesn't make money disappear, since the person selling the thing I buy must in turn do something with the money he or she receives.

So the economy finds itself with an abundance of money and people are trying hard to spend that money by buying lots of different things. Real estate prices are up, food prices are up, hotel occupancy is up, private jet travel is surging, commodity prices are up, computer prices are up, and many more prices are up. Shortages are developing. Over time some shortages will disappear, but without the Fed taking action to drain liquidity, prices are unlikely to fall back to where they were. A new equilibrium will eventually be achieved in which most prices are higher (perhaps significantly so), the economy grows, and the current stock of money will have fallen in relative terms to a point in which people are no longer trying to reduce their money balances. 

Chart #4

Chart #4 compares the level of economy-wide corporate profits to nominal GDP. Both are at all-time highs, and it's obvious that corporate profits have increased faster than nominal GDP in the past year.

Chart #5

Chart #5 shows corporate profits as a percent of nominal GDP. Profits have never been so strong relative to nominal GDP.

It's no wonder, then, that equity prices are also at all-time highs. We're in a profits nirvana of sorts, thanks in part to expansive monetary policy, but probably in large part due to corporate efforts to cut costs and streamline their business—all necessary to survival during times of Covid. Extremely low real interest rates are also a boon, since financing costs have never been so cheap. 

Chart #6

Chart #7

Chart #6 is a long-term view of Chart #4. What stands out here is the surge in profits that began around the mid-1990s. Profits averaged about 5% of nominal GDP from 1959 through the mid-1990s, but then they surged to 8-10% of nominal GDP. Years ago I discussed the then-prevailing view among many bearish investors that profits were mean-reverting and would eventually fall back to 5-7% of GDP. I disagreed, since I saw the rise in profits as a boon triggered by globalization. China's big boom started in 1995, not coincidentally. As world markets globalized, successful firms found themselves operating in a much bigger market with seemingly endless possibilities. Chart #7 compares US corporate profits to global GDP, and by this measure not much has changed over time. (The chart only covers the period ending 12/20.) Since global GDP has grown faster than US GDP, global corporations have seen their sales rise relative to the size of the US economy.

Conclusion: it is not necessarily the case that profits have to fall back to some much lower level of nominal GDP. Profits are arguably sustainable at current levels. That further suggests that equities are not necessarily or fundamentally overvalued at current levels.

Chart #8

Chart #8 shows my calculation of the PE ratio of the S&P 500 using the National Income and Product Accounts measure of corporate profits (the source for profits shown in the above charts) as the "E" instead of the traditional 12-month trailing average of GAAP reported profits. Yes, PE ratios by this measure are high, but nowhere near as high as they were in 2000. 

Chart #9

Chart #9 compares NIPA corporate profits to reported profits (12-mo. trailing average of adjusted profits, according to Bloomberg). These two different measures tend to track each other fairly well over the years, except that NIPA profits, being based on the most recent quarter, usually point the way to trailing profits. What that means is that there is likely more good news to come for the stock market. 

Chart #10

Chart #10 shows the risk premium of the S&P 500, which I calculate by subtracting the 10-yr Treasury yields from the current earnings yield of the S&P 500 (which in turn is the inverse of the reported PE level). What we have today is a relatively attractive risk premium. Equities, in other words, are not necessarily overpriced at all. In fact, during the bull market of the 1980s and 90s, the risk premium was negative. 

Brian Wesbury, Art Laffer and I all use a similar model to value the equity market. This model assumes that the discounted present value of future profits guides current market valuations.  This is a capitalization model which essentially divides current profits by the current 10-yr Treasury yield to get a sense of where the fair value of stocks is. When discount rates are low, such as they are now (10-yr Treasury yields are only 1.3% or so!) then the fair value of equities should be high.

At this point one should be worried about what happens when interest rates revert back to a higher level (where they should be given the prevailing rate of inflation). Does the inevitable Fed tightening mean that the stock market is headed for another crash? Not necessarily.

By my calculations, equities today are priced to almost a 4% discount rate. If they were priced to a 1.3% Treasury yield, then the fair value of equities would be multiples of what it is today. In other words, the market is already assuming that rates rise, so rising rates needn't be the death knell for equity markets.

UPDATE: Since this post includes a description of how I see monetary policy becoming a force for rising prices, I recommend reading my June post on the subject of inflation in Argentina: Argentine inflation lessons for the U.S.