Wednesday, March 10, 2021

More signs that inflation is set to increase

For many years I have been unconcerned about the Fed's conduct of monetary policy. To be fair, neither has the market (inflation expectations priced into Treasury notes have been subdued), and neither have legions of economists who have noted that the inflationary impetus of the Fed's expansive monetary policy has been kept in check by the decidedly and protracted sub-par rate of economic growth (~2% per year) over the past decade or so.

Nevertheless, my reasons for being unconcerned are distinctly different from the prevailing view. I think inflation has been held in check by the public's apparently voracious demand for money and money equivalents. The Fed has not so much flooded the market with liquidity as it has supplied money—sometimes reluctantly—in order to satisfy the public's desire for money. As Milton Friedman taught us, when the supply of money is matched by the demand for money, no inflation results.

In any event, the Fed has not "printed" money with abandon, since it has simply transmogrified notes and bonds into T-bill equivalents by buying them and paying for them with bank reserves, which are not money in the traditional sense, since they can only be held by banks. Banks have apparently been quite happy to hold on to the more than $3 trillion of bank reserves that the Fed has issued this past year, because those reserves are an attractive asset (default free) and they pay a floating rate of interest (the Fed funds rate). Simply put, the Fed has taken in notes and bonds (which are in abundant supply, thanks to trillion-dollar deficits) and exchanged them for T-bill equivalents, which have been in short supply. Nothing at all wrong with that.

Banks used their strong cash inflows during the onset of the Covid crisis—in the form of increased bank savings deposits and checking accounts—to purchase the notes and bonds which they then sold to the Fed.

More recently, I've become concerned that the return of confidence and a rebounding economy would result in a decline in the public's demand for all that money, and that the Fed would be slow to react with offsetting measures: a) higher short-term interest rates, which would work to boost the demand for money, and/or b) a reversal of its quantitative easing (which would withdraw unwanted bank reserves from the financial system). Per Friedman, that is the classic recipe for a rising price level (i.e., create a surplus of money relative to the demand for it). So far, the Fed seems determined to do just that—to ignore (and even welcome!) signs of declining money demand and rising inflation. Moreover, they fully intend to keep purchasing more notes and bonds in the months ahead. It's getting increasingly likely that the supply of bank reserves will exceed banks' desire to hold them as assets. Going forward, banks could well begin to expand their lending (abundant reserves make this possible), which is a sure-fire way to increase the amount of money in the economy. A future tsunami of money would almost certainly "float" higher prices for just about everything.

To once again be fair, the market is also beginning to get concerned about rising inflation: inflation expectations over the next 5 years have risen from 0.5% last summer to now over 2.5% per year (see Chart #1 below). What I'm saying is that there could be a lot more of this in the future.

Today Congress sent a $1.9 trillion spending bill to President Biden's desk, and he will almost certainly sign it in short order. In deja vu fashion, it passed very narrowly without a single Republican vote—just like Obamacare. In my view, it will do just about everything wrong. Far from "stimulating" the economy, it will instead greatly expand the welfare state and greatly increase the power of the federal government. Worse still, it will artificially inflate demand for just about everything but larger checking and savings deposits. Taking money from the economy (by selling notes and bonds) can't possibly stimulate the economy, just as taking a bucket of water from one end of a swimming pool and dumping it in the other end won't raise the water level. A lot of the money dished out by the bill is going to end up being used by people paying higher prices for all sorts of things. We see the beginnings of this already in, for example, the market for used cars (see Chart #4 below).

The economy doesn't need more demand, it needs more people working and more businesses reopening. Paying more to those who are still unemployed (plus exempting those higher unemployment benefits from taxation, as the bill does) won't encourage them to return to work. On the contrary, it will unnecessarily prolong the return to full employment. Many workers will surely discover that they can earn more (after-tax) than they could by going back to work. See my friend Steve Moore's estimates of just how pernicious this could be. And do subscribe to his daily newsletter, which has gobs of depressing facts and statistics.

The economy undoubtedly will get a boost in the months to come, but mainly because the Covid crisis is in rapid retreat. Daily new cases in the US are down almost 80% since the peak of mid-January. In California, they are down an astonishing 90% over the same period. We are rapidly approaching herd immunity, with estimates that upwards of 50-60% of the population has by now acquired immunity, either through infection, innate immunity (T-cells), or vaccination.

As is to be expected, by the time politicians rush in to supply aid to an ailing economy it is no longer needed. Moreover, it is counter-productive. Politicians almost always screw things up. That's why I'm a libertarian: we need less government, not more, to solve our problems.

Chart #1

Chart #1 shows the level of 5-yr nominal (red) and real (blue) Treasury yields, along with the difference between the two (green) which is what the bond market expects annual CPI inflation to average over the next 5 years. This latter has jumped from 0.5% last summer to now over 2.5%. Note that virtually all of the rise in inflation expectations is due to the rise in nominal yields. Real yields are very low, and they have barely budged; that's a sign that the rise in rates is not due to increased growth expectations—it's mostly due to increased inflation expectations.

Chart #2

Chart #2 shows how gasoline prices have surged in recent months. People are driving more, economic activity is on the rise, and oil prices have risen as demand challenges supply. 

Chart #3

But as Chart #3 suggests, while higher oil and gasoline prices will certainly contribute to rising inflation, there are other, more powerful forces also at work. Rising inflation expectations far exceed the contribution to inflation resulting from higher oil prices. 

Chart #4

As Chart #4 shows, used car prices have exploded since last summer. Extra cash seems to be burning holes in many consumers' pockets, and that could be fueling the rise in prices.

Chart #5

Chart #5 compares the yield on 10-yr Treasuries (red) with the ratio of copper to gold prices (blue). Both of these variables tend to rise and fall as economic growth prospects improve and deteriorate. This market-based indicator is telling us that there is a lot of construction activity (copper demand) going on around the world, and the bond market is sensing that the prospects for an increase in nominal activity have improved from last summer's abysmally low levels. 

Chart #6

Chart #6 is a long-time favorite of mine, if only because it shows how tightly correlated the prices of these two assets (gold and TIPS) have been for the past 15 years. (I use the inverse of the real yield on TIPS as a proxy for their price.) It also suggests that gold prices tend to move in advance of TIPS prices. Right now that is telling us that TIPS prices are likely to decline (as real yields rise) in the future, but not by a whole lot. I would fully expect a big rise in real yields to happen at some point in the foreseeable future, either as a result of a stronger economy and/or a Fed tightening (which in turn would likely be a response to an unpleasant and/or unwanted increase in inflation). It's also interesting that gold prices have declined so much in the past year at the same time inflation expectations have risen. Gold is an imperfect inflation hedge, to say the least. Gold these days is likely being challenged by stronger growth expectations and the prospect of a tighter Fed in the future.

As I've said in earlier posts, although there is no shortage of reasons to be concerned about the future—number one being a significant rise in inflation followed by a Fed tightening response—I don't think things will collapse for at least the next 3-6 months. Indeed, there is every reason the economic landscape should brighten in the months ahead as the Covid crisis fades into history. It's unfortunate that the government seems hell-bent on doing the opposite of what is needed, but despite all the damage that may be done by the stimulus bill, a rebounding US and global economy—and higher prices—should provide significant support to the equity market. 

And besides, what alternative is there, if cash yields zero? The expected return on cash is virtually guaranteed to be negative, as inflation rises and the purchasing power of cash declines. And don't forget that equities give you exposure to a rising price level, just as real estate does. As I've said repeatedly, what the Fed is telling you to do its "borrow and buy." The Fed wants you to shun cash, and the Fed almost always gets what it wants eventually.


HDX said...

The so-called "covid bailout" includes 15 weeks compensation for federal employees, who never lost their jobs, their paychecks or their benefits. That 15 weeks is about $19,000 for each and every bureaucrat. Citizens who lost everything in an illegal lock down get $1400!?!?!?

You are out of your mind if you think there won't be blow back.

Hundreds of thousands of small businesses have been shuttered for good. They didn't pay rent for an entire year, which means land lords are out billions of dollars. It means CMBS bonds are not going to get paid. Thousands of people are unable to pay rent or mortgages, and the moratorium on evictions can't be extended forever. MBS bonds are not going to get paid -- there are limits to how much FNMA /FHLMC can make up the missed payments.

The Fed has manipulated interest rates below market for two decades. That allowed Uncle Sam to live large, but it decimated retirement funds. Have you noticed the baby boomers think they are going to retire soon? On imaginary income?

Children have lost an entire year of school. Yes, I saw the zoom classrooms. No, students didn't learn even a fraction of what they would in a normal year -- and the USA is already far behind other countries in critical subjects. Yes, government schools will still award diplomas (a worthless piece of paper), but the students won't have the skills. Lost productivity will reverberate through the economy for decades to come.

Bankruptcy and default are bad enough -- inflation is just a fancy way of saying the government won't pay its trillions of debt in full. Default by any other name is still default.

The loss of trust in government is the thing that you haven't even touched on. Its bad when bureaucrats are incompetent and screw up someone's life. But this covid lock down is a case where bureaucrats messed up on purpose, and used the resulting chaos to grab more power for themselves. This isn't ineptitude, this is corruption.

Whatever we all thought about individual incompetent leaders in the past... widespread truly corrupt 3rd world tyrants abusing their office for personal gain is not something the USA is familiar with.

The USA "always" bounced back in the past, but we didn't have the widespread corruption that dominates Washington DC and city hall, both parties, now. The business of government is collecting bribes, kickbacks and behind closed doors payments. They barely even pretend to care about the public.

The unofficial fourth branch (the media) is busy being woke, brazenly censoring opposition, and attempting to make opposing views illegal... like in a third world country.

This is not a foundation one can build a recovery on.

Benjamin Cole said...

I have two buttcracks.

The vertical one I came into the world with, and a horizontal one from sitting on the edge of my seat for the last 40 years, waiting for inflation. Still waiting.

People are fainting as yields reached 1.5% on 10-year US Treasuries. Seriously?

I agree with Scott Grannis---open up everything in this economy, and yesterday.

I want to see Full Tilt Boogie Boom Times in Fat City.

Less social welfare, and jobs everywhere. And never tax anyone who works.

Let us move to import taxes (tariffs), fuel taxes, property taxes, and cut taxes on labor. Cut government spending, especially anything overseas. End interventionism.

End all property zoning. You worried about inflation? If you end property zoning, you will have a 20-year building boom on the West Coast, and lower house prices at the end.

That's how you increase living standards, and beat inflation.

Unknown said...

What to buy then? The contrarian in me thinks, hold cash if they dont want me to. The diligent side of me says, cash is for suckers in an inflationary environment. The stocks for the long run part of me says, what companies have the strongest hold on pricing power. What say you Mr. Grannis?

Antonio said...

Scott you are so close. This may help.
BankA has 10 million in assets. BankB across the street has 100 million is assets. BankB is not overvalued. It just has more deposit under management. This is how a store of value works.
Bitcoin at 10 trillion(gold market cap) will not be overvalued compared to bitcoin at 1 trillion(current market cap).
Few understand.

Fred said...

I'm not sure ending zoning is the answer. Have you been to Houston? Jack-in-the-box next door to a $million+ mansion. No thanks. Now, if you mean ending ridiculous regulations that don't do anything to really help homeowners in California but rather make it impossible for developers to build reasonably priced housing, then I'm with you. I have a client that owns a well-known landmark in San Francisco who tried to build some apartment buildings but the regulations made it too expensive on a per-unit basis- hence the homeless problem.

Benjamin Cole said...

Fred--- Therein lies the problem. If you say property zoning is constitutional, you will live with property zoning as decided by government. The government will determine what you do with your property.

And, I am old-fashioned enough to believe in property rights and the rights of a property owner to develop their property as they see fit, barring certain health and safety issues.

Where I live now there is no property zoning. People adapt. If you want an urban single family house, you might build a walled compound.

Free markets aren't the perfect solution, they are just the best solution.

FDR said...

To argue that the $1.9B stimulus that largely benefits small business, the states, the poor, working poor, working and middle classes because it is non productive when the Cares Act was a giveaway to the upper class and the FED largesse to creditors since 2008 is to compare pittance with a king's ransom.

The US middle and working classes since the late 70s has been incrementally bled of approximately $50T to the top 1%.

Where was Calafia Beach Pundit complaining about the violation of his libertarian principles?

There are currently 30M children in the richest nation on the planet living in poverty.

The middle class is nearly nonexistent and definitely waning. We are evolving if not already a Banana Republic.

Most American families have less than $400.00 in savings but the uber rich have transferred more wealth to their coffers since the Cares Act.

I do agree that borrowing the money only enriches the wealthy because they are the creditors. A better solution IMHO would've been to openly transfer $1.9B from the top 1% to the recipients via a one surcharge on the Gates, Buffetts, Ellinsons, Bezoses of the world.

Salmo Trutta said...

The sterilization of commercial bank savings deposits generates low inflation. Banks don't loan out deposits. Deposits are the result of lending/investing. So, velocity inevitably falls. Such is the sole cause of secular stagnation.

Salmo Trutta said...

Historical FDIC’s insurance coverage deposit account limits (commercial banks):
• 1934 – $2,500
• 1935 – $5,000
• 1950 – $10,000
• 1966 – $15,000
• 1969 – $20,000
• 1974 – $40,000
• 1980 – $100,000 velocity begins to fall
• 2008 – $unlimited
• 2013 – $250,000 (caused taper tantrum)

Salmo Trutta said...

These fallacious ideas are vitiated on largely false premises on which deregulation, laissez-faire economics is based (“abstention by governments from interfering in the workings of the free market”), viz., that demand deposits in commercial banks constitute the “savings’ of the depositors, that these are “lent” to the banks, and that the commercial banks are only a “medium” through which this end is affected.

Ron Gruner said...

Scott, sorry to use a comment, but I'd like your input and can't locate your email.

I am writing a book "Knowing America: How presidents from Harding to Trump shaped America" to be published mid-November. I'd like your feedback on the Trump chapter. Not looking for an endorsement, just your candid feedback.

If you're interested, I can be reached at ron[ampersomething]gruner[d0t]com

McKibbinUSA said...

Your case for future inflation is both persuasive and alarming.