Wednesday, November 23, 2022

The Fed pivots—finally!


Thanks to today's release of the November 2nd FOMC meeting minutes, we know that the Fed has "pivoted" as expected; they are backing off of their aggressive tightening agenda. Instead of hiking rates another 75 bps at their December 14th meeting, we are likely to see only a 50 bps hike, to 4.5%, and that could well be the last hike of this tightening cycle—which would make it the shortest tightening cycle on record (less than one year). And they might not even raise rates at all in December—that would be my preference.

For more than two years I have been one of a handful of economists keeping an eye on the rapid growth of the M2 money supply. Initially I warned that it portended much higher inflation than the market was expecting. But since May of this year I have argued that inflation pressures have peaked: "Many factors have contributed to this: growth in the M2 money supply has been essentially zero since late last year; the stimulus checks have ceased; the dollar has been very strong; commodity prices have been very weak; and soaring interest rates have brought the housing market to its knees. All of these developments mean that the supply of money and the demand to hold it have come back to some semblance of balance." To sum it up, I think the Fed has gotten policy back on track, so there's no need to do more. In fact, the October M2 release showed even more of a slowdown than previously, thus underscoring the need to avoid further tightening.

For a recap of my thinking on all this, here is a short summary of relevant posts:

October '20: On the demand for money and other considerations

March '21: The problem with unwanted money and More signs that inflation is set to increase

July '21: Big changes in inflation and government finances

August '21: Inflation update: this is serious

September '21: Money and inflation update

October '21: Monetary policy is a slow-motion train wreck

November '21: Recession risk is very low, but inflation risk is high

January '22: The bond market is wrong about inflation

Beginning last May I began arguing that we had seen the peak of inflation pressures, thanks to a big decline in the growth of the M2 money supply.

May '22: M2 growth slows: light at the end of the inflation...

August '22: Inflation pressures cool, economic outlook improves

Sep '22: Inflation pressures are in fact cooling ...

I'm still firmly in the inflation-is-falling camp, and it's because of the unprecedented decline in the M2 money supply, coupled with forceful actions on the part of the Fed to bolster money demand with sharply higher interest rates. As a result, I believe we are going to see a gradual decline in inflation over the next year or so.

The following charts round out the story:

Chart #1

Chart #1 has got to be the most significant monetary development that almost no one is paying attention to. It shows how M2 surged above its long-term trend growth rate beginning in April 2020, and then stopped growing about one year ago. It is still quite elevated (i.e., there is a lot of "excess" money sloshing around), but the growth rate of M2 is now negative: over the past six months M2 is down at an annualized rate of -2%, and over the past 3 months it is down at a -4% annualized rate. This adds up to the weakest growth of M2 since at least 1960—and possibly the weakest growth ever. M2 today is about 22% above its long-term trend, whereas it was almost 30% above trend earlier this year. The amount of "excess" money is declining rapidly, and that is a good thing.

Chart #2

Chart #2 shows how the surge in M2 growth was almost entirely driven by massive federal deficit spending from 2020 through late 2021. In effect, the government sent out many trillions in "stimulus" checks to people and most of that money ended up being stashed in bank deposit and savings accounts. The demand for money was intense back then since there was great pandemic-fueled uncertainty and besides, lockdowns left people with little ability to spend money. All that money wasn't a problem until early this year, when the pandemic crisis began to recede. That marked the point when people started to spend the money they had stockpiled, and that spending surge combined with supply-chain bottlenecks to produce a wave of higher prices for nearly everything. In short, an improving outlook and a return of confidence meant that the demand for all that money was evaporating.

Chart #3

Chart #3 tracks the demand for money as defined by the ratio of M2 to nominal GDP. Let me explain: M2 is a proxy for the amount of money the average person holds in currency and bank deposits. Nominal GDP is a proxy for average annual incomes. The ratio of the two therefore tells us what percent of one's annual salary is held in the form of readily-spendable money. When the ratio is higher than people feel comfortable with (i.e., when there is no longer a need to stockpile funds for a rainy day), people attempt to spend down their money balances, and that fuels a surge in demand. Money balances decline, and nominal GDP surges. I estimate that the ratio of M2 to GDP will fall to almost 80% by the end of this year, down from just over 90% at its peak in Q2/20. Today there is simply no need for people to hold so much of their income in the form of cash. Indeed, I don't see why this ratio can't fall back to 70%, where it was before the pandemic hit. For that to happen, nominal GDP (mostly inflation) is almost certainly going to continue to grow, albeit at a slower pace, and M2 balances are likely to decline some more.

(Note: for those who prefer to think in terms of the velocity of money, just invert Chart #3. Velocity is simply the inverse of money demand, and vice versa. Today velocity is definitely picking up. For a longer explanation of this see this post.)

As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. It's critical to understand that rapid growth in M2 from Q2/20 through Q3/21 was not inflationary because the demand for money was very strong during that period. But when the demand for money started to fall early this year, then inflation surged, even though M2 was no longer growing. From this we can infer that the demand for money fell significantly.

Money demand is likely still declining, and money supply is still contracting, but the huge rise in interest rates this year has acted to bolster money demand: earning 4-5% on bank CDs is an incentive to hold on to that money you stashed in the bank—at least some it. The net result of all this is an easing of inflationary pressures. That can be seen already in falling commodity prices and housing prices.


Chart #4

Chart #4 shows the level of bank reserves held by US banks. Recall that bank reserves are not money that can be spent anywhere. They are assets of the banking system and liabilities of the Fed; their main role today is to collateralize deposits and provide abundant risk-free assets to the banking system, since bank reserves are essentially default-free. Reserves are still super-abundant, thanks to the Fed's decision in late 2008 to permanently expand the level of bank reserves while controlling interest rates directly (i.e, by paying interest on reserves). In prior tightening cycles, the Fed had to drain reserves in order to force interest rates higher; that put a real squeeze on financial markets since it reduced liquidity. Now the Fed simply pays a higher rate on reserves instead of shrinking their supply, so the system is spared a liquidity crunch.

Chart #5

Chart #5 shows option-adjusted credit spreads for corporate bonds. This is an excellent proxy for the level of economic and financial stress in the US economy. As we see, despite a massive amount of monetary tightening, spreads are still at relatively low levels. In prior tightening episodes, spreads surged and bankruptcies followed, because the Fed was restricting liquidity. This time around things are very different. The risk of a recession is therefore much lower in today's monetary environment. Another great indicator of financial and economic stress is 2-yr swap spreads, and today they are a mere 31 bps, well within the range of normal.

Chart #6

Chart #6 shows us that household financial burdens (financial-related payments as a percent of disposable income) are unusually low. They were much higher going into recessions in the past. Businesses and households are still in pretty good shape despite all the tightening. Thus a recession is less likely now than during prior tightening cycles.

Shall we call this "tightening lite?"

Tuesday, November 15, 2022

Near-term Fed pivot almost guaranteed


The release this morning of October Producer Price indices brings yet more evidence that the inflationary pressures sparked by multi-trillion dollar Covid "stimulus" checks in 2020 and 2021 peaked earlier this year, as I have been pointing out for months. Many factors have contributed to this: growth in the M2 money supply has been essentially zero since late last year; the stimulus checks have ceased; the dollar has been very strong; commodity prices have been very weak; and soaring interest rates have brought the housing market to its knees. All of these developments mean that the supply of money and the demand to hold it have come back to some semblance of balance, and that is of course essential if inflation is to return to a low and steady rate of, say, 2%.

This all but guarantees that the Fed soon will be scaling back on its tightening agenda. For my money, the FOMC's November 2 rate hike (from 3.25% to 4.0%) should be the last, but a hike next month of 50 bps (to 4.5%) is likely to be the Fed's last move for the foreseeable future. The Fed simply can't react as fast as the market does to changing realities—unfortunately, the Fed is usually "behind the curve." In any event, a 4.5% funds rate by year end is fully priced into the market and thus it should not be very impactful. What will change though is the market's expectation for where rates will be a year from now: lower than currently expected, and that is what is driving equity prices higher. 

What's most important is that the market is now beginning to see across the valley of uncertainty to a time when inflation comes back down to 2%. It may take up to a year for that to happen, however, but as long as we know that the worst is over, markets can anticipate a lower-inflation future and equity markets can drift higher. And although it's very good news that inflation has peaked and is now declining, the bad news is that thanks to the 2020-2021 explosion of M2, the general price level will have suffered a major increase that is unlikely to be reversed. Real incomes have suffered and it will take a long time for them to recover.

Chart #1

Chart #1 shows the year over year changes in the total and core (ex-food and energy) versions of the Producer Price index. Both peaked about six months ago, and that was about six months after M2 stopped growing. 

Chart #2

Chart #2 shows the 6-mo. annualized change in the total and core versions of the PPI; this highlights the degree of change that has occurred in the past six months. 

Chart #3

Chart #3 shows the year over year and 6-mo. annualized changes in the final demand version of the PPI (a version which began in 2009). Here the change is even more dramatic. Overall, these three charts tell a story of a rapid deceleration in the growth of prices in the early stages of the supply chain. These changes are likely to be reflected in the months to come in a moderation of the growth of the CPI. 

Chart #4

Chart #4 shows the ex-energy version of the CPI index (plotted on a log scale so that changes in growth rates can be more easily visible). This version of the CPI (which I think is best because it eliminates the extreme volatility of energy prices) has been growing at about 2% per year for a long time. After March 2021 it suddenly picked up to a 7% rate of growth. It is likely to continue to grow faster than the former 2% annual trend for perhaps the next 12-15 months even as the year over year growth rate declines. I'm guessing that when the CPI returns to a 2% annual growth rate, the index will be at least 10-12% higher than the original 2% trend, and that would be about 20% above the level of March '21. Meaning, of course, that the price level will have experienced a one-time increase of at least 10% on top of its typical 2% annual rise. 

Inflation will be with us for some time to come, but its rate of increase will continue to moderate. This doesn't mean the Fed has to continue to tighten, however. Just maintaining its current stance would probably be sufficient to get inflation back down to 2%. That assumes, however, that M2 growth continues to be essentially flat and the government avoids sending out another massive batch of checks funded with the printing press. 

Tuesday, October 25, 2022

Fed fever is cooling off


I'd like to think that last week's post got the ball rolling, because the impulse for the 5.6% rally in the S&P 500 over the past three days looks to be declining expectations for Fed tightening. I thought it was inevitable: a super-strong dollar, collapsing housing and commodity prices, and a huge increase in real interest rates were all but shouting at the Fed to back off and give the economy some time to digest things.

The following charts highlight three major news items revealed today:

Chart #1

As I've been noting for well over a year, Chart #1 (growth of the M2 money supply) is the most important financial news that nobody (outside of a handful of economists) has been paying any attention to. As the chart shows, there was explosive growth (completely unprecedented!) in the money supply in 2020, driven almost entirely by the monetization of Covid stimulus payments in 2020-2021. This was the proximate cause of the inflation which has wracked the country for almost two years. Fortunately, with the cessation of Covid payments in mid-2021, M2 growth cooled dramatically: M2 has not increased meaningfully for the past 9 months, and it has in fact declined at a 2.2% annualized rate over the past 6 months, as we learned from this morning's release of the September numbers. This all but guarantees a future decline in measured inflation. 

If the Fed had been paying attention to the slowdown in M2, they would have toned down their tightening 4-5 months ago. And of course, if they had been paying attention to M2 18 months ago, they would have begun raising rates long before it became painfully obvious that we had an inflation problem. 

Chart #2

Chart #2 compares the value of the dollar (white line) with the level of real interest rates on 5-yr TIPS. Long-time readers will know that 5-yr real yields are the market's expectation for what the real Fed funds rate will average over the next 5 years, and as such they are the best measure to watch for how much the Fed is expected to tighten. These two variables have been joined at the hip for at least the past year: rising real rates have tracked the increase in the dollar's value on the forex markets. Declining real yields this month have closely tracked the decline in the dollar's value. A weaker dollar has nearly everyone breathing a sigh of relief. Maybe the Fed won't have to cause a recession after all ... as I argued in a post last August.

Chart #3

The other big piece of news this morning was the sharp decline in national home prices (Chart #3 shows the 12- and 6-month rates of growth of prices). It's important to note that the August number is actually an average of prices over the 3 months ending in August, which means that prices today are almost certainly much lower than the chart suggests. This decline in prices was virtually assured, given the doubling of 30-yr mortgage rates this year and the huge decline in new mortgage originations that I highlighted last week (Chart #3 of this post). The last thing the Fed needs to do is kill the housing market yet again (remember 2008?).

The next FOMC meeting is scheduled for November 2nd, and it's going to be very important. Not too long ago the market thought a 75 bps hike in the funds rate (to 4.25%) following that meeting was virtually assured. Now it's questionable, while a 50 bps hike is beginning to look like a (remote) possibility. 

Monday, October 24, 2022

China's dismal prospects


One-man rule can never compete with a free market, and that's very evident in the plunge in the value of Chinese companies. Xi Jinping, now fully in charge of China, may think he has reached the pinnacle of power, but the market is thinking he's doomed to defeat.

These two charts say it all:

Chart #1

Chart #1 compares the MSCI China Index (priced in Hong Kong dollars) to the S&P 500 index. By these measures, Chinese equities are cheaper now than they were in 1995, while US equities have increased by 176%. (The chart starts in 1995 because that is just after China massively devalued its currency and began opening its economy to the world.)

Chart #2

Chart #2 compares the Golden Dragon Index (Chinese companies that trade in the U.S.) to the S&P 500. The recent destruction in Chinese valuations shown in this chart is more evident: the Dragon Index today is down almost 80% from it's Feb. '21 high. 

One-man rule can never compete with a free market. 

Wednesday, October 19, 2022

Fed's Rx for the economy should be a tincture of time


As I've argued in recent posts, there's plenty of evidence to suggest the Fed has already tightened by enough to bring inflation down: the dollar is super-strong, real yields have risen sharply, the yield curve is inverted, commodity prices are plunging, and the housing market has run into a brick wall. Yet the Fed seems determined to tighten even more. I think they're driving by looking into the rear-view mirror. They're trying to burnish their reputation as an inflation fighter, after having fallen miserably behind the inflation curve in 2020 and 2021. And I think that the long-discredited Phillips Curve (which posits that unemployment must rise if inflation is to fall) still haunts the Fed governors' minds. It's all so unfortunate.

Fortunately, however, a recession is neither imminent nor inevitable. Industrial production and jobs are still growing at decent rates, 2-yr swap spreads are still in normal territory, and real interest rates are not prohibitively high. But the economy could fall into a recession if the Fed doesn't change course (aka "pivot") before too long. There's a precedent for this—in January 2019, when the Fed realized it had become too tight and reversed course—and I don't see why they can't do it again.

Chart #1

Chart #1 shows two measures of the inflation-adjusted and trade-weighted value of the dollar. By any measure the dollar is very strong. This is fully consistent with US monetary policy being tight and much tighter than that of any other major economy. Demand for dollars is strong, and there is no shortage of reasons for why that is so: geopolitical turmoil in Europe and East Asia would surely suffice. From an economics point of view, it would be highly unusual for a very strong currency to also be experiencing inflation (otherwise known as a loss of purchasing power). Prices all over the world, when translated into dollars, are falling.

Chart #2

Chart #2 compares the inflation-adjusted value of gold (red line) to the inverted value of the dollar (blue line). Big moves in the dollar's value almost always accompany inverse moves in commodity and gold prices. What's striking about today is that gold and commodity prices have not fallen further given the strength of the dollar. Long-time readers will note that this chart, which has appeared many times in recent years, has correctly predicted falling gold prices.

Chart #3

Chart #3 compares the nationwide average rate for 30-yr mortgages (orange line) to an index of new mortgage originations (mortgages taken on to finance the purchase of a new home). Mortgage rates have doubled this year, and new mortgage originations have fallen by half. That's a huge development! In other words, soaring mortgage rates combined with very high prices have dealt a heavy blow to the housing market. This is a perfect example of how higher interest rates can change incentives and also slow the economy. People today are much less willing to borrow (which implies higher money demand) and much less willing to buy (which also implies a demand for cash rather than goods. The sharply increased demand for money is acting directly to neutralize much of the extra M2 money supply that was created a few years ago. And that, in turn, means declining inflation pressures. (Recall that M2 has been flat for the past 9 months or so.)

Chart #4

Chart #4 compares housing starts (blue line) with an index of homebuilders' sentiment. Sentiment has plunged in recent months as homebuilders have seen a sudden slowdown in home purchases. In the past, sentiment has often been a very good predictor of housing starts. We could be on the verge of seeing a big slowdown in residential construction, and that would be a surefire contributor to a recession. Chairman Powell, please take note!

Chart #5

The top portion of Chart #5 compares the average rate on 30-yr mortgages (white line) with the yield on 10-yr Treasuries (orange line). The bottom portion shows the difference between the two, which looks to average about 150 bps in normal times. The spread today, in contrast, is over 300 bps; no wonder the housing market is in trouble. As the bottom chart also suggests, such peaks in spreads is typically short-lived, since they most likely reflect panicked selling and hedging by institutional players. Something is likely to change before too long, and it's likely that mortgage rates and spreads to Treasuries will decline.

Chart #6

Chart #6 compares the value of the dollar (orange line) with the real yield on 5-yr TIPS. As I've noted before, 5-yr real yields on TIPS are equivalent to the market's expectation for what the real Fed funds is going to average over the next 5 years. Real yields have soared by almost 400 bps in just over a year, which is not only unprecedented but also indicative of an extreme tightening of monetary policy. It's sort of like giving a horse tranquilizer to a mildly psychotic patient. Please, Chairman Powell, enough is enough!

Chart #7

Chart #7 compares an index of U.S. industrial production with a similar one in the Eurozone. Without a big decline in industrial production it is very unlikely that the U.S. economy is experiencing a recession. And so far, industrial production continues to grow. The Eurozone economy has been battered by the Ukraine conflict and soaring energy prices, yet industrial production has yet to decline. Both economies have an urge to recover what was lost to the Covid shutdowns.

Chart #8

Chart #8 shows the level of private sector non-farm employment, which continues to grow at a healthy pace. Recessions are famous for throwing people out of work, but we have yet to see any sign of that in the U.S. economy. 

Chart #9

Chart #9 shows the level of 2-yr swap spreads, my favorite indicator and predictor of the health of the U.S. economy and financial markets. Swap spreads are still within a "normal" range, which implies that liquidity is still abundant and the corporate profits and the economy are likely to remain reasonably healthy. As the chart suggests, swap spreads would have to rise appreciably before one might expect to see a recession on the horizon. Note also that swap spreads have tended to decline in advance of recoveries. 

Chart #10

Chart #10 is my favorite recession "dashboard," since it tracks two key indicators of monetary tightness and how they interact to produce recessions. Every recession here was preceded by an inversion of the yield curve (red line) and a significant rise in real short-term interest rates (blue line). As I noted in Chart #6, the market expects the Fed to raise short-term real interest rates (a key measure of Fed tightness) to at least 2% in coming years, but that has yet to happen, and so far the yield curve is only mildly inverted. To be fair, I'd score this chart as tentatively predicting a recession within the next year or so. 

Summing things up, there is little doubt that the Fed has already tightened monetary conditions to a significant degree. Sensitive prices (e.g., the dollar, commodity prices, gold) have turned down meaningfully, which alone would be a decent indicator of lower inflation to come. It would be a real shame if the Fed were to continue on its present tightening course in the belief that only by crippling the economy (e.g., higher unemployment, falling industrial production, and a collapsing housing market) can they hope to get inflation back under control. 

My recommendation would be for Dr. Powell to give the economy a "tincture of time," not higher interest rates.

Wednesday, October 12, 2022

Charts you probably haven't seen

Headline news can often be misleading.

The current drumbeat of news goes like this: the US economy is probably in recession, inflation and interest rates are soaring, our national debt is out of control, and the Fed needs to get tighter. Things are a mess.

The reality is very different: Financial markets are highly liquid and far from breaking down. The economy is growing, albeit slowly. Inflation pressures peaked months ago. Our national debt is still manageable. The Fed will likely adopt a less aggressive policy stance soon. 

The charts tell the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads. I pay a lot of attention to these spreads, because they are excellent coincident and leading indicators of the health of the economy and the financial markets. They are a bit esoteric for those unfamiliar with the inner workings of the bond market, which is probably why you haven't heard much about them (unless you've been a long-time follower of this blog). Here is a short primer on swap spreads if you want more information.

2-yr swap spreads currently stand at 31 bps, which is just below their long-term average of 33 bps. As the chart shows, spreads tend to rise in advance of recessions, and they tend to fall in advance of recoveries. Levels above 40-50 bps reflect an economy that is in trouble; current spreads say conditions are close to normal. 

Chart #2

The current level of spreads also reflects the fact that that liquidity is abundant, and that's extremely important. Up until recently, the Fed tightened monetary policy by shrinking the supply of bank reserves (before 2009, banks always held just enough reserves to collateralize their deposits, because reserves did not pay interest). This forced banks to bid up the price of reserves, since they needed more reserves to support a growing deposit base. Higher borrowing costs and a general shortage of liquidity put marginal borrowers and overstretched firms and individuals in a bind, and that in turn led to higher credit spreads, rising bankruptcies and eventually a recession. But since 2009, Fed tightening is very different: instead of shrinking the supply of reserves, the Fed simply raises the rate it pays on reserves, which have been and continue to be abundant, as Chart #2 shows.

Abundant liquidity is essential to a healthy financial market. And we have it in spades.

Chart #3

Chart #3 shows the level of BBB-rated corporate debt (the majority of corporate bonds are rated BBB). Although spreads here are a bit elevated, they are still well below levels that coincided with economic distress.

Chart #4

Chart #4 shows the real yield on 5-yr TIPS (red line), which is the market's expectation for what the real Federal funds rate will average over the next 5 years, and the current inflation-adjusted level of the Federal funds rate (blue line). This tells us that the market is expecting the Fed to tighten significantly in coming years (a high real funds rate is the very definition of tight money). Note also that real rates have not been as high as they are today for a very long time. High real rates mean monetary policy is tight, but they can also be a sign that the economy is very strong (as they were in the late 90s). Since a strong economy is going to be tough to come by these days, high real rates confirm that money is very tight. Very tight, and most likely tight enough to bring money supply back into line with money demand. We know that, since we can observe many sensitive prices declining (as my recent posts have highlighted)> 

Chart #5

Chart #6

Chart #7

Charts #5-7 show different measures of Producer Price Inflation (inflation at the wholesale level). Chart #5 compares the headline, year over year change of the PPI to the core (ex food and energy) change. Inflation by either measure has most likely peaked. Charts #6 and #7 compare the year over year change in the PPI to the 6-mo. annualized change. Here it becomes quite obvious that the peak of PPI inflation was several months ago. 

Chart #8

Chart #8 is the key to understanding the current state of the housing market. The top half of the chart compares the national average rate on 30-yr fixed rate mortgages to the yield on 10-yr Treasuries. The two are joined at the hip most of the time, and that's how it should be. The bottom half of the chart shows the difference between the two, which is now at a record high. 

In other words: mortgage rates today are extremely high relative to yields in the Treasury market, and this situation is very unlikely to last much longer. Prior peaks of this sort were short-lived. Super-high mortgage rates act as a brake on housing prices, since they boost the cost of home ownership. Homes today are very expensive relative to everything else, and there is mounting evidence that home prices have peaked and are now declining. Not surprising. Mortgage rates and housing prices should become more affordable before too long.

Chart #9

I'm sure you heard about the fact that Federal debt has now surpassed the staggering sum of $31 trillion dollars. Actually, that's not true. Federal debt held by the public (which is the correct measure) is only $24.3 trillion. The larger figure includes $7 trillion that the government owes itself, which is nonsensical. But isn't it huge relative to the economy? Well, yes, as Chart #9 shows. It is just under 100% of GDP, and that's big, but it's not unprecedented, and it hasn't increased in recent years.

Chart #10

What about the burden of all that debt? It must be huge, given the amount of debt outstanding and the recent rise in interest rates. Well, not exactly, as Chart #10 shows. The interest cost of our federal debt is less than 3% of GDP, and that's relatively low by historical standards. It's going to rise, to be sure, since the federal government is still running big deficits. But rising interest rates only affect debt that is issued currently, not the great bulk of the debt that was issued at lower interest rates, so interest costs are going to rise slowly. And don't forget that nominal GDP currently is rising by leaps and bounds: third quarter real GDP is likely to be at least 2% and on top of that we will likely see at least 5-6% inflation. At an annual rate, nominal GDP is increasing by at least $2.5 trillion per year, while the deficit is increasing by about half that. So we're not spiraling out of control. 

But of course we would be far better off if we weren't spending so much. The deficit today is not due to tax revenues, which are exploding higher, but out of control government spending, which acts to slow the economy because most of that spending is wasteful.

Friday, October 7, 2022

Inflation visualized


Before leaving for Argentina a few weeks ago, I arranged with Western Union to pick up $2000 worth of Argentine pesos at the "blue" rate of 300 pesos to the dollar.

I knew in advance that I was getting a great exchange rate and that things would be very cheap in Argentina, and I wasn't wrong. What I didn't know was that the largest bill in circulation is a 1000 peso note. Which meant that my $2000 would become 600,000 pesos, in the form of 600 1000-peso notes. It took the cashier at a local Western Union kiosk about 10 minutes to organize and count the bills. The photo says it all: 6 bundles of 100 notes, each bundle worth $333.33; each note worth $3.33. I needed a bag to carry all that money back to our hotel.




It took one of these bundles of peso cash to pay for a dinner for 24 family members at a great restaurant in Tucumán called Di Vino. We tried a dozen different wines, and everyone was served empanadas, salad and a traditional Argentine BBQ (parrillada). The final cost with a tip thrown in (most Argentines tip very little or nothing at restaurants), was 92,000 pesos, or about $12.80 per person. Our huge suite at a local hotel was $75 a night. A 20 minute taxi ride cost less than $5. We took some friends to an estancia in Tafi del Valle; the bill for 3 rooms for 2 nights (including breakfast) was 126,000 pesos ($420).

You can find good wine for 2000 pesos, empanadas for 250 pesos, steaks for 1,700 pesos. Expensive wines run about 8,000 pesos (the cheapest wine in a trendy US restaurant these days starts at $40). Yesterday we had lunch at Fervor, one of my favorite restaurants in Buenos Aires. There were four of us and we ordered one Parrillada de Pescado y Mariscos—a huge selection of grilled fish, shrimp, squid, and calamari. We couldn't finish it all and it only cost 10,000 pesos ($33). We enjoyed two bottles of my favorite Argentine white wine, MariFlor Sauvignon Blanc, for 8,000 each.

A brief history of the peso: Today, a dollar gets you 300 pesos; a year ago a dollar was worth 200 pesos; two years ago 150; three years ago 70; four years ago 37; and ten years ago about 5. Why has the peso lost so much of its purchasing power? The answer is simple: the government pays most of its bills with the printing press. The M2 money supply has grown from 400 billion pesos 10 years ago to now over 10 trillion pesos. That works out to an annualized growth rate of about 40% per year. M2 has increased about 70% in the past year alone. Not surprisingly, Argentine inflation this year will exceed 100%.

Argentina has actually been suffering from bad monetary policy forever. When I lived there in 1975-79, inflation averaged about 125% per year. If Argentina had not changed its currency by lopping off zeros and renaming it 5 times since 1916 (when a dollar was worth 2 of the original pesos), the exchange rate today would be 3,000,000,000,000,000 pesos per dollar.

As Milton Friedman taught us, inflation is a monetary phenomenon which occurs when the supply of money exceeds the demand for it. Argentina has proved that countless times over the past century. It's no mystery, but nearly everyone—especially the Fed—completely ignores the fact that our inflation problem today started with a huge expansion of our money supply in 2020 and 2021. Most people seem to think that the inflation is up because the economy is "running hot," and that to get inflation down the Fed needs to cause a recession. Not so: the Fed simply needs to slow the growth of the money supply and boost interest rates by enough to restore a balance between money supply and demand. As I explained in my last post, it looks like they have done enough already. 

You can read more about this in my posts over the past two years. This is a good place to start. Also see this. Last June I stopped worrying so much about inflation, and this explains why.

UPDATE (10/12/22): Below is a chart of Argentina's dual exchange rates. The current "market rate" is also known as the "Blue" rate. Note that over the course of almost 17 years, the peso has dropped from 3 to the dollar to now over 300, for a loss of 99%. Cry for Argentina.



Tuesday, September 27, 2022

Everything's down except inflation


And that means inflation has peaked and will be headed down in the months to come.

Inflation as measured by government indices (e.g., CPI, PCE Deflator) is a lagging indicator of true inflation. True inflation is defined as the loss of purchasing power of a currency. Right now that is just not the case: the dollar is soaring against nearly every currency in the world and virtually all commodity prices are collapsing.  Don't pay attention to inflation; pay attention to sensitive market-based prices—they tell you where inflation is headed.

The Fed was very slow to see the inflation problem which showed up in surging M2 growth in 2020, and they are being very slow to see that inflation fundamentals have improved dramatically this year.

Chairman Powell has it all wrong: the way to kill inflation is not to kneecap the economy, it's to reduce the supply of money and increase the demand for it by raising interest rates. The Fed has already succeeded in doing that! There's no reason at all that we need a recession to get inflation down. In fact, a growing economy can actually help to bring inflation down by increasing the supply of goods and services. I just don't see the Fed continuing on the inflation warpath for very much longer.

This bad Fed dream will be over soon. This is not the time to be cashing out of risk assets.

Chart #1

The dollar is very strong and rising against virtually every currency in the world (Chart #1). That means that most prices outside our borders are going down. Come to Argentina, where I am at the moment, and you won't believe how cheap things are. Great wine for  $3-5 per bottle. Steaks for $3. A 1-mile Uber ride for $1.  Tip a cabby with 1000 pesos (the largest-denomination bill, but worth only $3.33 US) and they will sing your praises. We have a 3-room suite in a nice hotel for only $70 a night. To worry about US inflation at a time like this is crazy.

Chart #2

The M2 money supply (Chart #2) has risen at a paltry 2.3% annualized rate over the past 9 months, and M2 has been flat for the past 6 months. If rapid M2 growth beginning in 2020 was the fuel for inflation (very likely), then the inflation fires are already dying down. The surge in M2 that began in 2020 was the spark that triggered rising inflation about a year later; the lack of M2 growth that began late last year will undoubtedly result in a decline in measured inflation before year end. 

Chart #3

The CRB Raw Industrials index (Chart #3) is down 18% since its early March high. Nearly every commodity has exhibited the same behavior, as the following charts show.

Chart #4

Chart #4 shows copper prices, which are down 35% since March. "Dr. Copper" is telling us that the Fed has no reason to worry. But maybe they should worry because they are threatening a whole lot more tightening when none is needed. This is what is called "closing the barn door after all the horses have left."

Chart #5

Chart #5 shows gold prices, which are down 22% from last March's high. Gold is traditionally very sensitive to changes in monetary policy. This is a strong signal that the Fed may have already tightened too much.

Chart #6

Chart #6 shows crude oil prices, which are down a whopping 35% since mid-June. This is a very significant decline that will have the effect of lowering the prices of all things that depend on energy.

Chart #7

Chart #7 shows the best measure of US housing prices. Note that prices stopped rising a few months ago according to this measure. However, since the index is based on an average of prices over the previous three months, it's quite likely that the actual peak in housing prices happened some time in the March-April time frame. And it's not at all surprising that housing prices have peaked considering that mortgage rates have more than doubled so far this year (most recent quote is 6.7% for a 30-yr fixed conventional mortgage). This is how monetary policy impacts prices and inflation: higher rates increase the demand for money and reduce the demand for borrowed money; people become much less anxious to own things when interest rates are high. It's better to hold on to your money than spend it; better to rent than buy, which is why rents are increasing as housing prices soften. 

Chart #8

Finally, as Chart #8 shows, the market's expectation for what CPI inflation will average over the next 5 years has now fallen to 2.33% (the bottom half of the chart), thanks to a huge increase in market interest rates (top half, representing 5-yr Treasury yields and 5-yr TIPS yields. 

Markets these days are a lot more worried that the Fed will needlessly kill the economy than that inflation will do anything but decline. 

UPDATE: We've been in Argentina for a week now, and it's painful to see the sorry state of the economy and the abysmal level of prices. Food here costs about one-fourth what it does in the U.S., not because unemployment is high (which it is), but because no one earns enough to afford to spend more. Those pundits who argue that the Fed needs to tighten by enough to push unemployment higher so that inflation will come down should come to Argentina to see the results of high unemployment. Prices for basic things may be low, but the inflation rate here is about 100% a year. Anything produced outside of Argentina comes in at international prices, and sooner or later the prices of basic things will necessarily rise to international levels. Things are cheap here only temporarily. The lower and middle classes are being robbed of their purchasing power by inflationary monetary policy, and the only one benefiting from the theft is the government. That's called the inflation tax. The government prints money to pay its bills, and anyone who touches that money loses purchasing power on a daily basis, while on the other side of the coin the government gets to keep on spending. Bottom line: Argentine M2 is growing by leaps and bounds—70% a year at last count, whereas in the US, M2 is flat. The US is on the cusp of disinflation, while Argentina is on the cusp of hyperinflation.

If higher unemployment were necessary to bring inflation down, Argentina would be suffering from deflation by now.

Monday, September 19, 2022

More predictors of lower inflation


The whole point of tightening monetary policy is to increase the demand for money and/or decrease the supply of money at the expense of other things. Tighter monetary policy today serves to balance the supply of money with the demand for money, and that is what will deliver low and stable inflation. Higher interest rates increase the appeal of holding cash and cash equivalents, and at the same time they discourage the borrowing and spending of money (and thus tend to depress prices). Unfortunately, nobody knows (not even the Fed) how high interest rates have to rise in order to slow and ultimately reverse the recent rise in inflation.

So we (and the Fed) must instead rely on old-fashioned methods such as watching prices. Continuously rising prices are a clear sign that interest rates are too low and/or monetary policy is too easy. Falling prices, on the other hand—if sufficiently widespread—are a pretty good indicator that monetary policy is gaining traction and thus helping to bring inflation down.

Such is the case today. So far this year we have seen significant declines in a number of prices and markets, and here are just a few that are down significantly: stocks, commodities, foreign currencies (see Chart #1 in my last post), TIPS, bonds in general, and used cars, the latter of which have declined by 18% in real terms (see Chart #1). Though not down year to date, gasoline prices are down 27% since their peak last June. 

Chart #1

Since reliable measures of housing prices take months to show up, it's best to look at indicators that update more frequently, such as mortgage refinancings, which have plunged to levels not seen since 2000, and new applications for mortgages, which have dropped by 43% since the peak of early 2021. Both of these are symptomatic of what we would expect from higher interest rates: reduced demand for borrowed money. The rise in housing prices which began about 18 months ago coupled with sharply higher mortgage interest rates (Chart #2) has caused housing affordability to plunge to levels not seen in over 30 years (see Chart #3), and there is little doubt this has arrested the boom in the housing market, which can be seen in a sharp decline in applications for new mortgages (Chart #4). Home prices are almost certainly falling on the margin and we saw a hint of that in the August numbers. 

To be sure, even though the bloom is off the housing rose, and prices are weakening on the margin, rents have been slow to catch up to the rise in prices. I would expect to see rents rising for at least the next 9 months, and this will add to measured CPI inflation. But rents are a lagging, not a leading indicator (if for no other reason than that rents are infrequently adjusted as leases expire); the important thing is housing prices which change daily. Rents don't cause inflation, and neither do wages; only excess money causes inflation, and there seems to be a lot less of it recently, which is great news.

Chart #2

Chart #3

Chart #4

TIPS prices are down sharply because real yields are much higher, having risen from a low of -2% on 5-yr TIPS to now 1.2% (Chart #5). That's because TIPS are an inflation hedge, and in the presence of tight money the demand for inflation hedges should decline. This might be the best chart of all, because the "tightness" of monetary policy can be measured directly by the level of real yields. There is no question but that the Fed's policy stance has gained traction significantly and is thus affecting markets all over the world. Icing on the cake: Chart #5 also shows how inflation expectations have declined this year, from a high of 3.7% in early March '22 to now 2.5%.

Chart #5

Meanwhile, supply chain bottlenecks are clearing up rapidly, thus facilitating the supply of goods, and in turn tending to lower their prices. For example, the Baltic Dry Index (an index of shipping coasts in the eastern Pacific) has fallen by 72% since its peak last October. Where there used to be over a hundred container ships anchored off the coast between San Clemente and Palos Verdes waiting to unload, there are now just a handful.

In Chart #6, note how builder sentiment has fallen dramatically in recent months. This likely reflects decreased housing demand, soaring mortgage rates, and softer prices, and that further presages a slowdown in housing starts (and weaker demand for construction materials), some of which we have already seen.

Chart #6

A CPI report is old news by the time it's released. Indicators such as the above tell you where the CPI is headed.