Since inflation has been such a hot topic on MM of late, I thought it would be appropriate to share a thought piece and get some of our readers' inputs.
Keep in mind this is less not really an immediately trade-able view but rather my general musings.
From reading stories and textbooks, I find many paradoxical parallels between our time today and the late 1970's/early 1980's.
Back then, the US inflation (as a result of Federal Reserve policies and an overemphasis for economic stability via full employment) was at its zenith. Paul Volcker came out on a Saturday to shock the markets with a 100bps raise of the fed funds rate. [1] This ultimately culminated into a 4% rate increase in a single month! [2]
The shock to the rates market would eventually lead to inflation tapering off. But it is important to note that this takes time.
As you can see here - after the start of a dramatic shift in policy, the percentage change in inflation year over year did not top out until the end of 1980 at 13.50%. Inflation continued increasing, albeit more slowly, at a notable rate of 10.30% in 1981.
As inflation subsided, people ended up enjoying the biggest stocks and bond bull market that has more or less lasted until today. Commodities meanwhile languished within a bear market until the rise of Chinese demand in the early-2000's.
I have distilled into several factors that I believe were the main attributions in the decline of inflation and subsequent moves in prices in the various asset classes over the course of the ~30 years following 1980.
1) Preoccupation with inflation. When you had the head of the most important Central Bank in the world ripping rates like Spongebob ripping his pants, chances were he would eventually have some impact eventually.
2) Fiscal austerity - less money spent means less inflation. There are nuanced differences between fiscal austerity in different times in history, in different countries. However, it is hard to argue against the idea that general austerity should lead to disinflationary pressures.
For example, the 1990's in the US was a time of fiscal austerity - the Clinton administration was responsible for the biggest reduction in government spending as a % of GDP since the end of WWII. [3] Since we were still growing and coming down from relatively high prints in inflation (as compared to today), the decline in inflation was viewed with a benign eye.
Another example of austerity led deflation was in 2010's Eurozone. The European debt crisis led to large cuts in government spending in a number of periphery countries that has coincided low inflation [4]
3) The great deleveraging. In close relation to fiscal austerity in select regions, there has been deleveraging since 2008. Both in the US and other parts of the global economy, debt to income/GDP has been on the downward trend putting pressure on increasing investment and thus inflation.
4) Globalization. The period of 1980's to 1990's mark the rapid rise in global trade. This shift in paradigm resulted in better allocation resources - companies are able to lower their costs in both materials and labor, which ultimately led to downward pressures on goods and services.
5) Demographic pressures (declining populations) and low productivity growth. As the labor growth falls in a number of developed regions, we have had pressure on inflation as a result. [5]
Now that I've documented how we've gotten here from the 1970's/1980's. I think there are paradoxical reasons why we about to have a shift in paradigm towards the other direction. Let's go through the same bullets one by one again, this time through 2017 lenses.
1) Preoccupation with deflation (why helicopter money could emerge). We've come a long way since Volcker. Instead of an inflationary bogeyman, we have a deflationary one. The Fed, as a result, has expanded its balance sheet to unprecedented levels. Has it worked? - that's something still up for debate.
But I argue that it has the potential of working. QE led to an increase in the monetary base. However, that money didn't technically make into the economic system per se. Banks and governments were able to borrow cheaply, but very little of that money was actually spent to expand the economy. In fact, the unintended consequences of ZIRP and NIRP were actually contributing to deflationary pressures.
I documented this at my firm last year in April of 2016 (I think I was one of the first to make this note - I believe Credit Suisse sent out a similar note a few weeks after I sent my initial email internally):
– Squeeze on bank’s net interest margin income through the flattening of the yield curve
– Flow into non-revenue generating assets (Snapchat, bridges to nowhere, etc.) that will eventually prove deflationary as debt led to assets with poor income generating capabilities
– General economic signaling and cash hoarding occurred as the market deemed the economy to be in a poor state as Central Banks' emphasis on QE measures
Are all reasons why deflationary pressures should dominate. Due to the enumerated reasons above why deflation exists - simply increasing the money supply to create inflation (monetary policy) was not enough. You need both monetary policy (increasing the money supply) and fiscal policy (putting that additional money into the hands of end users).
Interestingly, out of US, Europe, and Japan, US came out of 2008 the best – why was that? The US was the only place where both sufficient fiscal and monetary policy occurred in coordination, albeit this was unintended.
In terms of Europe: Aside from Trichet raising rates shortly after 2008 (turned out to be a big mistake) – the ECB decisively lowered rates and kept them there – however all the talk in Europe was for fiscal austerity NOT fiscal expansion – so you have all this cheap borrowing and record low yields for core Europe and periphery but no growth/inflation because the money wasn't really going into anything.
Lastly, Japan – you saw a spike in inflation right at the beginning of Abenomics. As some of you might remember, Abenomics and the reinvigorated Japanese monetary policy started with fiscal stimulus (one of the arrows from Abe) – then they tried to lower the deficit by cutting spending and raising the consumption tax, which sent USDJPY crashing back down.
My main point here is that the world has done a tremendous amount on the monetary side to solve the deflationary problem. There is plenty of dry powder for inflation, as soon as there is a fiscal policy match to light it.
2) This leads perfectly towards point #2. Fiscal austerity has put tremendous pressure on the middle and lower classes - populism and the fiscal expansion that comes with it is a symptom of fiscal austerity and general income inequality. [6]
Although it is debatable how much impact our current populist officials will have (Trump, May). What is undeniable is that there is a surge in popularity for fiscal expansion and populism in general.
If we do have tax reform, additional fiscal spending and the likes, that combination with years of loose monetary policy will, in essence, be helicopter money, aka wealth transfer. That, in turn, will mean more money spent in the economy and thus lead to inflation.
3) We have had a need to deleverage. As we deleverage, the increase in savings should correspond to an increase in investment. The current deleveraging has led to insufficient investment. As the world moves from a glut of debt to a glut of savings, increasing investment will eventually follow suit.
4) Populism gains prominence, one of the main characteristics of the times will be protectionism. The two evidently goes hand in hand as we revisit Bridgewater's study on the subject matter. Needless to say, protectionism is ultimately inflationary - as the efficient allocation of resources and labor that existed during globalization will no longer be the case.
5) Low labor and productivity growth will lead to labor and supply shortages. These shortages and deficits are inflationary. Companies will eventually have to pay more for the same amount/level of labor and same amount/quality of goods.
This has started to occur and other we haven't seen strong growth in wages, I feel like that is ultimately inevitable. [7]
In conclusion, what I believe we have in store in the ultra-long term is the opposite of what we have witnessed in the 1980's.
To revisit, back then, after we top ticked inflation, we experienced a tremendous equity and fixed income bull market and a prolonged bear market in commodities.
I believe we are standing on the precipice of the opposite side. A huge bull market in commodities and a bear market in stocks and bonds in the works.
Some market thought leaders sniffed out this possibility last year. After a while, many other market participants ascribed to the view and jumped on the bandwagon post-election. However, the inflationary pressures and the subsequent rise in yield was short lived as many gave up as asset prices came back down.
Not necessarily applicable for the typical macro trader with a time horizon of 3 to 6 months. I do believe the key here is that it is indeed an ultra-long-term development and one that could affect the world for decades to come.
Thoughts welcome.
As you can see here - after the start of a dramatic shift in policy, the percentage change in inflation year over year did not top out until the end of 1980 at 13.50%. Inflation continued increasing, albeit more slowly, at a notable rate of 10.30% in 1981.
As inflation subsided, people ended up enjoying the biggest stocks and bond bull market that has more or less lasted until today. Commodities meanwhile languished within a bear market until the rise of Chinese demand in the early-2000's.
I have distilled into several factors that I believe were the main attributions in the decline of inflation and subsequent moves in prices in the various asset classes over the course of the ~30 years following 1980.
1) Preoccupation with inflation. When you had the head of the most important Central Bank in the world ripping rates like Spongebob ripping his pants, chances were he would eventually have some impact eventually.
2) Fiscal austerity - less money spent means less inflation. There are nuanced differences between fiscal austerity in different times in history, in different countries. However, it is hard to argue against the idea that general austerity should lead to disinflationary pressures.
For example, the 1990's in the US was a time of fiscal austerity - the Clinton administration was responsible for the biggest reduction in government spending as a % of GDP since the end of WWII. [3] Since we were still growing and coming down from relatively high prints in inflation (as compared to today), the decline in inflation was viewed with a benign eye.
Another example of austerity led deflation was in 2010's Eurozone. The European debt crisis led to large cuts in government spending in a number of periphery countries that has coincided low inflation [4]
3) The great deleveraging. In close relation to fiscal austerity in select regions, there has been deleveraging since 2008. Both in the US and other parts of the global economy, debt to income/GDP has been on the downward trend putting pressure on increasing investment and thus inflation.
4) Globalization. The period of 1980's to 1990's mark the rapid rise in global trade. This shift in paradigm resulted in better allocation resources - companies are able to lower their costs in both materials and labor, which ultimately led to downward pressures on goods and services.
5) Demographic pressures (declining populations) and low productivity growth. As the labor growth falls in a number of developed regions, we have had pressure on inflation as a result. [5]
Now that I've documented how we've gotten here from the 1970's/1980's. I think there are paradoxical reasons why we about to have a shift in paradigm towards the other direction. Let's go through the same bullets one by one again, this time through 2017 lenses.
1) Preoccupation with deflation (why helicopter money could emerge). We've come a long way since Volcker. Instead of an inflationary bogeyman, we have a deflationary one. The Fed, as a result, has expanded its balance sheet to unprecedented levels. Has it worked? - that's something still up for debate.
But I argue that it has the potential of working. QE led to an increase in the monetary base. However, that money didn't technically make into the economic system per se. Banks and governments were able to borrow cheaply, but very little of that money was actually spent to expand the economy. In fact, the unintended consequences of ZIRP and NIRP were actually contributing to deflationary pressures.
I documented this at my firm last year in April of 2016 (I think I was one of the first to make this note - I believe Credit Suisse sent out a similar note a few weeks after I sent my initial email internally):
– Squeeze on bank’s net interest margin income through the flattening of the yield curve
– Flow into non-revenue generating assets (Snapchat, bridges to nowhere, etc.) that will eventually prove deflationary as debt led to assets with poor income generating capabilities
– General economic signaling and cash hoarding occurred as the market deemed the economy to be in a poor state as Central Banks' emphasis on QE measures
Are all reasons why deflationary pressures should dominate. Due to the enumerated reasons above why deflation exists - simply increasing the money supply to create inflation (monetary policy) was not enough. You need both monetary policy (increasing the money supply) and fiscal policy (putting that additional money into the hands of end users).
Interestingly, out of US, Europe, and Japan, US came out of 2008 the best – why was that? The US was the only place where both sufficient fiscal and monetary policy occurred in coordination, albeit this was unintended.
In terms of Europe: Aside from Trichet raising rates shortly after 2008 (turned out to be a big mistake) – the ECB decisively lowered rates and kept them there – however all the talk in Europe was for fiscal austerity NOT fiscal expansion – so you have all this cheap borrowing and record low yields for core Europe and periphery but no growth/inflation because the money wasn't really going into anything.
Lastly, Japan – you saw a spike in inflation right at the beginning of Abenomics. As some of you might remember, Abenomics and the reinvigorated Japanese monetary policy started with fiscal stimulus (one of the arrows from Abe) – then they tried to lower the deficit by cutting spending and raising the consumption tax, which sent USDJPY crashing back down.
My main point here is that the world has done a tremendous amount on the monetary side to solve the deflationary problem. There is plenty of dry powder for inflation, as soon as there is a fiscal policy match to light it.
2) This leads perfectly towards point #2. Fiscal austerity has put tremendous pressure on the middle and lower classes - populism and the fiscal expansion that comes with it is a symptom of fiscal austerity and general income inequality. [6]
Although it is debatable how much impact our current populist officials will have (Trump, May). What is undeniable is that there is a surge in popularity for fiscal expansion and populism in general.
If we do have tax reform, additional fiscal spending and the likes, that combination with years of loose monetary policy will, in essence, be helicopter money, aka wealth transfer. That, in turn, will mean more money spent in the economy and thus lead to inflation.
3) We have had a need to deleverage. As we deleverage, the increase in savings should correspond to an increase in investment. The current deleveraging has led to insufficient investment. As the world moves from a glut of debt to a glut of savings, increasing investment will eventually follow suit.
4) Populism gains prominence, one of the main characteristics of the times will be protectionism. The two evidently goes hand in hand as we revisit Bridgewater's study on the subject matter. Needless to say, protectionism is ultimately inflationary - as the efficient allocation of resources and labor that existed during globalization will no longer be the case.
5) Low labor and productivity growth will lead to labor and supply shortages. These shortages and deficits are inflationary. Companies will eventually have to pay more for the same amount/level of labor and same amount/quality of goods.
This has started to occur and other we haven't seen strong growth in wages, I feel like that is ultimately inevitable. [7]
In conclusion, what I believe we have in store in the ultra-long term is the opposite of what we have witnessed in the 1980's.
To revisit, back then, after we top ticked inflation, we experienced a tremendous equity and fixed income bull market and a prolonged bear market in commodities.
I believe we are standing on the precipice of the opposite side. A huge bull market in commodities and a bear market in stocks and bonds in the works.
Some market thought leaders sniffed out this possibility last year. After a while, many other market participants ascribed to the view and jumped on the bandwagon post-election. However, the inflationary pressures and the subsequent rise in yield was short lived as many gave up as asset prices came back down.
Not necessarily applicable for the typical macro trader with a time horizon of 3 to 6 months. I do believe the key here is that it is indeed an ultra-long-term development and one that could affect the world for decades to come.
35 comments
Click here for commentsYou know the front page I like. The one at the moment. "oh, the market for banana's has thrived up north". What a joke it all is. Spin Spin Spin the chocolate wheel until it suits the result you want. Guess what. The market just threw all of it in. No, the ability but, what matters most, willingness. The market couldn't be fucked getting out bed for the toffs or the elite market investors. Goodluck with it.
ReplyFRONT PAGE "THE SUN"
ReplyTHE ONLY ROYAL HAND WORTH HAVING...IS THE ONE WITH MONEY ON IT.
The market for banana's has not lost its bearings. The market just return to its long lost home the betting shop, and knows how fucked up all this is.....the lot of it.
Replyhttps://www.youtube.com/watch?v=3bS8xdwO40M
Did you say three Mrs Banana's walkout the trading dance floor door?
ReplyNooooooooooooooooooooo....your kidding.
You know why they have American options in Wall Street and the City, London. You can get out anytime you want.
ReplyYou know why they call the option the "calendar spread", because because one investor can pay for the shorter term call, while the other investor can receive the other longer term call at the same going rate.
ReplyNo, not the Vogue spread.....the "Calendar Spread".
ReplyTell me , Red Detroit. You think I'm finished on Wall Street yet or what. Do I have to keep going.
ReplyGreat post Dtroit - doffs cap.
ReplyI'm not sure who worked harder on this post--DR in content or Amps in comments.
ReplyI really like how you put this together--there is certainly still a low for long, inflation is dead consensus that can be overturned. Will it in the foreseeable future? my thoughts on your bullets:
1) I think QE *did* work, inasmuch as it was intended to. Per your point about the coordinated impact of fiscal and monetary policy, it plugged the gap in domestic demand and investment when it gapped lower and smoothed the secondary effects of the GFC.
2) that did indeed lead to asset price inflation that went disproportionally to the rich--but I don't see the populist movements as necessarily far-left ones--France (yes, sort of), UK (Corbyn), but not in the US, Italy or Germany. So unclear if we are going to get that fiscal loosening, especially after years of increased borrowing to keep inflating new bubbles.
3) Unclear to me that deleveraging and increased savings would lead to inflation. Recent history in the US (where consumer debt/gdp has fallen since GFC) would argue otherwise. Debt and savings are two sides of the same coin--and increased investment would potentially improve productivity, rather than increase inflation.
4) agree on the protectionism point, that is the one common thread of pretty much any populist movement. But Macron's victory might argue this isn't catching fire.
5) I agree philosophically with your point on labor shortages and demongraphics, but Europe and Japan are way further down the demographic rathole than the US and we've yet to see evidence of it.
Lastly re: commodities, I think the bull run in commodities in the 70s and 00s is strictly a supply/demand function--and not clear to me that the long term is bullish for commodities as global economies move away from the internal combustion engine and mining becomes more of a manufacturing process, rather than extraction. A global weakening of currencies would be supportive, though.
I think the most likely factor to uncork this theme is your first two points--a material fiscal and/or monetary loosening that whacks the domestic currency of G3 economy and touches off a currency war. Wouldn't even require a healthy dose of protectionism, but that may be a secondary effect.
Thanks for reminding some of us how old we are :)
ReplyThoughts... Don't forget the biggest deflationary tool ever created by humankind - Internet - and its power to depress prices for longer than anyone expects. I think CBs have nothing on that yet.
That being said, should your prediction come to fruition, I am already getting myself ready. Buying gold - classic inflation hedge as currencies get annihilated. Buying vacant land - scarce commodity impossible to produce. Buying multi-unit dwellings - rents will rise with wages.
That was an epic hockey game!
Great post, DR. I'm seeing more people talking about inflation now, which makes sense that we are later-cycle and the global cycle is finally synchronized. That said, on the secular front, I can't get too excited. To my mind, the inflation of the 70s was driven by a demand shock from Boomers buying stuff (I just went from married to married with a kid and my consumption rate has gone up 4x) and supply shock from oil. The big deflationary force the past decades has been the entry of former Communist countries into the global labor pool, and while that is passing, technology/automation is next. Then there's demographics and while it's conceivable that inflationary effects may follow initial deflationary ones (from Boomers cutting consumption on retirement), as Shawn rightly points out, we have not seen that yet in "The Country from the Future" -- Japan.
ReplySure, there are some cyclical inflation pressures but it's hard to see them getting too hot. China is key, in terms of demand pressure, and now that tier-3/4 cities inventories are back to normal, I think the economy will be allowed to slow (tellingly, shanty town renovation targets for 2018-20 are lower than for the past years). In the US, the Trump tax plan -- supposing something actually gets passed -- is going to be a big nothing for demand. If you cut corporate taxes, but not for the middle class that could drive incremental consumer demand, then corporations are going to save their tax cuts, not invest them to serve a tapped-out consumer. We may see wage inflation, eventually, but when? Unemployment in Japan is 2.8% and they really don't have acceleration in full-time wages. In Czech, they have 3% UE and they do have wage inflation now. What's the difference and what's one to expect in the US? Maybe it's Czech productivity gains making the difference? In any case, we're still a ways off from 3% UE.
Nearer term, I would expect inflation to start reverting higher. But I'm not betting on it happening in tomorrow's PCE print. And the last thing I read says not to hold one's breath for October either. But by turn of year, I'd expect inflation to revert higher a bit.
There's a theory out there that central banks all got "financial stability"-minded at Sintra. Claudio Borio's paper "through the looking glass" is good. I mean, we all sit here and say, "Look, these central bankers caused the last two asset bubbles which caused the last two recessions. It's so obvious!" If it's obvious to us, then it may well have sunk in with the central bankers, though they could never admit openly to it because then finger-pointing politicians would take away their independence tout suite. So, we're never going to have a really open policy shift, but maybe between the lines, one is afoot. What do you all think?
Supposing this policy shift is happening, then real rates are going up. That's bad for gold (and why I don't share IPA's enthusiasm for it). Admittedly, if all central banks tighten for "financial stability" reasons, then there may be some convergence versus the US, and so that helps gold priced in USD, but I'd expect the real rate component to predominate.
One big question is what happens to the inflation component of yields. Will markets say, "central bank reaction function has changed and disinflation is likelier with this financial stability-driven tightening?" So, what real yields giveth, break-evens taketh? The US 10Y breakeven has been rallying since Sintra, so maybe not.
In FX, I actually got long some EURUSD. Seemed a good price, if the bullish EURUSD story remains in tact; if not, stop not too far from here. EURNOK looks the wrong price again. Been holding off on USDJPY after missing the last NK panic. Eyeing tomorrow's PCE with caution. Has Abe made a May-like blunder calling an election?
I completely disagree with your conclusions, drawn, but more importantly, I find your 95% of content well presented but a complete disconnect between facts & figures and your drawn conclusions:
Replya) None of what you presented supports in the slightest a possible future bull run in commodities and sell off in stocks and bonds. How did you get to this and what data do you use to support such?
b) your assertion that some market players already attempted to put on positions that would correlate with your conclusion is factually incorrect. We have not seen any meaningful profit taking in stocks nor bonds. One could make a case for some houses looking for the bond exit but certainly not in equities.
And if I may suggest, it would make a lot of sense if you presented your conclusion at the very beginning and then continued with backing up such conclusion, it was very hard to find what you are actually getting at and what your point was...
Otherwise, thank you for sharing your material...
@johno, there is really no lasting negative correlation between interest rates and price of gold.
ReplyDo you follow http://www.epsilontheory.com/ at all? Similar thesis in play there, plus a lot of interesting observations in general.
ReplyI liked the presentation personally. A few thoughts, just opinions really
ReplyI agree with Shawn as noted above that increased savings and paying down debts are not inflationary, but healthy economic decisions that will lead to near-term productivity and long-term capital stock gains. This improves terms of trade for exporters and strengthens domestic currencies.
I see ECB, BOJ continuing some version of QE for a little longer IMO. SNB could still be buying assets and the BOE seems to wait to officially taper until end of 18. With QT/BS unwind simultaneously occurring while other CB's are still buying that will be dollar bullish and in a big way. Rumor is 10% repatriation fee for corporations off shore cash. That's hard to pass up. If you look up the World Banks statistics on debt for 2017 the dollar dominance is nothing less than shocking. Again, all very bullish. Also there is a global premium for dollars to be stored as cash on balance sheets. EM is the strongest area, but AE markets are similar. Carry trade pervelance plays a role as well. (BIS 510)
Again with the dollar paradaigm and it's dominating presence in the market participants like corporations, governments, import/exporters, farmers, etc they all have learned ingenious ways to currency invoice, hedge, or even to understand the value chain in their production process to substitute value-added goods to offset dollar/local currency movements (see a great paper (BIS 653). With that being said China's demand is the wildcard. I personally don't see them slowing down anytime soon.
Treasury will no longer allow major mergers with China period. It's well known they actively want to steal our technology. The first step towards disarming tensions would be multiple concessions on Chinese policy...reciprocity being one of them. IMO this will greatly slow Chinese progress in value-added manufacturing. So a strong dollar and continued Chinese indsutrial demand results in moderate inflation if much of any...kind of a wash. Now pure supply and demand is a whole other story. So something like African and Indian farmers struggling to harvest AGAIN we would most likely see a surge in demand for high protein crops and prices could spike sky high. India is currently dealing with an agricultural/farming disaster for example.
IMO inflation, as we try to define it can't exist without a central government with the ability to spend and tax. Unlike the federal Gov citizens have to watch what they spend. They actually have to be thrifty at times. A great example is our current predicament. They are all at a loss at the fed to locate any signs of inflation. Well, when wages haven't budged in decades and salaries now include a record 33% of pay in benefits. These benefits don't encourage consumption like cash would and are ephemoral at best... who has the money? Throw in interest on the vehicles, college loans, credit cards and even wealthy individuals have seriously reduced buying power. Not to mention they completely ignore the cantion effects of QE. Housing, Health, Education, and consumer credit costs are through the roof. All of those industries are tied at the hip to congress and K street in DC.
So I agree with you (DR) whole heartedly if spending for spending sake is what the FED wants they seem to miss the middle class and serious fiscal injections as a sure fire route to get inflation. People can't spend money they don't have. Credit is limited and comes with charges which eat into available cash. I also agree with Shawn that a fiscal boost of a large magnitude (maybe with a Q or 2Q lag) would boost global consumer inflation. The US market is the engine. As for a currency war IMO it wont be so much currency but barriers to trade that will be the protectionist measures taken. I'm a rook to the blog and haven't posted much so forgive the lengthy response. Just looking for new perspectives and opportunities to learn.
(PART 1)
ReplyI look at the inflation conundrum in much simpler terms:
With free trade and global competition among manufacturers, entrepreneurs, fueled by the internet and cheap shipping and low tariffs, inflation has to be manufactured rather than being the result of productivity increases. American or German or Japanese wages will not go up because some domestic politicians want it to be so or because of any changes in domestic economics. Nowadays, wages are a direct function of global competitive wage pricing.
When Africa opens up its manufacturing hubs (and it is most likely China will be the main driver to do so and a lot of the lower level manufacturing will shift from now Bangladesh or like places to Africa if it has not happened already) then this will put downward pressure on global manufacturing wages. Likewise in highly paid jobs: AI, automation, but also Chinese domestic know-how will greatly depress wages of those in computer science, legal professions, even the medical field. My point is that inflation will at best be depressed by downward wage pressure but I do not see any catalyst that would cause wages to increase by much and even less the chance of that pushing up prices of consumer price baskets. Hence my point that I do not believe in inflation increases as function of wage increases or productivity increases. You can invent an awesome self-driven car tomorrow at bargain prices and that exact same model will be replicated the day after tomorrow in China or elsewhere. China is technologically advanced enough to take on top technology in most every sector in Europe or the US.
So, the only way inflation increases will be through deliberate inflation "manufacturing", imho. And I believe it will go down the following way: Most central banks will raise rates not because of inflation worries, to the contrary, inflation will actually be weighted less in rate setting decisions going forward. What many central banks have to concern themselves with is employment but much more importantly investment returns. One can have the best job, imaginable, but when even the lowest levels of inflation over time erode fixed income investments and savings there will be little to nothing left for anyone when they retire in several decades. The current scenario will only increase the disparity of wealth distribution. Currently, equity investments trump and savings and fixed income investments (not traded FI products but savings products) are losing out big time. Central banks will be forced to see the need to focus again on making savings and FI investments palatable. And that can only happen by raising rates that trickle through the system to prime rates and other savings rates.
(PART 2)
ReplyIn the end economics is really this simple: The price of anything and everything is determined by supply and demand. The health of an economy depends on the supply of products and the consumption/purchase of products. Without money/savings in peoples' pockets you can have the most technologically advanced products and the highest productivity imaginable, it will not make a single dent if the consumer is not there or able to pick up such products. The problem is on the demand side, not the supply side. Consumers are the ones that are suffering, not the manufacturers or middle-men. Consumers are only better off with higher wages, which I argued above is most likely not gonna happen, or with capital appreciation in savings and retirement accounts. And that is something each central bank can directly impact by raising rates. That is what I was above referring to as manufacturing inflation. Only with increased demand and the ability to demand will prices increase and inflation tick up. I see chances of major economies shutting down trade and basically creating an isolated domestic market place at near zero probability. Hence the only way is via an increased incentive to save.
I believe most economists have it dead wrong when they believe that more incentive to save will mean less consumption. In our world today people can and do save and use savings as collateral to consume. In fact this exact mechanism is perused by most everybody on a daily basis.
Some may argue that in the past with super low savings rates and sky high consumption rates in the US the US economy and the consumer fared great. Sure, that was the case because consumers had plenty in their pockets to consume even if it did not leave much left to be saved. However, today, consumers do not have enough anymore to consume sufficiently to balance out supply in most major developed economies. I sternly believe most everything I learned in economics just 20 years ago does not apply or work anymore today. We need a major re-think of consumption incentives, money-multipliers, inflation, essentially an entire re-think of all of economics.
Frankly I think most people looking at the effects of monetary policy have it wrong. The assumption always appears to be it creates/fuels consumption. I would say that is not the case. It is in effect a time swap of economic activity with intergenerational implications. It can bring forwards consumption decisions ,but with implications for filling what implicitly must be a consumption vacuum created for the future. Without fiscal action to fill that void all you have achieved is something akin to a zero sum tradeoff moving activity from one period to another.
ReplyShawn,
Replyregarding savings and QE you might find this interesting.
https://www.valuewalk.com/2017/09/impossible-math-federal-reserve/
@checkmate, I would agree with that notion if consumption was not based on credit. As soon as credit comes into play monetary policy has a huge impact on consumption, not just a time shift. A persistently high fed funds rate of, say 10%, would price most consumers out of home purchases forever, unless paid for in cash. Nobody would be able to afford to pay mortgage interest rates. But it would on the other hand wash plenty of returns into retirement and savings accounts off which consumption can be based today, off the back of savings as collateral.
ReplyI think you will find it makes a lot more sense when you start to consider the effect of monetary policy on capital values then consider how interest rates and affordability works out.
ReplyI'm quite confident in my understanding of how this all works out in practice. God knows I have had long enough on this planet to observe it firsthand in it's various iterations.
@AsiaProp, one can argue that 10% Fed funds rate would do exactly what it intends and adjust the prices downward in order to make homes affordable. Also, I am pretty sure that it won't happen in a vacuum. How did the rates get to 10%? At that point in cycle the unemployment could be at closer to 0% and the consumer could be able to afford a home purchase through higher wages, higher disposable income, and higher wealth. Not to mention that things like longer borrowing terms, exotic mortgage lending vehicles, and owner financing could be back in vogue by then as well.
Reply@AsiaProp I agree with you in terms of savings and consumption. Keynes had that all wrong. In normal capital markets/money markets individuals save and banks lend the savings for productive activity in the economy. This is the interest rate signal. Yes, I agree they can manufacture rates high enough that would make the dollar strengthen such that you would see a productive deflation. Still, prices are reflections of supply and demand (value) In aggregate, with some time, 350 million people with more money in their pockets will deleverage and spend which will affect supply and demand. I am not claiming it would be runaway inflation, just a more normal inflation scenario we are accustomed to. Yes, wages were depressed by opening up the world labor markets, but that's mostly in the past. China is the poster boy example of labor just eventually demanding higher wages. With automation and higher wages less will be employed. That will be the communist party's big challenge. This new phase in China has helped spur Vietnam's industrial arrival. Africa is next maybe, but I am not hopeful for serious growth in the near term there. I agree were in a new capital markets world. We do need to rethink economics and some finance...
ReplyFrom a technological standpoint, China will be at a disadvantage now that Treasury is finally taking intellectual property theft serious. Long gone are the overpriced mergers, massive FDI in America, etc. Your right technology and globalization has played a serious role in wage suppression. There are other creative ways to pay employees. I believe we will see a lot more of this. I also believe corporations will wise up to the fact that labor needs more share of revenue. There are a multitude of different taxes, laws, regulations that play a huge role in the cost of labor. These things should and I believe eventually will be changed. That reduces the cost of capital for the employer.
@asiaprop @shawn
Reply@asiaprop good point - I guess I wasn't as focused as I could have been and my mention to commodities was done on a bit of a tenuous basis.
My main points were supposed to be *inflation/rates-focused*, not necessarily commodities-focused.
Secondly - again please keep in mind my points were inflation-focused - I would strongly disagree and say that there were market participants that believed we had a turn in rates and inflation.
They were the ones that went long breakevens and shorted nominals at the end of the year last year. Also, what would you make of the move in base-metals? I think its reasonable say a large portion of the move was based on the anticipation of further inflationary pressures.
@shawn and his point that the commodities bull run had been supply/demand based, which I think this is a good point. My jump in logic/assumption was that the rising inflation also contributed to the rise in commodity prices during the 70s - something I can review and study further.
The piece was meant to generate discussion and I'm glad to see not everyone agrees. Appreciate all the comments and input. Keep them coming.
@checkmate
ReplyYes I largely agree with your thinking. The fiscal side is needed in coordination with monetary policy. That in essence is helicopter money and will enter the economy through government spending.
If that happens, it will be “manufactured inflation” per @asiaprop but inflation nonetheless.
Interesting post and debate. I tend to agree that fiscal policy will be the final piece in the puzzle to manufacture inflation and we are not going to see that very soon. DR may be right in every respect but this might not be the 2018 trade. Maybe the 2025 trade…..or 2035, even 2045, if you are a student of Japan and/or you like to think mainly in demographic terms.
ReplyIn the much shorter term, we think that the recent sell-off in fixed income is done and so we got long US bonds (belly and the long end), for a swing trade. Yet again the latest PCE data were not indicative of raging inflation, and we think the tax proposal that seemed to move rates will become mired on the Hill very quickly. We like the idea of a "slower lower" curve flattener trade again here, not least because of the imminent arrival into the markets of Q4 fund flows.
We are imagining another swing lower in US10y during October, perhaps breaking below 2.00% once more, before fear of the Fed and its Dec rate hike takes hold once more, perhaps around Thanksgiving.
As far as geopolitics are concerned, a market mover is more likely to be the events in Barcelona than in Pyongyang.
Putting aside the possibility of higher inflation further down the demographic road than Japan has traveled (and therefore at least a decade out for the US), I think what could drive a real burst of inflation in the US is re-distributive fiscal policy. Certainly not likely through 2020. The idea of a Trump/Republican plan generating inflation seems quite unlikely to me.
ReplyAsiaProp put forward an interesting idea -- consumers will consume more if either wages go up (which they won't because of global labor and now automation) or interest on their savings go up. My initial reaction to the second part of that statement is to say, "one guy's interest income is another guy's interest expense." And so maybe higher rates would just depress consumption by debtors/the young and raise consumption by creditors/the old. A wash, in the aggregate. But then, maybe there are different propensities to consumer of those groups.
IPA, the past decade, there's been a close relationship between gold and real (not nominal) rates and USDCNY. If we get higher real rates and China doesn't massively slow down next year, I see gold down.
Shane, be careful about that repatriation narrative for the USD. The comparisons to the '04 HIA are problematic, and the US was hiking versus rest of world during that '04-'05 rally sometimes attributed to HIA.
A Fed Chair announcement in the next weeks? Yellen, Cohn, Warsh, or Powell? Cohn -- a weak dollar guy, but has tax to do and has fallen from favor with Trump. Warsh -- how is he Trump's "low rates guy?" Yellen -- Trump probably realizes now that she's what he'd want, but he'd upset his base. Powell -- like reappointing Yellen but looks like change. Maybe Powell, then!
Wow, LB. Sub-2% in October? Yikes.
I can understand the fixed income swing trade ,but I think it would have to be fear based at this point given the backcloth of central bank activity generally expected in the last quarter. Not sure I like the risk reward on that one this time.
Reply@LB: US10Y below 2.00%? Is that based on Trump's tax reforms completely falling apart?
Replynice post detroit. but I think you will need to wait a bit for inflation. Goodhart had a nice paper that dovetail with your thesis. http://www.bis.org/publ/work656.pdf
ReplyCheck out the ISM/PMI's WTF. running hot especially prices. And this is before China winter shutdown which has the possibility to get commodity markets all messed up (iron ore down but ali and steel up). XLE and oil both at key levels. But I think can rally even with a stronger dollar.
Yes Fed fund rates already pricing in move to 2%. I get it, but I dont wanna short rates now.
Still can't see how Trump chooses Warsh. If Warsh were Fed Chair, guys like Trump would get purged by recessions. No more aspirational bull sh1t artists sustained on the gravy train of unchecked money creation. It would be wonderful, but would "low rate" Trump really kill off his own type?
ReplyJohno, whats your feel for EM FX. I am getting ready to pull the plug, shorting SGD and ZAR and tactically long CAD along with Dollars. More based on a slower china 6 months ahead vs higher US rates, but hey that doesnt hurt either.
Replyabee, check out XOP and OIH. It's pretty much XLE on drugs. The party has only begun.
Replythat the recent sell-off in fixed income is done and so we got long US
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