Entries by Stephen

What happened to the cow?

In the classic fairytale Jack and the Beanstalk, Jack is charged with the important job of taking the family’s cow to market to sell for some much needed money to put food on the table.  Jack, however, gets stopped by some scammers and is convinced to sell the cow for a handful of ‘magic beans’.  […]

Spurious Fed policy

A lower than expected CPI result of +0.4% for October in the US sparked an explosive rally across risk assets last night.  If this number propogates for the next year then the Fed is finished tightening.  If the number continues to fall then the Fed will be led to reverse course.  Interest rate dependent securities […]

ALM, LDI and CSA spells trouble for the BOE

I cannot remember the number of times I walked into meetings to discuss Asset – Liability Matching (ALM) with pension funds and insurance companies.  Insurers fell into two buckets – the savvy ones running sophisticated matched portfolios and the others with serious mismatches.  Pension funds, alternatively, either lacked instruments to reduce the mismatch or fell […]

Inflation IDK – better raise rates!

I have argued repeatedly in this blog that one of the great economic unknowns is what causes inflation and why.  The classical argument is money supply expansion, which seems to work empirically for hyperinflations, but not for moderate or galloping inflation rates.  Indeed, the best general equilibrium economic models we have are completely devoid of […]

The markets are not scared of inflation, they are scared of the Fed

The Fed, it seems, has regressed to a New-Keynesian mindset.  Despite employing reams of Finance professionals it still doesn’t understand the concept of informational efficiency.

The key to fighting inflation is to manage expectations.  Exactly how expectations are formed determines policy.  The New-Keynesian way is ‘adaptive’ – that is economic agents extrapolate from the latest CPI print and that’s that.  The New-Keynesian way is backward looking and economic agents systematically make errors by forming expectations in this way.

The Finance way is to look forward and come up with a best guess of the future using all available information.   The Finance way is couched in the language of informational efficiency and is often called ‘rational expectations ‘ in the economics world.  Rational expectations stokes the class war between New-Classical and New-Keynesian economists but no-one would dispute that financial markets operate in this way and no-one disputes that financial professionals spend their lives dealing with uncertainty in the best way they can. 

Active New-Keynesian policy making, however, relies on adaptive expectations to justify itself.  If the CPI prints at 8% then the assumption is that inflationary expectations are 8% and that the Fed needs to raise interest rates above 8% to beat those expectations lower. But how can the 10 year bond rate be just 3.4% if inflationary expectations are 8%?  Clearly the financial markets do not believe the New-Keynesian story and any price spike will not propogate itself into an 8% inflation rate. 

The Fed has indicated that it will do everything it needs to control the inflation rate.  Those needs depend on expectations.  The Finance approach leads to a super-neutrality of money result which means that interest rates don’t need to rise to control inflation.  In fact, the CPI print is recording changes in relative prices rather than inflation.  The New-Keynesian approach is quite irresponsible, actually, since it risks leading the Fed into a highly restrictive and economically damaging policy of extreme rate rises only to be met with the future of benign inflation outcomes that the financial markets are predicting.

The stock market’s fall in response to the CPI reflects concern about the Fed’s policy.  Put simply, the financial markets are not scared of inflation.  They are scared of the Fed.

The inflation playbook 4 decades later

The current market belief that inflation is rife comes during a time when very few in the markets can recall the oil price shocks of 1972 and 1978 nor the Volcker years of monetary targeting from 1979 to 1982.  Indeed, the ‘inflation playbook’ that central bankers are gleefully dusting off (their relevancy now is greater than at any time during the last 4 decades) is 2 generations old and, quite possibly, predicated on unproven beliefs.

The current policy response to the perceived ‘inflation shock’ really needs some modern thinking.  Let me reason…

Is there an inflation?

This question is fundamental to the policy response but no-one has proven that there is an inflation problem.  Sure, the CPI is up 8.6% year-on-year in the US but this is not inflation per se.  Energy and food prices have risen but other prices are stable.  The wide variation in CPI components (energy is +106%, airfares +60% while doctors fees are +1.1%) points to a relative price effect that could easily be reversed (the Ukraine war finishes causing oil prices to fall and post-covid demand for travel wanes leading to airfare discounting).  But, more importantly, this disparity does not fit the definition of an inflation – where all prices rise proportionally – that is an 8.6% across the board increase in prices.  Further still, inflation is not just an increase in prices – it is an increase in the rate of change of  prices.  This means that energy prices dont just rise and stop.  Inflation means that prices (all prices) rise and continue to rise through time with a propogation mechanism that allows it.  The traditional mechanism has been money – where the money supply is allowed to grow at a rate that at least matches the rate of inflation over time so that the nominal price level does not feel short of fuel to continue the price increases.  The jury is out on whether inflation is with us or the CPI rise just reflects a temporary increase in the price of a few key commodities and services.

Is inflation such a bad thing?

Despite 4 decades of stable prices, the inflation literature concluded that inflation is quite an efficient form of taxation.  Seignorage is the decline in purchasing power suffered by holders of nominal assets such as fixed rate securities and (heaven knows who does this these days?) holders of currency.  In the present case, holders of US dollar bonds and currency are paying the taxes.  Whereas in the 1970’s the amount of currency in the average worker’s wallet was high, the current situation is much lower with most electronic forms of payment being linked to interest bearing deposits.  As interest rates rise, the nominal tax on currency holdings is cushioned.  The incidence of the taxation effect or seignorage is diminished on the average worker and increased on the holders of nominal assets (typically bonds). Nevertheless, the inflation tax can make the government’s real debt burden shrink quite quickly without political repercussions.

The 4 decade old playbook

The death of inflation in the 1980’s was somewhat surprising to economists who never really got around to understanding why inflation stopped let alone why it started in the first place.  Hyper-inflations are clearly monetary in their cause and propogation but mild or moderate levels in the high single digits are curious.  Without knowing the cause it seems silly to respond with a generic policy response like jacking up short term interest rates. This was Greenspan’s Fed reaction function and arguably kept short-term interest rates too high for too long at around 4%. It does seem we are heading back in this direction particularly when the President of the European Central Bank Christine Lagarde says things like “…we will do everything we can to keep inflation within our 2% target range.” No debate here about relative prices and inflation…

Some believe that sectoral shifts are confused with inflation where prices signal resource re-allocations (eg high oil prices stimulate switching to solar) and this gets reflected in the CPI.  The correct policy response to this event is to facilitate the shift rather than stifle it.  My head and heart are in this camp.  That is, it remains to be seen whether the current CPI increase is inflation.  If not, then the price mechanism needs to do its thing.

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Australians all let us rejoice, for we love money and mischief

With over a month to go until the Australian election I am prepared to call it:  The incumbent Liberal party led by Scott Morrison will be returned with an increased majority.  Why so?  Well, the money v mischief theory has both legs in favour of the Liberal party. 

A brief recapitulation of the M v M theory with reference to the current political climate in Australia.  The first plank in the theory is that the ‘thoughtful swinging voter’ does not make up his/her mind until they are in the voting booth.  They then ask themselves, ‘ what has the current guy in power done for me?’  Money is the main issue here and the current government has done a lot to feather the pockets of the electorate.  The over 10% reduction in the petrol price recently to cushion the cost of higher energy prices is a classic.  How many electors go out to the polling booth and stop off to buy petrol on the way?   Only 1% who do this will be enough to win the election.

The mischief piece is also in favour.   Despite being one of the least inspiring, boring and uncontroversial leaders of the opposition, Mr Albanese still finds himself as favourite to win the election in the opinion polls.   These statistical flumoxes are so irrelevant and incorrect that they are not worth the paper (or electrons) they are printed on (or stored by).   Nevertheless, they find themselves in the news thereby forming the view that the true underdog is the government.   Mischievous voters favour the underdog. 

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Hey Vlad, whats in it for me?

The power for prosperity trade has long been perfected in Asia.  Be it the Chinese Communist party or the Singaporean Peoples Action Party, it is well established that if you want to rule a country you need to pay the masses for their support.  Asian people are not philosophically committed to democracy, by and large, so they will listen to a deal.  If those seeking political power want to, say, build a casino or two, or rid the nation of defiant opposition, then there is a price that the people will extract to compensate them for their acquiescence. Typically this can be in the form of rapid economic growth.  Economic power is political power in our modern era and smart governments know this.
 
The Chinese Communist Party has played this trick for decades and won.  It is difficult to foresee a situation where Chairman Xi loses power while economic growth ticks along at 6-7% per year or, put another way, the average Chinese family’s income doubles every 10 years.   But you cannot treat the electorate as stupid –  one prominent Singaporean’s  threat to cut housing assistance to electorate’s that didn’t support the PAP 15 years ago was a little too blunt to be acceptable behaviour in a nation that counts itself as the intellectuals of Asia.
 
So what can Vladimir Putin learn from Asia’s winning formula? Where do we start? Is the Ukrainian invasion a winner?…Whereas modern warfare had been expected to take place in either the bang-bang world or cyber-space it seems the true theatre of war is the banking system.  Big missiles may look good at parades and kill indiscriminately but nothing can compare with no money.  Only rich countries go to war.  Poor countries can make their own arrangements.
 
The West is doing its best to make Russia poor.  Having worked with Central Banks for much of my JPMorgan career I can say that the Central Banking community have been dragged kicking and screaming into this fight. Typically, Central Banks keep their reserves with each other since they trust each other not to default.  (The pressure on each Central Bank, however, to deny Russia its assets has been strong and they have frozen these assets.  However this sets a nasty precedent for them and they will be scrambling to protect their own reserves from similar actions.)  In Central Bank – land, liquidity is King and it is not uncommon for them to keep ‘secret accounts’ that act as emergency funds in the event of official reserves being frozen.  These accounts are typically held at money-centre banks, sometimes administered by hand selected members of the Central Bank itself seconded to the bank.  While Russia had USD670billion in foreign reserves prior to the Ukraine invasion, they may have had USD6billion in secret accounts that may or may not have been recalled.  If not withdrawn in advance, these accounts will be frozen inside the private institutions.  USD6billion is hardly enough to run a war however it could buy some time.
 
The meme-culture that has been so effective driving the likes of Gamestop to prices that cannot be justified is probably Vlad’s biggest foe.  Angry young men and women with a smart-phone and a brokerage account are difficult to placate so any company that baulks at supporting the Russian blockade will suffer their wrath.  Major companies such as Apple, Zara, Shell, Coca Cola and others have simply just abandoned their assets in Russia which is a small price to pay compared with the alternative from the meme-brigade.
 
So what, Vlad, is in this invasion for the average Russian or the far-from average Oligarch?  Cut off from their wealth and their instagram accounts, the Russian people must be asking what’s the point of the Ukrainian invasion.  Old school propaganda is the natural fallback for Vlad Putin but this is the 21st Century and no-one laps that rubbish up without asking questions.  The private jets and ships that the oligarchs play with have effectively been seized and impounded with scant regard for their property.  One can only imagine how quickly these treasures will turn to rust-buckets or become target practice for international navies.  Red Square in Mayfair will soon be overtaken by squatters.
 
Nothing above indicates that Vladimir Putin has understood the forces that have kept him in power, made excuses for his errors and allowed him to prosper.  These are economic forces that, as in Asia, have created wealth along with his power.  Putin was a folk hero of sorts, challenging the West while making his people rich.  Now he is just a thug and a murderer who has missed the point of modern politics.  What’s in it for me, Vlad? Nothing, you say, Vladimir…oh dear.  Then that is the end of you, Vlad, it’s only a matter of time… 
 
 

 

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Crypto-in-the-utility-function

Why do people gamble?  A straight application of prospect theory says that when offered the choice of $1 with certainty versus a gamble with expected value of, say, 85cents then it is rational to stay with the $1.  Yet the gambling industry is alive and well and has been for thousands of years. Why? Milton […]