inflation Archives - Page 2 of 2

November 17, 2018

Federal Reserve Independence

When it comes to Federal Reserve policy, we need to focus our worries about the correct thing. Hint: It’s not inflation. Also, it’s not recession. Also, It’s not the rate of interest rate hikes.

It’s the Fed’s independence. Even President Trump agrees with me. Although admittedly, for reasons diametrically opposed to my reasons.

In recent weeks, President Trump has ramped up his attacks on the Federal Reserve. Trump told Fox News that “my biggest threat is the Fed.” Also, that the Fed is “loco,” and he’s unhappy “because the Fed is raising rates too fast, and it’s too independent.”

After three interest rate hikes earlier in 2018, the Federal Reserve will raise short-term interest rates one more time this year. The Fed will likely rise another 1 percent over the next two years, according to their future guidance, and barring unexpected developments like war or recession.

The fact that Trump is unhappy is not particularly surprising. In fact, White House grumbling about the Federal Reserve is a common enough theme over the last eighty years. Not using Trump’s uniquely colorful language, mind you, but it’s still not wholly new.

History of Presidential Jawboning

Political leaders in power always want pro-growth policies. Low unemployment and high asset prices tend to make leaders look good. Presidents generally don’t want the Federal Reserve to – in Fed Chairman’s William McChesney Martin’s famous phrase “take away the punch bowl just as the party is getting started.” President Nixon reportedly blamed his 1960 loss to Kennedy as a result of Fed Chairman Martin’s tight monetary policy of high interest rates.

President Johnson complained as well, saying “Martin, my boys are dying in Vietnam, and you won’t print the money I need.”

President Nixon reportedly both put pressure on Martin’s successor at the Federal Reserve Arthur Burns to keep interest rates low and money flowing during his 1972 re-election, which he handily won. Paul Volcker, Fed Chairman during the 1980s, published a book in late October 2018 in which he claims President Reagan’s Chief of Staff James Baker told him in 1984: “The president is ordering you not to raise interest rates before the election.” Volcker adds to the story that the Federal Reserve at the time had no plan to raise interest rates.

George HW Bush was upset in the fall of 1992 that the Fed was raising interest rates, before he went on to lose his re-election to Bill Clinton.

President Clinton’s budget chief Leon Panetta and later Chief of Staff twice tried to preempt the Federal Reserve, saying at his 1993 confirmation hearing “we ought to have cooperation from the Federal Reserve,” meaning lower interest rates, and then in a 1995 interview “it would be nice to get whatever kind of cooperation we can get to get this economy going,” referring again to Federal Reserve policy. Despite the instincts of leaders in power, Federal Reserve observers think we have made a lot of progress since the bullying of President’s Johnson and Nixon.

Presidents George W. Bush and Barack Obama avoided appearing to try to influence interest rate policy. Inevitably, political leaders oppose higher interest rates because they reduce business borrowing, risk increasing unemployment, and knock down asset prices of real estate and stock markets. Political leaders want lower interest rates – it’s stimulative to the economy, and therefore helpful for their political prospects.

Volcker’s legacy

Since Paul Volcker famously raised interest rates early enough in the Reagan presidency to tame inflation in the early 1980s, the Fed has built a rock-solid reputation as independent from political influence. It is believed to manage the money supply without favor or political influence, giving investors worldwide confidence in the dollar.

The key question then is whether Trump’s attacks on the Federal Reserve will have an effect. We need to hope they do not. Just as the greatest risk to Trump’s presidency is not the independence of the Fed, neither is the greatest risk to the US economy inflation or the rise in unemployment, the two typical concerns of the Federal Reserve.

Rather, the greatest risk to the US economy is that people the world over would come to believe that the US Federal Reserve is not acting independently of political pressure. A primary reason the dollar still remains the global reserve currency of choice is that global allocators of capital believe the Federal Reserve is not captive to the US political system.

In a clever take that emphasizes a silver lining in the storm clouds, the Wall Street Journal’s Spencer Jakab recently argued that Trump’s recent Fed bashing is actually a good thing, since it proves that the Fed is willing to do an unpopular thing for the right reasons. Since it continues to defy Trump’s wishes, we should be happy that the Federal Reserve is under attack. I mean, I guess? Like a Category Five hurricane slamming against the retaining wall protecting the coastal city is a good thing, because it didn’t break the wall this time, and that shows us how strong the retaining wall is right now. So, yay, hurricanes? I’m sorry, that logic is bass-ackwards.

The real risk

We can survive a recession. We would have a harder time surviving the loss of confidence that would follow if Trump could jawbone the Fed into keeping rates low, for political purposes.

We can survive a little inflation. A little inflation does not make us much closer to Venezuela. Rather, a political leader who can get what he or she wants with monetary policy does make us a lot more like Venezuela.

Please see related posts:

The Federal Reserve and Inflation

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November 9, 2018November 9, 2018

Federal Reserve and Inflation

The Federal Reserve has raised short term interest rates three times already this year by one-quarter percent, and it seems poised to do so again in December, even though it left rates unchanged this week. Over the next two years, barring an unanticipated war or recession, the Federal Reserve will raise short-term rates by another percentage point.

We may have different reasons for benefiting from higher or lower interest rates, depending on whether we are primarily borrowers or savers, employers or employees, exporters or importers, young or old.

The effects of rate hikes on the economy are complex and incredibly important. But we probably think of interest rates and the Federal Reserve a bit like changes to the earth’s climate – massive forces shifting ominously, seemingly far beyond our individual control. We vaguely understand them to have huge implications. We’d like to know more, but how?

There are two big questions to understand today about the Federal Reserve and rising interest rates.

First, what is the relationship between inflation and interest rate hikes?

Second, what is the proper relationship between political leaders and the Federal Reserve?

I’ll talk about the inflation question here and leave the political question of the Federal Reserve for a later post.

From a multi-decade perspective, we’re moving from artificially low interest-rates – dating back to a period that started with the 9/11 attacks and were renewed by the 2008 financial crisis – to a more “normal range” interest rate environment.

In normal times, the Federal Reserve raises rates when it worries about inflation, and it lowers rates when it worries most about unemployment. The Fed’s not worried about unemployment – currently at a 49-year low. Instead, the Fed seeks to keep inflation in check. But because inflation apparently isn’t rampant, the Fed can take it’s time with gradual rate hikes.

One of the great economic mysteries of the last decade is the absence, or at least inconsistency, of observable inflation, despite the fact that the Federal Reserve pulled out all the stops to make lots of money available in the years following the 2008 financial crisis. Pretty much every observer, even supporters of the post-2008 crisis policy of easy-money-plus-low-interest-rates, predicted a significant uptick in inflation. That, seemingly, was the price we had to pay to kickstart the economy.

But then, it didn’t happen. Or it didn’t happen in the way we expected. From the beginning of 2010 through September 2018, the Consumer Price Index – a traditional measure of inflation – rose only 16.4 percent. Annual inflation averaged less than 1.7 percent in that period, which is totally non-threatening. Consumer inflation from 2010 to today is like the dog that didn’t bark in the night.

We can be a bit more sophisticated though in understanding different types inflation and what it means for different people in an economy.

Inflation types

We should be aware of least three different types of inflation.

There’s the traditional type of consumer price inflation we see, which shows up in the price of gasoline, the stuff we buy at WalMart, health care, tuition, and the cost of a pizza on a Friday night. I know you think you’re paying too much lately for this stuff, but compared to other decades consumer inflation has been pretty modest.

At least two other types of inflation matter as well, however, asset price inflation and wage inflation.

Asset price inflation shows up as the increase in the price of real estate and the stock market. We generally cheer this type of inflation as a healthy sign of economic growth, although it’s not a purely good thing, depending on who you are.

To pick one real estate measure for example, the St. Louis Federal Reserve House Price Index for Texas has risen by 49.8 percent since the beginning of 2010. In other words, even though consumer goods cost just 16 percent more, houses in Texas cost 50 percent more than they did in 2010. What about stocks? To pick another measure, the Russell 2000 Index of small capitalization stocks is up 150% since the beginning of 2010. The rise in stocks isn’t entirely inflation, as its partly due to retained profits and buybacks, but inflation is part of that 150% rise in stocks.

So, is asset inflation good or bad? It depends.

Where you stand depends on where you sit

If you’re a twenty-something or thirty-something trying to save for your first home purchase, and home prices rise by 5-10 percent each year over a decade, this type of inflation actually hurts your plans. Similarly, for a young person trying to accumulate a retirement account nest egg through stock investing, a rising stock market is actually quite a bad thing. A twenty or thirty-something saver and investor should fear asset price inflation because it makes their wealth-building plan much harder to enact.

Interest rates hikes have traditionally had a dampening effect on asset price inflation.

Finally, there’s wage inflation. If you’re a worker earning a salary, you of course want high inflation of your wages and benefits. Measuring the change in the Employment Cost Index for civilian workers since 2010 until the latest 2018 numbers, we can calculate an average of 19.2 percent inflation in total compensation.

An employer, obviously, will experience wage inflation as a big problem, one that directly cuts into the cost of doing business and profits. A worker, by contrast, directly benefits from wage inflation.

I mention all these different types of inflation because interest rate hikes tend to dampen all three types – consumer, asset price, and wage inflation. Depending on who you are, higher interest rates will affect you in different ways, even though we typically only think of consumer inflation. Are you a worker or an employer? Are you an importer or an exporter? Are you young or old? Are you a borrower or a saver?

With observable consumer inflation so low, does it even make sense for the Federal Reserve to raise interest rates? President Donald Trump doesn’t think so. He has argued in recent weeks that the Fed is “loco,” and that “my biggest threat is the Fed,” and because “you don’t see that inflation coming back” that he disagrees with the Federal Reserve’s moves to hike interest rates.

Let’s talk about that in a later post.

Please see related post:

Federal Reserve and an Independent Central Bank

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April 17, 2017

100 Year Bonds In The Trump Era

The United States does not currently issue bonds with maturities longer than 30 years, but the idea of super long-dated national debt is back in the air. Long-dated, as in bonds due in 100 years. One reason 100-year bonds are kind of neat is that nobody alive right now ever needs to worry about paying the principal back!

Setting snark to the side (for just a moment), Treasury Secretary Steve Mnuchin, in an interview in December, appeared open to the idea of 50-year or 100-year bonds, floated by financial newspaper Barron’s back in November 2016.

Barron’s followed up in February with the report that Mnuchin asked his staff at the Treasury department to look into the pros and cons of 100-year debt.

Some of the best reasons for the United States to issue 100-year bonds fit reasonable, prudential, debt-management principles. Other reasons facilitate wackier scenarios. I’ll describe both.

But first, who would buy 100-year bonds from the United States? Buyers are not typically individuals like you and me, but rather institutions that have to make payouts far in the future.

Barbara Mckenna, Managing Principal of Longfellow Investment Management Co, a Boston-based firm managing over $9 billion in assets, noted to me last week that buyers of ultra long-dated bonds tend to be pension funds and life insurance companies, institutions which need assets to match their liabilities, stretching into the future for many decades.

These were the buyers for Austria’s 70-year debt issued in late 2016 at a rate of 1.53 percent. Ireland and Belgium both issued 100-year bonds earlier in 2016 presumably to that type of buyer as well, both reportedly with a 2.3 percent coupon.

“Feed the ducks while they’re quacking,” we’d often say in my old bond salesman days, when we issued new debt. There’s an element of that to justify the US issuing 100-year bonds. Right now, the pension funds and insurance company ducks would happily quack for extremely long-dated US Treasuries, so we might as well satisfy their hunger.

The three most legitimate reasons for the US to issue ultra long-term debt are:

To ease “rollover” risk,
To fund ourselves at historically low rates, saving money, and
To facilitate long-dated corporate bond issuance

First, if your country issues mostly short-term debt, as ours does, the “rollover” problem happens constantly. If you have, on average, more long-term debt including for example 100-year bonds, you’ve gone some way toward relieving your rollover problem.

Next, the cost-savings from long-term low rates could be significant. A few numbers can help put this into context.

The federal government currently owes approximately $19 trillion to all creditors, and paid $433 billion in interest on its debt last year.

The federal government pays 2.26 percent on all of its debts, as of March 31, 2017, an extraordinary low rate.

15 year ago, the average interest rate on long-dated bonds was 8.27 percent.

10 years ago, the average interest rate on long-dated bonds was 7.55 percent.

Right now a 100-year bond – depending on a variety of factors such as the size of issuance and the demand from investors – could cost something like the current rate on 30-year bonds, or approximately 3 percent per year. McKenna agreed with me that a 100-year bond “probably would not be dramatically different from a 30year bond in terms of yield.” It might cost the US government a bit more, although it also might cost less.

While a 3 percent 100-year bond would represent a higher rate than the US currently pays on average over all, locking in that rate for a long-time probably offers big interest cost savings over the long run.

We’ve got close to $2 trillion in long-dated bonds outstanding currently, due between 10 and 30 years from now. To point out some simple math (albeit simple math with a lot of zeros involved) a 1 percent drop in the average interest rate on a trillion dollars in long-dated bonds saves $10 billion per year in interest payments.

The third reason for 100 year bonds – and this reason appeals more to bond nerds like me, concerned with smooth-functioning capital markets – is that private corporations can issue more long-dated debt if there are long-dated US Treasury bonds to compare them to. Bond traders really like corporate bonds to match the length of government bonds, as it makes hedging and trading those corporate bonds much easier.

So 100-year US Treasury bonds aren’t crazy, could be issued affordably, and offer some capital market advantages.

Now, you’ve been patient with me and my bond math, so let’s get a little crazy. For readers interested in historical bond trivia – and yes, I’m talking to both of you – ultra long-dated bonds have interesting ties to global catastrophes.

England issued perpetual bonds to finance itself during the Napoleonic Wars, and 100-year debt to finance itself during World War One.

I think of this global catastrophe and 100-year bonds because a time may indeed come in the medium-term future when we have trouble rolling over our debts.

If we were in a shooting war with China – or even just a nasty trade war – for example, we might have trouble with the fact that Chinese institutions own approximately $1 trillion of US sovereign debt. Heck, if we get into a shooting war with North Korea this week or next week we might face rollover trouble, as a signal from Chinese institutions displeased with our unilateral military actions.

Fortunately, our current President has deep experience with the inability to roll over debts. He ran his casinos into the ground this way. Given his experience, he stated his plans for federal debt issuance while still a candidate, just last summer.

“I’ve borrowed knowing that you can pay back with discounts. I would borrow knowing that if the economy crashed, you could make a deal.”

Oh, sweet mercy, please, no. But then a few days later candidate Trump clarified, default isn’t really necessary. “People said I want to go and buy debt and default on debt. I mean, these people are crazy. This is the United States government.”

I was starting to feel better.

But then he continued,

“First of all, you never have to default because you print the money, I hate to tell you, okay, so there’s never a default.”

Ah, yes. Thank you Mr. President for clarifying your views on sovereign debt.

Dear Treasury Secretary Mnuchin: Can we please issue massive amounts of 100-year bonds quickly before anyone re-reads these quotes and thinks about them too closely?

A version of this post ran in the San Antonio Express News and the Houston Chronicle.

Please see related posts:

Trump and the coming Financial Crisis

Trump: Sovereign Debt Genius

Book Review: The Making of Donald Trump by David Cay Johnston

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May 24, 2015

Rent vs. Buy – The Simplest Answer

The “Rent v. Buy” discussion offers endless opportunities for debate.

We can talk about the opportunity to buy a piece of the mythical ‘American Dream’ – on the path to acquiring key accessories like a white picket fence, 2.3 children, and a Viking stove.

We can talk about the extraordinary risks taken by mortgage borrowers borrowing to the maximum before 2008 and the devastating financial losses many suffered in the aftermath of that financial crisis.

We can talk about the pride of fixing up one’s own dwelling as an owner. Or just as easily, we can note the smug satisfaction of calling Bob the superintendent and ordering it done. Make it quick, Bob!

Some of these preferences derive from personal leisure time preferences, risk tolerance, or lingering Leave It To Beaver fantasies. I don’t have any comment on those factors.

I do have comments, however, on the financial implications of the Rent v. Buy debate.

Online calculators

You can find delightful Rent v Buy calculators online.

I prefer The New York Times’ calculator myself, but there are other great ones on various realtor’s sites as well as brokerage sites. Another site, BankRate.com walks you through a series of qualitative questions to determine suitability for home ownership versus renting. These are all fine and cool.

I do not recommend spending too much time with any of these online models, however, because ultimately the financial models depend on inputting assumptions about a bunch of unknowable future financial factors. Do you know what your income taxes and real estate taxes will look like five years into the future? Do you know the future rate of inflation, the rate of increase in rent, the insurance and repair costs of a home? I mean, if you had certainty and accurate insight into these things you’d be running a high frequency trading fund by now, not fiddling around with online rent v. buy calculators.

I’m in the ‘making things simple’ business, and I believe you only need to satisfy two conditions to make the move from rent to buy.

First thing: Do you have a steady, predictable income? If you do not, then home ownership is a terrible idea. It’s just too risky.

Second thing: Do you plan to stay in the same place for the next five years? If not, real estate values are too volatile to mess with, and the frictional costs of getting in and out of real estate ownership are too high – after factoring in brokerage, title, loan, and attorneys fees.

So that’s it: If you’ve got a steady income and plan to stay five years in the same place, then go for it.

Wait, I haven’t said this strongly enough.

Commodities Trader says Buy — Commodities Guy says: BUY! BUY! BUY!

Picture me for a moment like those commodity trading pits guys (who don’t really exist anymore) a phone in each ear and tie askew, hands gesticulating wildly and shouting “Buy! Buy! Buy!” into both phones simultaneously. That’s how strongly I feel about the financial advantages of home ownership, if you can satisfy my two conditions above.

In order of importance, here’s why home ownership offers powerful financial advantages.

Automatic Savings

I can’t prove this, but I’m convinced this is the most important financial reason to buy a home. Most of us have no extra money month-to-month, so the idea of putting money away for long–term investments is, let’s say, elusive. But when we own our home with a mortgage, we end up paying small chunks of principal in the ordinary course of paying for our shelter. Over 30 years many middle-class homeowners manage to sock away hundreds of thousands of dollars of wealth without much pain because it happens monthly, automatically, even sneakily.

Tax Advantages

Everybody talks about the mortgage interest tax deduction, which is fine, but not the most important tax advantage of home ownership. The most important tax advantage – by far – is that in most scenarios when you eventually sell your home, $250,000 of capital gains are tax free, or $500,000 for a married couple. No other financial asset offers that kind of tax-free growth in value. Not only that, but real estate taxes are deductible from federal income taxes, as are other mortgage expenses like ‘points.’ Home ownership is just a great big bundle of tax advantages, courtesy of your middle-class homeownership-pandering Congress. Thank you US Congress! We love you! Muah!

Inflation hedge

Hey gold bugs, you’ve got the wrong idea. Home ownership is an awesome inflation hedge, because you can reasonably expect the price of your home to go up in line with inflation. When you rent, inflation hurts. When you own, inflation helps. If you own a home, especially with a mortgage, you can be all, like, ”Inflation? Bring it on! I am hedged!”

Leverage

That’s finance-speak for buying more than you can actually afford, through borrowing. Of course being debt-free is a great idea that everyone should aspire to, but the leverage part of home ownership has long been a key part of middle-class wealth-building.

Outside of mortgages, lenders will never offer you 4-to-1 leverage, meaning the chance to buy a financial asset by only putting 20% upfront and paying off debt over time.

How does leverage work?

If you put down just 20% of the value of a thing, and then the thing goes up in value by 10%, with 4-to-1 leverage the value of your ownership in that thing increases by 50%. This is amazing! Obviously leverage (aka debt) is a double-edged sword and can lead to catastrophic losses if your thing goes down in value by 10% (or more!) But still. Leverage!

Small print disclaimer before my summary conclusion: I have not mentioned the issue of down payment (you need it!) and decent credit (you need it!) when deciding on Rent v. Buy. So there’s that to consider as well. But for now let’s focus on the simple message below.