Inflation and the Fallacy of Composition, an Interview with Mike Ashton, The Inflation Guy

Mike Ashton Headshot

Not a day goes by that we’re not hearing about inflation in the headlines, and that’s why we’ve gotten Mike Ashton, the inflation guy, back on with us. Mike, thanks for being on.

Mike: Hey, it’s always good to be back here. This is getting to be a regular thing and I like it.

Stewart: That’s exactly what I was going to say, it’s great to have you back on frequently. You and I start talking and I think sometimes people lose sight of the commercial aspects of what you do. You’re the managing partner or CEO of Enduring Investments. Can you talk a little bit about what Enduring Investments does, and for clarity, you and I don’t have an economic relationship here. I love your views on inflation and that’s why you’re on, but I just want people to know what you do.

Mike: I appreciate that. I’m an inflation guy. And so, Enduring Investments, it was originally conceived to be an investment management firm specializing in inflation. And that’s a lot of what we do, but it’s really a vehicle for deploying intellectual property around my expertise in inflation in lots of different ways. So everything from consulting, we’re now getting paid a little bit for content creation, which I never really thought was going to happen. We license investment strategies to other asset managers. We run some investment strategies for our own clients, both in separate managed accounts and commingled accounts. So I like to describe us as being sort of the Memorial Sloan Kettering of inflation. We spend time diagnosing inflation illnesses and problems and curing them. And we’d like to be thought of as sort of the pre-eminent place to go if you’re feeling a little under the weather and you think you might have an inflation disease.

Stewart: I like that analogy. You’re also an expert witness, right? You’ve served in that capacity as well.

Mike: Yeah, that’s sort of, again, not something that I necessarily sought out, there isn’t a whole lot of inflation-related litigation out there, but it’s just, again, it is another way to deploy a rare expertise in inflation and inflation markets and inflation trading and inflation investing and so on.

Stewart: So everybody’s talking about this, right? Inflation’s up a record amount, followed up by another record amount. You and I trade emails once in a while. And my job on this deal is to have some crackpot theory, and you put some facts around it and say, well so here’s my anecdotal thing. I’ve heard about a zillion people say of all walks of life, well things are so high right now. And I’ve got a diesel pickup. I paid $5.65 for diesel. Three-quarters of a tank was a hundred and a quarter, which raised my eyebrows. Most I ever paid for to fill up a vehicle. We all know fuel prices go up a lot faster than they come down. I know of four construction projects that are on hold because building materials are so high and that smells like a recession. You’ve got people like the CEO of Goldman Sachs saying the recession risk is high. We’ve proven an old economic theory which is: you add a bunch of stimulus and inflation flies out the other end. And this has been a pretty quick case study, right? What is going on? Can you separate truth from fiction and headlines from reality and what’s really the case out there?

Mike: Well, what I like about you is we get these nice focused questions where I can give a yes or no answer.

Stewart: Somebody said to me, “Has anybody ever described you as laid back?” And I’m like, “Never.” And what you get out of these questions is what is rattling around in my head. That really ought to scare you. I’ve released a video that, as you know, that gives you some insight. So, sorry. I’m sorry in advance.

Mike: No, that’s okay. That’s okay. Look, I mean we’re all hearing the same questions and the recession one—I think I’ve been pretty straightforward with my approach to this question. I think there’s almost no chance we don’t get a recession. I think that when you have gasoline prices doing what they’re doing and you have the federal reserve raising interest rates, either one of them usually leads to a recession. You put them together and you’re kind of guaranteed to get a recession. I’d be shocked if we don’t get one. And I’m going to say by the year, by early 2023, because if you’re in Congress and you’ve got an election coming up, there’s an enormous incentive here to start writing big checks again, which would prevent you from recording a recession at least until later this year, early next year.

So I kind of think that even though I think we’re sort of right before it, I think they’ll manage to push it off until after the election. But I can’t imagine we are not going to have a recession. Now, the next question that people tend to ask me when I say there’s going to be a recession, is they say something like, “Whew, that’s great. Inflation will go down.” And sadly, that’s not the way things work. And so inflation is going to, and we are past sort of the peak inflation rate, but we’re not going to see falling prices and we’re not going to see inflation go back to one or 2% just because we have a recession, unfortunately.

Stewart: And there’s been a bit of a reset, right? One of the things that COVID changed is it allowed a lot of people to go buy a house and move where they wanted to in retirement, but keep working. Right? I mean houses have just been, at least in our area, we’re out in the hinterlands of Chicago land, lots of house purchases. With regard to fuel prices though, while there’s a lot of headlines and it makes good TV, a lot of us are buying less fuel and driving less than we had to. Is that a mitigating factor?

Mike: Well, see-

Stewart: See, that’s not crazy of a question. That’s a not-

Mike: No, that’s good.

Stewart: That’s somewhat narrow.

Mike: Much more focused and it’s true, at least in a personal consumption sense, we’re probably consuming less gasoline than we used to. And certainly, when you get high prices, you tend to consume less, there is a price response, although it turns out that gasoline demand is fairly inelastic in the short run and it’s very elastic in the long run. So over the next couple of years, you’ll see people move from the SUVs to smaller cars and so eventually you’ll get some price response to it.

You’re right. Probably the bigger effect is the fact that people are working closer to home than they used to. But whether it’s supply or demand, I think a lot of it obviously is the supply side. You do have high prices. And, I guess the other sort of thing to keep in mind is that we don’t tend to think about this in terms of when we think about commodities, but we’ve raised the overall price level. And so even if you have prices go back down relative to yesterday’s price, they’re still going to end up being higher than they were the two-year-ago price.

Stewart: Yeah. That’s a great point. I mean, and it’d be the CPI geek for a second. I mean, what you are measuring is changes in prices of a set basket of goods, right?

Mike: Yes.

Stewart: And that’s what gets published.

Mike: Well, and I think that by the way, there’s been a lot of talk about peak CPI. I think this is a horrible mistake of communication from the top, but a lot of people talking about peak inflation, and the administration’s talking about this all the time and economists are talking about it all the time. The problem is that peak inflation, peak CPI, to an economist means the rate of change is going to go down. But if you say peak inflation to the average person on the street, they think you mean prices are going to go back down to where they were, and that’s not going to happen. The price level has changed. We have gone up. And if we have peak inflation, then that just means the rate of change is going to slow. It doesn’t mean prices are going to go down. I think that’s where we are. Even if inflation decelerates from here, there going to be a lot of people who are expecting prices to go back down and they’re not actually going to get it.

Stewart: I think from a risk to the economy perspective, that would be deflation-

Mike: Right.

Stewart: … which we’ve never seen it, but it’s a death spiral. Right?

Mike: It’s as far away as it has been in a long time, we’re not going to get deflation, but you’re right. But that’s the way people though think about when you see peak inflation. Somebody said to me the other day, they said, “I’m glad we’re past peak inflation. I’ve been waiting to buy a used car until prices go back down.” And I’m like, “I got news for you.”

Stewart: You’re going to be waiting a while. Yeah.

Mike: But it’s waves versus tide. Right? So the tide is coming in. The tide is rising prices. And so prices are gradually rising. Every wave is going to a higher level price-wise. And so even if you have a wave that pushes a relative price back a little bit, it doesn’t go back to the old level. And that’s what the rising price level means. And we’ve got 40% more money in the system than we did prior to COVID, that tells you that the price level is going to be 30%, 40% higher at the end of all this. And we’re not there yet.

Stewart: And someone said this to me, that COVID, while a health disaster and a health pandemic, economically had less of an impact than was originally thought and that, in retrospect, maybe there was excessive stimulus. Is that how you see it? I don’t want to put words in your mouth here. I’m just trying to figure out, is that a fair way to look at it?

Mike: No doubt. No doubt. If you compare national income to GDP, we are production-wise, GDP-wise, we’re kind of back on the trend where we were pre-COVID, but income-wise we’re way, way, way, way above that. And that’s because we created money and dropped it into people’s accounts and that’s where all the inflation comes from. So no doubt that the government, if they’re going to force us to shut down, they needed to do something to make sure people don’t starve, but they way, way, way overdid it. And I think we knew at the time they were way, way, way overdoing it.

Stewart: But like a lot of things right in the immediacy of “We have to do something and we have to do something significant in order to stem the fears of: “I’m going to starve to death,” And it ended up being too much, but you go, “Okay, well, what’s the other side of that?” And the other side of it is ugly. Right? It’s really ugly.

Mike: Well, I think that you can make a good argument for trying to—Here’s the way I look at it. If you look back at the global financial crisis, the banking bill was 800 billion or something. And so you go into COVID and you’re like, “Well, this is much bigger, this is a global pandemic. So it needs to be bigger than 800 billion.” And the 800 billion didn’t have any inflation effects. So it didn’t because it was a banking crisis, not a sort of different type of crisis, but so we can afford to add more. I think that was the initial thought. The real mistake and then, by the way, we’re talking orders of magnitude. We’re not trying to fine-tune this to get the right number of millions we’re trying to just get, oh, how many trillions.

But as soon as you knew that you had done too much, then it was incumbent on the incumbents to just start pulling it back and to shrink the Fed’s balance sheet and stop buying all the bonds and let interest rates go up if that’s what was going to happen and stop spending money like it’s going out of style. And that didn’t happen. We just kept on going. And that’s where the real mistake was made. It’s very hard to blame people, blame the government for doing too much in April 2020 but by September 2020, we knew it was too much. So it’s kind of from that point on that things got really bad and we’re going to be paying the price for it for some time now.

Stewart: What about the labor market? People have said, called it the great resignation, other people have called it the great upgrade. You know, the fact is that I see a ton, a ton, a ton of help wanted signs every which way. “We’re hiring,” factories, restaurants, you name it. Where did the labor force go? What happened? Because everybody, I mean, these stimulus checks weren’t a zillion dollars. I mean, it helps, but come on. What happened?

Mike: Well, so let’s go back to the income versus GDP. So we’re back on the old trend of GDP and that’s kind of limited by how much we can actually produce. And one of the things which limits how much you can produce is how many people you can hire. But the income, that amount of personal income is still way, way above that, which means that each individual business says if I had more people here, I could produce more and sell more. And so every single business says that. So you have what looks like, well, what is a real shortage of labor. We would have had the same shortage of labor before if we had had the same level of demand, but we’ve created this supply constraint, right? So everyone talks about this being a supply disruption and supply constraints.

They’re really not. It’s really a demand constraint. We created way too much demand. And that’s when you find out what you could be doing, if you had enough supply, that’s why stuff piles up at the ports, suddenly everybody needs lots and lots of goods from overseas. It’s why you see all the help wanted posters is because everyone is walking around with a STMI check or an extra-large bank balance, because they got a STMI check and so they want to go out to eat. And so there’s a shortage of labor in that, in that respect. But again if we didn’t have that big stimulus, then right now we’d be producing and consuming at about even levels. And you wouldn’t see this, the big imbalances we’re seeing. So it’s all self-induced, but by the way, that’s part of what the recession will end up doing is taking away that extra income and bringing it back into alignment unless the Fed keeps printing to try to stop the recession, which we’ll see, would not surprise me at all to see further stimulus once we start to see growth weakening.

Stewart: Yeah. And I mean, there’s an old joke that goes, “What does every first term politician want? It’s the second term,” right? They don’t care after the election what happens. It’s like, “I need to get my seat.” So housing, I would love to tell you that I’m some sort of a financial forecasting genius, but clearly this was dumb luck. We locked in like a 275, 30-year fixed mortgage. That rate is substantially higher today. Housing prices seem to be strong, not a lot of supply. What do you think about the housing market? Is it overextended? Is it just a reset of the price level? People are moving to where they want to go live. I mean, what do you see there? Do you see another housing crisis? Seems like it’s easy to get a mortgage. I see people advertising 5% down and the kind of stuff that you saw before the GFC.

Mike: Well, and yet you have people talking about how traffic is slowing in the realtor markets, the outlook for existing homes, existing home sales was very weak last week. It was weaker than expected. And it was kind of back to the levels prior to COVID, but prices are continuing to rise. We have to separate these things and so for 25 years, we’ve connected quantity and price, and those are not guaranteed to go together. This is why you can have a recession and you can still have inflation.

Those are not necessarily related. And that’s what you’re saying in the housing market. You’re saying less turnover, less foot traffic, but guess what? First of all, as you get these higher prices. So what I keep hearing is people are being priced out of the housing market. And so housing prices can’t keep going up. Well, first of all, the first people who are priced out of the housing market are the new home buyers who have elastic demand. If you have an existing home that you’re going to sell and move to another existing home, you’re not very price sensitive because you’re doing a sprint.

Stewart: You’re hedged.

Mike: Yeah.

Stewart: Right.

Mike: And so the fact that there’s less foot traffic, it’ll affect the number of sales, but it doesn’t necessarily affect the price. But the other thing is it’s a real asset. And so again if we’ve got 40% more money, so since, (I was doing this the other day) since 2010, M2 is up 148%. So the total amount of money out there is up 148%, which tells you have the value of your individual dollars down commensurately and home prices are only up 122%. So that to me, even though it sort of accelerate, and actually, if you look at the chart, you look at the chart of money growth versus the chart of home prices, they kind of are parallel. And when we got this inflection over COVID and the Fed started printing money like crazy, that’s when home prices accelerated.

So you sort of see this chart and you get this nice inflection at the same point. But if you sort of look at home prices as a multiple of incomes and sort of all the traditional ways that we tend to look at, at housing to see if there’s a bubble, you’d start to get a little concerned. Part of that is that incomes lag. So I don’t really see any real problem there yet. I mean, at some point obviously, there probably will be. And if the industrial purchasers of housing, all of the institutional purchasers of housing, all the pension funds that have been buying up houses as a real asset, if they all ever decided to put all that inventory back on the market, then you’re going to have a problem. But at least so far, I don’t really see that there’s a major problem in housing. I can see that the home sales will decline, but prices are going to keep going up.

Stewart: That’s interesting. We had a-

Mike: By the way, they’re not going to go up at 25% a year like they’ve been going up.

Stewart: Right. Yeah.

Mike: 15% over the last year in the last 12 months, about 14% or 15%, they’re not going to keep going up that fast, but 14% or 15% when you have inflation at 8% is the same as an 8% increase when you had inflation at 2%. And the problem is we’re looking at all these things with 2% inflation glasses and you see 14 birds just fat. And you’re like, “Wow, that’s really high.” Well, wait, that’s really high if inflation was at 2%, but because inflation is at 8%, a 14% increase, it’s not as much as it looks like.

Stewart: You know, while we’re on things that are impossible to forecast, we might as well add interest rates, big, big, big backup in rates. I had a prof at the University of Chicago who is at the Cleveland Fed. I’m sure he’s retired by now, but he talked about the fact that people, the average person, not an economist, not a financial services person, not a finance geek, whatever, thinks that Fed sets interest rates like they set them like, “It’s going to be this.” And as we all know, the Fed sets the overnight lending rate and the market sets the back end of the yield curve-ish. And the Fed is, in my analogy is a tree branch, right? The Fed is pulling down on the tree branch and it’s lower. It was pulling down hard and now it’s up a little bit. How much do you think, or to what extent do you think the level of tenure note is reflective of what it would be if the Fed let go of the tree branch?

Mike: When I first got into fixed income markets, our rule of thumb was, and it makes very good sense, but the rule of thumb was that nominal interest rates at equilibrium, should be roughly where nominal GDP growth is at equilibrium. So, if you’re expecting 2% real growth and 3% inflation or vice versa, then you’d expect 10-year, 30-year rates to be around 5%. And there’s kind of some good arguments from equilibrium, why that kind of needs to be the case something like that. We’re clearly way below that, we have zero real interest rates, something like that and 2.5%, 3% expected inflation, that doesn’t seem to make any sense to me either now or in equilibrium. I would think that if you get back to equilibrium, you’ve got to have real rates that are reflecting real growth in the economy.

That’s got to be 1.5%, 2%, 2.5%, and expected inflation, that’s something like expected inflation. And maybe right now, that’s at 3%, you can argue for more than that. But I think that until you get nominal 10-year longer rates up near 4% or 5%, I don’t know how you can even argue it’s equilibrium. But the funny part is, of course, the Fed does argue that’s equilibrium, does think that 2.75% is about, is the equilibrium real short-term rate. And it’s just kind of crazy.

Stewart: I don’t know, this is the professor in me. Can you talk a little bit about when you say nominal and real, just for folks who aren’t economists or whatever, can you differentiate when you had used the term nominal, yield, and real and so forth, can you just kind of unpack that a little bit?

Mike: Sure, sure. Yeah. So the real interest rate is if you got paid back in goods. So if I bought a bond that paid in pastry and I paid one cake today, and it was a three-year bond, so that in three years I get a cake back. So it’s a real bond. Okay? The question is, how big are the cupcakes, the cupcakes for the interest rate? Now, if-

Stewart: Is there a broker-dealer that sells these? Because this sounds like a good investment.

Mike: It’s like business, doesn’t it? I always go you think about what kind of real bond and I always go to pastry because that’s what I would buy.

Stewart: Absolutely.

Mike: But so then you put that in a nominal space and you can do the same thing. You just index it to pastry prices. And so your bond, that initial cake costs a hundred dollars today, but you’re going to have to pay off $120 3 years from now because the cake’s worth more, and the cupcakes would gradually increase in size. So the price of those cupcakes is your nominal rate. So if you look at a regular 10-year treasury that pays you a coupon, that’s a nominal bond. And that interest rate consists of the cupcake, the real part, and the price adjustment because that cupcake’s going up in value.

And so that expected inflation is part of that interest rate. And so when you take real and add expected inflation, you get a nominal interest rate. So nominal is the world we live in. All the prices we see are nominal prices. But if we want to compare things over time, we have to compare them relative to the price level. And that’s when you move into real space. And you say that yes, the price of a computer today is the same as the price of a computer in 1982, but the overall price level’s much higher so that it’s actually much, much cheaper.

Stewart: I really like that analogy. That’s a good one. So we’re getting kind of to the end here, what do you think as an insurance investor looking out today, what is your biggest concern?

Mike: Well, if interest rates are at 3% and I think that the equilibrium is 4% or 5% and by the way, what that also sort of means is if inflation is going at 5% and you can borrow at 3%, then you should borrow at three and invest in something which is going up with the rate of inflation, right? So, that says everybody should be borrowing at that rate, which is one of the reasons the rate should go up. But if that’s the case, if we’re going to see interest rates go up to 4% or 5%, and if inflation is going to keep going like I think it’s going to go, that also works in sort of an additional drag and we’re going to have a recession, which is what I expect then yeah, stocks are 20% off their highs, but at their highs, they were riding a wave of liquidity and very, very optimistic about the long run.

So now we’re off 20%. I don’t see, it seems to me that we could have a considerable amount further to go, not in a straight line, but we’ve got a fair amount further to go. Now the good news is the overall price level is going up. So the real price of stocks is going down. So I guess that’s good news, but stocks are not an inflation hedge. And if there’s one thing I have to, I work very hard to convey to institutional and individual investors. You know, lots of people are told and believe that the stock market is an inflation hedge because an individual business gets revenues and pays expenses that are related to inflation.

And so people think about a business as being, and obviously, some businesses are more inflation-protected than others, but a business is a real asset and stocks are not, because stocks also have a multiple attached to them and the multiple tends to go down when the discount rate goes up. So that’s the, I would say that people who have moved out of bonds because the yield is too low. They moved in equities because they think that’s inflation protected, that’s wrong. And they should be looking to diversify into more inflation-related assets, which are more expensive now than they were two years ago. But still the amount of that are much less risky as well, at least in an inflationary environment.

Stewart: So we talked about the idea that there was not additional stimulus. It was blocked by Joe Manchin. And we never talk politics here. This isn’t a political statement yet at all, but the fact that there was not additional stimulus helps, by keeping the price level down and we would have higher inflation than we would have. So you started talking about, I mean, if-

Mike: The fallacy of composition.

Stewart: Right. The fallacy of composition, meaning if we all get a check, none of us get a check. Right? I mean-

Mike: Yes.

Stewart: … talk about how that inflation translates into balancing the budget, for example.

Mike: Yeah. So this is sort of interesting. It’s not sort of, it’s very interesting. So Friedman said a long time ago, he said, “Look, the government can’t really spend more than it takes in.” It can take it in two ways. It can take it in taxes or it can take it in implicit taxes by causing inflation. And that’s not theoretical. If you look at what’s happened to the balance, to the budget balance since prices started surging higher, revenues have gone up a lot because they’ve come in through sales taxes and property taxes and income taxes. And so you’re paying more in taxes simply because the price level is higher. And so this gets to the fallacy of composition. If any one of us gets a check, it’s great. But if everybody gets a check, then the price level just sets higher and you are no better off than you were. I think we all kind of implicitly feel that, like, we all feel like we got this nice STMI check and I think we all kind of feel a little bit like we’re treading water and we’re paying higher taxes and that’s really true. That’s exactly what’s happened.

Stewart: I love it. Listen, man. Thanks for being on. It’s always great. We always have a, for full disclosure, people don’t know, but we have no questions, no prep, no prep call, no nothing. We just get on the phone and I hit the record button and you and I just start talking and it’s been great. Michael Ashton, CEO of Enduring Investments, otherwise known as the inflation guy. Mike, thanks for being on.

Mike: Thanks a lot, Stewart.

Stewart: My name’s Stewart Foley. I’ve been your host and this is the podcast.

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