Inflation, Labor Markets, and the Fed featuring Mike Ashton, the Inflation Guy

Stewart: Welcome, welcome, welcome to another edition of the insuranceaum.com podcast. Today's podcast is brought to you by SS&C Technologies, we're very happy to have them on as a platinum member. I'm joined today by Mike Ashton, the inflation guy. Always a very entertaining podcast. Mike, welcome.

Mike: Oh, thank you. That was three welcomes. Is that one for you, one for me, and one for SS&C?

Stewart: That's right, that's the three. Man, I love having you on. You're a repeat guest and your jam is inflation. I don't know if you heard our intro, but one of your very entertaining quotes is part of our new intro, we're thrilled to have it. I can always count on you. So where's the Fed right now? What's going on with inflation and the Fed, and where have they got it right, if anywhere, and where have they got it wrong?

Mike: If anywhere? I like that. Well, I think that I have to give credit where credit is due. I thought that the Fed would, in keeping with their historical approach, that they would... Back when they first started the tightening cycle, I thought they would tighten a couple of times and then something would break in the markets and they'd stop. And I guess partly because nothing really has broken in the markets, they've kind of kept on going much further than I ever thought that they would. I think that they're in the process of tapering off to, they want to end with Fed funds something around 5%. And I don't know if that's end-end. I suspect it is because it's kind of rare for the Fed to stop and then to continue.

But given how fast they've moved rates up, it's entirely prudent at this point to sort of stop and take a look around and see if they're getting the reaction that they expected to. Monetary policy does work with a lag, and so if you're tightening as quickly as they are, then you risk way overdoing it if you don't stop every now and then to take a look around. You've got inflation coming down, but it'll take a while for them to figure out is that just natural ebb and flow stuff or have we really broken the back of the thing? And that'll take some time. And so it is prudent to get to where you wanted to go and then stop and take a look around.

Stewart: On the previous podcast, you had said, basically, it's the wrong tool and money supply has expanded by 40% and you can expect prices to go up by 40%, direct relationship. And if the Fed is successful, and they will be successful, at slowing the economy and grinding jobs down. But if they get it right, it's purely by accident. And I'm paraphrasing, but that's about where that's... I love listening to our podcast because the Fed is using interest rates in monetary policy, but it is such a lagged tool that they often overshoot, right?

Mike: And I think it's important to note that they are addressing this inflation in a way that they never have. They've never used monetary policy in this way to address this problem. And that is using only interest rates rather than directly addressing the money supply. I actually just wrote a blog post on this and it's on the inflationguy.blog and it's called The Monetary Policy Revolution in Three Charts. Because I've been talking about this for a long time and trying to explain why the way the Fed used to effect monetary policy is they would restrict reserves and that would cause interest rates to go up as one of the results. And how that differs from what they're doing now, which is raising interest rates and totally ignoring the quantity of reserves, in fact over-providing the quantity of reserves.

Now the interesting thing up to this point has been, money supply growth has crashed way back down. I mean it's been flat for the last six months or whatever. And I think in this blog post I sort of show these different charts and I think you walk away hopefully understanding how that could happen, but also how the Fed either has to have a really, really good handle on exactly what the demand curve looks like for money or they've got to get really lucky. And I suspect what we've seen with the slowing of the money supply is kind of a temporary shock adjustment that will eventually, given copious excess reserves, I don't think we'll keep money supply growth down zero.

Stewart: Okay, so just so everybody gets this, it's in theinflationguy.blog?

Mike: No, it's just inflationguy.blog.

Stewart: Inflationguy.blog. And it's called Monetary Policy in Three Charts. What are the three charts?

Mike: So the three charts are, I mean they really sort of the same chart with different lines drawn on them. So the basic chart is your free market interest rate chart. So you have the quantity of bank lending versus the price of the loan. So you have your P axis, your vertical axis, and your Q axis. And the Q is the quantity of bank loans and P is the price of the loan that is interest rates. And so the demand curve slopes downward. The higher the interest rate, the lower the quantity of loans that people want. The lower the price of the loan, then the higher the quantity of loans that people want.

Stewart: Yeah, it makes perfect sense. I mean if interest rates were zero, there'd be a lot of demand to borrow money. And if interest rates are 20%, there'd be a lot less, right?

Mike: Absolutely. And the supply curve, and this is the part that's sort of the important part. So we know that demand curve is downward sloping, but we don't know exactly what it looks like. You know it's downward-sloping, but you don't know how elastic it is. The supply curve at higher interest rates, all those being equal, banks want to lend more. And it's really probably spread, not the absolute level, but whatever. As interest rates go up, obviously whoever's lending you money wants to lend you more money at higher interest rates. But the important thing to remember with banks is, at least traditionally, the supply curve eventually goes vertical. There, historically, has been a point at which banks couldn't lend more because they didn't have enough available reserves and the Fed had not provided enough reserves for banks to lend more. And so the way that the Fed effected lending was to make more reserves available so banks could then lend more.

And so that shifts the supply curve. And that's chart two is, here's how we traditionally would tighten is we would pull back on reserves which moves that vertical part of the supply curve left, you get higher interest rates, you get a lower quantity of bank loans. So that's the way it traditionally has worked. And then chart three is, okay, let's suppose though that we're not going to do anything with reserves. We're just going to put a floor on interest rates. Okay, we're just going to move interest rates and let's suppose that the floor is binding, which of course it's not with the overnight interest rate. But then that creates a different dynamic, let's just put it that way. And you can see that third chart on the blog. But it means that if you guess the shape of the demand curve exactly right then you know exactly where to raise interest rates to, to get the quantity of loans and therefore the amount of money you want.

But you better know that curve exactly right. If you're at all wrong, then you can get totally disparate outcomes. And so the optimistic way of looking at what the Fed is doing right now is that they're raising interest rates to the neighborhood of what they think is the right answer. And then they're going to look and see if they're getting the right outcome, if they measured that demand curve right, if they guessed correctly. And that's sort of the optimistic way is that they understand that they're doing something that's totally different and they want to see if they've calibrated it properly. That's the optimistic way of looking at what they're doing.

Stewart: So we just got through with the drama of, oh, we've hit the death ceiling. And it's like when you get politicians, it just makes me shake my head. But you go, okay. Now when rates are as low as they were for as long as they were, there's a lot of folks who say that created inflated asset values. And while the Fed has this stated target of, I think it's 2%, who knows. But one of the ways that you deal with this massive outstanding amount of debt is you can inflate it away. So can we talk a little bit about, do you think the Fed is really going to land and be comfortable with a higher level of inflation? I mean when the cost of the interest on this debt is increased, there's bigger implications here than just loan demand. I mean, how does that all fit together?

Mike: Well, you hear that a lot, the idea that the Fed and other policymakers want a higher level of inflation to inflate their way out of the debt. But if you try to sit down and you build yourself a model of what you'd have to do to inflation to inflate your way out of the debt, it just doesn't work. It works under the following circumstance. You have a lot of long-term debt termed out and you're not adding lots and lots to that debt. That's pretty important because everything you're adding, obviously you're adding at the higher interest rate. And you don't have anything directly related to that higher level of inflation. Well, we don't tick any of those boxes. Most of the debt is relatively short-term, like in the next five years kind of thing. So that if you raise inflation over the next two years, five years from now you've rolled all that debt at the higher interest rates. So that doesn't really help you that much.

Two, we are also continuing to add lots and lots of new debt at these higher interest rates. And three, there's an enormous part of the liabilities of the Federal Government that is inflation-linked. Medicare is implicitly inflation-linked because it's linked to the price of medical care and Social Security is explicitly inflation-linked. And so there's really not... If the Fed wants to inflate their way out of our debt problem, it just ain't going to work. And I think they know that, there's no real way if you spend a half hour trying to take those pieces and try to model them and okay, so now another year has passed, here's the price level, here's the value of the debt, now we roll it over and blah blah blah. You just can't make it go away. You can't make it even decrease all that much. Unless you have an enormous spike in the very short term. So get inflation to 50% or 100% or 20% for one or two years and then drop it back down and then you can get away with it.

Stewart: That is a very radical-

Mike: A, it's almost impossible to do-

Stewart: It's almost impossible, yeah.

Mike: B, it doesn't help you with the Medicare and Social Security part, which are trillions and trillions and trillions. But at least your marketable debt in that case would go down and be less of a burden. But it's really hard to do. And then you refinance any of that 20% debt and you can reduce that problem too. But it's awfully hard to do. And actually, I think part of the problem that we're going to run into now is I think that the Fed has successfully re-normalized interest rates to where they probably should be in the long run. Maybe the 10-year rate should be a little higher between 4% and 5%, in the long run. You're talking 2% growth, 2%, 2.5% growth, and 2% 2.5% expected inflation. So, nominal rates between 4% and 5% in the long run.

But the problem is as you start to roll over all of the debt and add new debt, you automatically increase the deficit because of the interest rate costs going up quite a bit. And with inflation like we've had it, you're getting a 9% increase in the Social Security expenditures. I think that the problem that could visit on us, and on the Fed by later this year, if we're unlucky, is that it gets harder and harder to place an ever-increasing amount of debt, which makes interest rates go a little higher. Remember, the last time we had these massive deficits, we had the Fed buying. And now the Fed is not buying and even letting some of the debt roll off.

So you would expect a higher equilibrium interest rate. And if that's the case, then that means more interest, which means more deficit, which means more... So at some point that might be the thing that breaks not stocks, but maybe bond, the bond market breaks and then the Fed is going to have to step in and try to control that sell-off. The Bank of Japan has been dealing with that a little bit and the Bank of England went through a little bit of the same sort of thing. So if the US has to do it, then it's obviously a much bigger issue because we have so much more debt.

Stewart: So just as a refresher, nominal interest rates, that's the interest rate that is quoted in the market. There's the real interest rate, which is theoretically the nominal interest rate minus inflation, that's the real rate, right? Those are the three components of essentially, right?

Mike: Well yeah, you have to be careful because people don't talk about real interest rates the right way. So if you look at the 10-year treasury rate and say it's 4% and you look at current inflation at 6%, then you say, well we have a -2% real interest rate. Well that's not right. The real interest rate for 10 years is tied to the 10-year inflation expectations. So you just have to make sure that you match your maturities there. And so right now we have an environment with long-term real interest rates of 1.5% ish, 1.5% to 1.75%, and you have long-term expectations around 2%, 2.25%, which is insane, but that's kind of where you get around the 4% interest rate.

Stewart: And that's-

Mike: High threes.

Stewart: Okay, so is that long-term inflation rate expectation observable? I mean, is there an index that you look at?

Mike: Yes. It's observable, well in sort of two ways, but one way is to look at the inflation swaps market. So where one party pays a fixed rate and the other party pays actual inflation over the next decade or whatever the tenor is. And so that's a very direct way to view what the market is pricing that risk at. And the other way is to look at the difference between TIPS, which is a real interest rate plus what actually happens to inflation over that time period and comparing that interest rate to the nominal fixed interest rate.

So we call that the break-even, what inflation do we need to be indifferent between those two things? And those two measures of inflation give slightly different answers for quantitative reasons. But they both say roughly now that over the next 10 years the market 'expects' that's in quotes, market doesn't really expect anything but risk is being exchanged at something like a 2.25% CPI average over the next 10 years. Which just strikes me as outrageously optimistic and probably the best we're likely to get. And so therefore the risk is kind of one way from there.

Stewart: When you say optimistic, you mean, if I'm interpreting this correctly, that the inflation expectation is lower, or on the low end of what you would expect given everything that's going on today?

Mike: Exactly, given what we've just gone through. So before we had the inflation spike up to 8%, you could be excused for thinking that a long-term inflation expectation should be around 2%, because that's what the Fed was targeting and they'd been successful for 20 years. So that's not a bad guess. Now if you are an insurance-minded person, then you should recognize that the tail risk to that is all to the upside. And so you should be willing to pay that expectation knowing that if you get a long tail upside outcome, then it's all in your benefit. And in fact, that's exactly what happened. If you were smart enough to be buying break evens around 2% prior to this whole debacle, you've done quite well, even though expectations have now gone back.

But now that we've actually seen that outcome, it beggars belief that that's still where you want to exchange risk, because now you've actually seen the tail risk case. You've seen the hurricane, you never knew anything about hurricanes, and so you insured a bunch of Florida real estate, and then a hurricane hit and you said, "Oh, criminy, I need to price that insurance differently." But the market is not pricing it differently, they're still selling hurricane insurance at the same price they were prior to the last hurricane. That's crazy.

Stewart: That's an interesting analogy.

Mike: I just came up with that on the fly.

Stewart: That's the kind of brilliance you bring to this thing. That's the kind of brilliance that you bring to this podcast.

Mike: You can't dazzle them with brilliance, baffle them with bull. That's what my dad always said.

Stewart: Absolutely. So do you forecast interest rates yourself? Do you have an expectation of where you think the 10-year note is… call it six months from now? Is that something that you dabble in or is that something that you just say “Uh-huh, I'm not touching that.”

Mike: Well, look, before I was a trader and an inflation guy. I was a fixed income strategist. I mean, that's kind of what I did. And so I can't-

Stewart: You're not an inflation guy, you're ‘the’ inflation guy.

Mike: ‘The’ inflation guy.

Stewart: ‘The’ inflation guy-

Mike: I mean even before that.

Stewart: You're branding people. We got to talk to your branding.

Mike: Even before I was ‘the’ inflation guy though, I was ‘an’ inflation guy. So you have to start with the generic, the ‘an’-

Stewart: Got it.

Mike: And then you go to the definite article after that. But even before that, I was a fixed income guy and so I sort of had to do that. And so I don't like to do this but anyway, I'll mention my blog a second time, inflationguy.blog. I haven't done this for a number of years, but I did put up a 2022 year-end thoughts about 2023. I hate doing year-end outlook pieces. But I think I guard it properly by saying, look, this is just how I'm thinking about how all these things work and fit together. It's really the right questions. Anyway, so I do have sort of a forecast in there and I talk about some of the things we've already been talking about. But I do kind of project that at the end of the year for 10 years, I put in there 1.85% on TIPS yields, that's real yield and 2.65% on breakeven. So you add those two together and you get 4.5%.

Stewart: There you go.

Mike: So four and a half percent 10-year rate at the end of the year.

Stewart: Let's change gears just a little bit. So headline recently, there's been a lot of talk around tech layoffs, right? It's like, oh my god, Google laid off and Microsoft laid off and whatever. And at the same time, my wife is a huge fan of the CBS Sunday Morning show. And so we're watching that thing yesterday and they do a piece on ChatGPT, this AI writing app that I think Microsoft paid a fortune for. And AI, everybody's talking about AI. So what's your view of the labor market right now? And this is kind of a wacky question, but how do you think AI is going to impact the knowledge worker, the lawyer, the accountant? The people who are in rules-based professions that, there was a Stanford professor who said "AI won't replace lawyers, but there will be lawyers who use AI and lawyers who don't use AI and the lawyers who use AI will ultimately win." That was the gentleman on yesterday morning. So lots of stuff thrown up against the wall, but it's our last question. So what the heck?

Mike: No, look, I mean I think that AI, any new whizz-bang technology, its capabilities get initially exaggerated and eventually we come back to earth. And clearly it all depends on your timeframe. Eventually, AI will be able to do everything humans can do, probably. This is sort of a sick and sad observation, but will AI ever replace lawyers? Will they ever replace accountants? And the answer is they won't. And it isn't because AI can't do the math. It's because that one of the reasons that we need an accountant, one of the reasons that we... I mean, I can do my own taxes, it's not that hard to do. But one of the reasons is that we need someone to point fingers at, I can't sue AI. And if my lawyer, my doctor, my accountant gives me malpractice, I can sue them. And so that's a locus for a lawsuit, is the actual human being who's doing it, who supposedly has judgment.

So unless, someday law will change and recognize that you can sue whoever offered you the chatbot, the AI, we're going to still need those people. And that's horrible. But even if they use the computer, we use computers to do stuff that we used to use big ledgers and to write all the information down in. So I just think it means labor changes. I don't think that the need to work will go away. It didn't go away with the invention of the cotton gin. It didn't go away with the invention of the plow. It didn't go away with the invention of the computer, the internet. It just changes and it'll disadvantage some people and it will advantage some other people. And at the end of the day, 40 years from now, we'll probably have more leisure because that's where we've been trending for the last 200, 400, 2,000 years. But I don't think the need for labor's going to go away. And I guess that's what I think about that.

Stewart: That's interesting, I think that's interesting. So what about the labor market more generally? What are you thinking here? When you see the layoffs and whatnot, do you view that as an early sign or a late stage sign? How do you see it?

Mike: I think I've said this on your program last year, that with what happened to energy prices last year, with what happened to interest rates, it's inconceivable that we will get out of this without a recession. It would be the first time ever that we've had those things happen and not have a recession. My view at this point, and it scares me a little bit because I think it's a consensus view, and I hate having the consensus view, is that we're going to have a recession. And it's going to be, say, a soft recession or a garden variety recession. Something we haven't had in forever and ever and ever. But that's sort of what it feels like to me. I think that there's enough demographic contraction that it's going to be hard unless you have a real disaster happen. It's going to be difficult to get the unemployment rate super high, especially as we're near-shoring everything.

So it's going to be much harder to export jobs and we're going to be importing jobs. So I think that we are in a better place in terms of keeping everybody employed than we have been in the past. But the bad news on that from the investor's standpoint is that as a worker, you represent the labor's share and you want labor to have a greater share of GDP, because you're labor. As an investor, you want capital to have a better share of GDP, and those two add up.

And so labor has been getting less of a share over the last 20 years. And that's why corporate earnings share is so high. But one of the things that inflation does is it gives more power to organized labor, it gives more power to individual laborers. And the shortage of labor generally gives more power to labor. So I think that you're going to see layoffs, you're going to see the unemployment rate go up, but it's not going to go up to 9%, it's going to go up to 6%. But you're going to see margins come down as workers have to compete for what it is now starting to become a workforce where skilled labor is somewhat scarce. Or maybe they just hire a ChatGPT and call it a day.

Stewart: There you go. All right, so I got a new icebreaker question for 2023.

Mike: Oh no.

Stewart: You ready?

Mike: You didn't warn me about this.

Stewart: I know, this is what makes it great, right? Okay. Who would you like to have lunch with? Anyone, alive or dead?

Mike: Who would you like to have lunch with? You mean, other than you?

Stewart: Oh hello, well that's very kind. Absolutely, it'd be my pleasure.

Mike: Anyone alive or dead? Well, obviously, being a Christian, the first answer that jumps to my mind is Jesus. But I think he probably wouldn't enjoy the same kind of food that I do. So that might be a... Seems like he'd be a salad guy.

Stewart: How did we get to that?

Mike: Don't you think?

Stewart: I don't know.

Mike: I'm imagining. But actually, I think it would be really interesting, and I'll make this a one of two, you choose. I think that the giants of the time period when I was growing up in the early eighties, the political giants were Ron Reagan and Maggie Thatcher. And I think either of them, I didn't want to go back to Winston Churchill. But I think that Margaret Thatcher and/or Ron Reagan would be just super interesting and entertaining to have lunch with, for different reasons. I think Margaret Thatcher was much more of a hard-nosed leader, and especially as a woman for that time, I really, really admire her. Whereas Ronald Reagan was, obviously, super entertaining and intellectually a lot higher up the scale than people gave him credit for. He was an economist, actually, before he ever became an actor. So I think either of those people would be super interesting.

Stewart: Outstanding. Mike, thanks for being on.

Mike: Well, thank you for having me again. I'm sure I'll probably see you again on this.

Stewart: I certainly hope so. We will get you slated for next quarter, it's fantastic. I have to thank our sponsor, SS&C technologies. The views expressed on this podcast are our own, Mike's and mine. Thanks for listening. If you would please follow us and rate us and review us on Apple Podcast, we'd sure appreciate it. And if you have ideas for podcasts, please shoot me a note at podcast@insuranceaum.com. Thanks for listening. My name's Stewart Foley, and this is the insuranceaum.com podcast.

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