Inflation: Transitioning to Troubling from Transitory

Stewart: Everybody's talking about inflation these days and there's nobody better to ask than Mike Ashton, the Inflation Guy. Mike, thanks for coming back on.

Michael: It's good to be back here. Thank you for inviting me back. It must not have been that bad the first time.

Stewart: You know what? This is something that economists and people in your line of work don't like to do is go back and go, "Hey, what'd you say the last time." But in your case, you were on the money and I want to talk about that. First of all, this is Stewart Foley, I'm your host. This is the Insurance AUM Journal podcast. At the end of the day though, you started doing your own podcast.

Michael: Thanks to you.

Stewart: And lo and behold, I see you all over Bloomberg and I'm like, maybe this podcast launched your career. I can't imagine, but hey, never know.

Michael: I'm a little old to be launching a career.

Stewart: Yeah. Tell me. Definitely, that one hits close to home. Let's talk about the inflation, what you talked about last time. You talked about this concept of kernels of popcorn popping and that's what inflation really was. I'm a geek about this kind of stuff. Can you talk just to kind of level set the conversation so that people can understand the terms that you're going to use? Talk us through the popcorn inflation analogy?

Michael: Sure. We tend to think about inflation and I think has something to do with how it's taught but we tend to think about inflation as sort of this smooth process. That 5% inflation means all prices went up 5% and that's obviously not the way it works in reality. Now there's a lot of economics that doesn't work the way in reality. And in fact, that's part of the problem we're having now is that the economists in charge are expecting these things to work the way they do in the book and they don't really work that way. But when we look at inflation, what happens is if you have 1% inflation, it doesn't mean that every year when you go into the barber that they raise your cost of a haircut by 1%. And when you buy a tomato, it goes up in price every month by 1/12th a percent or anything like that, that's not how it work.

Michael: Prices are sticky and have jumps and not everybody raises their price at the same time. It's the analogy I used last time was microwave popping corn, where you put a bag of microwave popping corn into the microwave, you apply heat and then you start to hear popcorns popping. They don't all pop at the same time and the reason I use that analogy is that we have this tendency and we were seeing it when we had this last podcast, we were seeing a tendency to sort of explain the individual pops. That well, this is used cars and it's because of this. And this is we're having a problem with computer chips due to this and all these one offs and acting like they didn't matter because they were all one offs.

Michael: But the point is that that's what inflation is. Eventually you have of all of these one offs popping and the microwave popping corn bag is full of popcorn. It's this sequence of different things popping all the time that gradually aggregates to the entire price level being higher. That was sort of the analogy is that it's not a continuous process. It's a discontinuous process.

Stewart: And is it fair to say, to kind of go on this popcorn analogy that at the end, you've got a bag full of popcorn and you've got a several kernels that just didn't pop. That over any given period, some prices in the basket are going down. They're not all going up at a uniform rate and they're not all going up. Some are going down. I don't want to put words in your mouth.

Michael: No, that's great. Let's take this analogy until it breaks. And you also get some kernels in the bag that are a little bit burnt. Some of them pop more than others or pop earlier so they get burnt. There's an unevenness of the process and it would be really weird if they all kind of went up the same way. But at the end of the day, rather than focusing on the kernels and especially if you're a policymaker, you're trying to figure out, well, how do I stop this? It's not helpful to focus on an individual kernel. What's helpful is to say, "Well, let's remove heat from the bag."

Stewart: Yeah, absolutely.

Michael: Because the raw cause is we're pouring heat into the bag.

Stewart: Let's go just a one step further because I'm practicing without a license as it is so here we go a little bit more. I've thought for a long time that this Phillips curve analogy where you've got this relationship between inflation, unemployment and fiscal stimulus and monetary stimulus, that that's sort of the theory behind it all on the underpinnings but that requires in our vernacular here, the lid has to be on the pot or the popping corn is really only US. But once you get the global economy involved, is that why you said policymakers may be getting it wrong because it's not like what's taught in the book? Is that globalization? Is that geopolitical? But clearly it's different today than it was taught when Adam Smith came up with a couple of ideas. Is the model different? Let's say it like that.

Michael: Yeah. Look, I think the problem is that a lot of the theories about inflation that policymaker use now they've developed over the last quarter century when there was no inflation. And so testing those models has been difficult. And so we're finding that there are a lot of things that they got wrong and they're actually in the last couple weeks, have been a couple of papers that come from Fed staffers about inflation expectations and the importance or lack thereof of anchored inflation expectations. Now I've been skeptical of that forever because I don't think that.

Stewart: Just for the people, anchored inflation expectations means just in colloquial English?

Michael: Sure. The theory is that if everybody expects 2% inflation and you get 5% inflation temporarily, that you kind of know it's going to be temporary because the inflation expectations would actually drive prices. That a seller, a vendor cannot persistently raise prices at 5% because the consumer will rebel and not buy the product because they expect 2%, you raised five and so they think you're being mean and they won't buy your product. Now, I don't know about you but when I go to my grocery and I say, "You know what? Price of milk went up too much. You're a big meany, I'm not going to buy your milk."

Stewart: Right, exactly.

Michael: He says, "Then don't buy the milk and we're able to sell the milk at that price." And so inflation always seemed weird to me that if you know anybody who is a business owner, they care about what their customers think.

Stewart: Absolutely.

Michael: But that's not all they care about. And so we also don't know how to measure inflation expectations very well so we're relying on anchored inflation expectations to explain why it is that prices won't go up seemed really crazy. And these papers, one of them in particular, basically said, "The theory behind this is weird and there's no reason to expect it to work. The data doesn't suggest that it's worked, the model is bad." And so that's one example of a model that was developed over the last quarter century, was a really important model or still is for a lot of central bankers and yet doesn't appear to really have much connection with reality. But there are a bunch of examples of that. And the Phillips curve is one of those things that gets debated a lot. And I do think that part of the problem is globalization but part of the problem is also that Phillips curve means different things.

Michael: Phillips when he wrote his original paper said that unemployment and wages are related. He didn't say anything about the broad level of inflation, unemployment and wages. And it turns out that that's still true. Unemployment and wages are actually really are still quite tightly related. Unemployment and consumer prices have become disconnected but you can see there's already an extra step there and that's, well, what are wages doing relative to consumer inflation? What're real wages doing? And that doesn't rely on the same things as the general price level. There are just problems with these models. And again, going back to it, we developed a lot of these models and in a period where there was no independent way to test them. And so, now we're going and figuring out which of them break when we actually have actual inflation.

Stewart: Let's get back. I'm sorry, because I'm completely geeking out on that. What'd you say last time? Because you were dead on the money. Just can of you remind everybody what you said when we talked, I don't know, a quarter ago?

Michael: I think..I believe I used the terms spastic. What I was focused on was as someone who's mostly a monetarist was that we had money supply growth at 23% or 25% a year and that was literally unprecedented. We've never seen anything like that. And anything that was even, in the seventies it got up to 14%. And in fact we'd never seen any society where you had that kind of money growth that did not have inflation. And so it was absolutely inconceivable to me. Yes, money velocity declined for some different reasons but it was inconceivable to me you could have that much money printing and not have it result in a vastly higher price level.

Michael: And so you have the bottom line is that again, thinking about taking the heat off of the bag, basically, the federal government was spending money as if it was just being printed. It was made up money and then turned out that it was being printed and made up money. And so between those two things, not terribly surprisingly, you got inflation. And when we first talked, we didn't have that inflation yet. It looked like it was going up but it wasn't 5% or anything like that. I think we were worried about used cars and that was kind of it at the time.

Stewart: You also talked about insurance companies were obviously exposed to inflation, which means their liabilities go up. They also have big bond portfolios that when the inflation goes up, the value goes down generally, so that's an issue. And we said, what can insurers do? And I believe you also said that there's an increase in the probability of a tail event. Do you want to just kind of recap that? Because I want to get into your current outlook because I think it's really a good one and an interesting one.

Michael: Yeah. I guess in the context of an insurer, I think that insurers are sort of naturally positioned to understand the hurricane like nature of an inflation event. That they're infrequent events that have very long tails. If you look historically through the data, you find that it isn't that inflation kind of goes from two to three to four to three to two and just kind of wanders around. It'll do that for a while but then once it starts heading higher, you get very high numbers and something like, I can't remember the numbers right now, but something like a third of the time in the last century that we've been over 4% inflation in the US, we've also been over 10. And so that's sort of the problem from an investor's perspective.

Michael: And again, I think insurers understand this better than a lot of investors is that you may have a portfolio that works pretty well at 2% inflation and 3% inflation and maybe starts to suffer a little bit at four but completely becomes unraveled over that. And the problem is that once you get up to four, you just can't tell how far it's going to go and it can go really, really far and so you have these nonlinear effects. Again, there isn't a whole lot in the investment world that really behaves quite that way but I guess it's a little bit like a credit breakage or something.

Stewart: Yeah. And I think too, just the way the regulatory framework is set up and ratings framework is set up, you get a lower capital charge on highly rated fixed income instruments and the things that can hedge inflation better than that. I'm not saying you can hedge inflation perfectly at all but what I am saying is that long dated high grade corporate bonds are at the bottom of the list as the ways to do it but the regulatory framework and ratings framework make it difficult for insurers to buy assets that can hedge that risk, which really puts them in a challenging position. Is that fair?

Michael: Oh, absolutely. Things like commodities that have very high inflation betas are just poison from the standpoint of an insurance company.

Stewart: Right. Exactly. I know you've got about five components of your current outlook. Can we just start with the first one, core inflation?

Michael: There are different ways to measure inflation in the central tendency of inflation. And we tend to focus on the core measures, core CPI, core PCE. In a second I'll talk about the other things like median or trim mean, but core inflation. Back when everyone started to get concerned about inflation and core inflation, we were seeing these really large jumps up coming from things that were recovering from COVID, the COVID categories, people would call them or the shutdown categories. Things like air fares that had gotten absolutely obliterated in 2020 were recovering. And by the way, haven't gotten all the way back to where they were previously but we're bouncing a lot. And so in the first half of this year, you had a bunch of those items, lodging away from home, air fares, things like that that were bouncing back and were pushing core inflation higher.

Michael: And that's kind of when everybody started to say, "Oh, this is transitory because these are just things coming back from the dead." The problem is now we have kind of high and kind of rising core inflation but those categories actually pushing down. Airfares have kind of rolled back over and the last couple months have been declining. Hotel prices are going down again, partially because there've been some renewed shutdowns but partly because they kind of go up and down but you can no longer look at those things and say, "Well, this is all just used cars."

Stewart: Right, exactly.

Michael: It's all just airfares.

Stewart: Right. You're starting to see cars on dealer lots, not full, but definitely starting to see them. You think in short that core inflation right now is being held down. You're an independent guy and at the end of the day, that's a Mike Ashton statement that I love and I love that because I've not heard anybody else say that.

Michael: It's being held down by the things that everybody was pointing to and saying, "That's the reason it was going up." And so those things aren't going up anymore, they're going down. So you can no longer look at core inflation where it is and say, "Well that's because of those categories going up." It isn't anymore. And so core inflation is still rising but one of the reasons it's still rising and is going to stay higher and keep moving higher for a while is that we have rent inflation and that's I think, so we've moved from these kind of one off things to these big, slow moving broad categories like shelter. And by the way, this isn't really a mystery, we've known for some time we were going to get a rise in shelter inflation. It was being held down by the eviction moratorium.

Michael: It turns out that when you stop people from moving around, then you could have all the increase in asking rent in the world, you could have all the increase in home prices but if everybody is staying in the same apartment that they were in last year and especially if they're not allowed to be thrown out so that not everyone pays, that tends to depress rents. And so that was what was happening. And as soon as we did away with the eviction moratorium, people started to move, people who hadn't paid rent suddenly said, "I'm going to leave and go start paying rent somewhere else." And all those things started to push rent inflation higher and it's going to keep pushing it higher for quite a while.

Michael: I think we've moved beyond even just for that reason, we've moved beyond the whole COVID categories thing. And so it's getting harder and harder, well honestly, I think the whole transitory thing is dead. The things we pointed to and we said those are transitory in the way it was originally meant, those aren't the reason that inflation is high and rising now.

Stewart: You also are mentioning that inflation is broadening. Can you help with that? Just kind of explain it?

Michael: This was the actually the most alarming thing from the most recent CPI report wasn't rents, we kind of knew that was going to happen. It wasn't all the weird little categories. The most alarming thing was that if you looked at some of the broader measures of inflation, you saw very large increases. Median CPI, I probably don't have to explain this to your listeners but I often explain it. The median is the point at which 50% of the categories and 50% of the weight in the basket is inflating slower than that and 50% is inflating higher than that. Unlike an average like core CPI, it's the not influenced by the outliers. Really the used car prices on one side and the airfares and the other side, those things don't even show up because we were talking about the middle of the distribution.

Michael: Well, median inflation had the largest monthly change since 1990 in the most recent figure. The 16% trimmed mean CPI, which is another way of looking at the middle of the distribution and cutting off the tails, also had the largest jump in decades. And so those are measures which are not going to be influenced by little one off changes. That's indicating that the center of the distribution that most prices are now rising and median inflation jumped at a level that's roughly 5% annualized, that zone. And that should be disturbing because that's real and it means you're seeing it everywhere. Almost 80% of the components of CPI are inflating faster than two and a quarter.

Stewart: Wow.

Michael: And two and a quarter is roughly what the Fed's target equates to on CPI. It's roughly two and a quarter and 80% of the basket is inflating faster than that.

Stewart: Heaven knows that there's enough versions of CPI in the world but core CPI, if I'm reading between the lines here but I can look at median CPI and perhaps get a more representative view than if I look at core CPI, is that fair? Or is it I'm looking at two different things?

Michael: No, no, that's true. Right now when there are all moving a lot, it's hard to figure out what's the best indicator and they're going the same direction, they're just going at different rates because of the various base effects and how they happen. But if you had to pick an indicator that was going to help you forecast next year's inflation, then something like median or trimmed mean is much better than core inflation and headline. Think about headline inflation, which is core plus food and energy. The reason we take out food and energy is they're mean reverting. Well, they're not mean reverting recently but they tend to be mean reverting. And so if gasoline goes up a ton and so headline inflation is 7% but it's because of gasoline, then 7% isn't a good forecast. In fact, a better forecast is that that's going to reverse going forward. When you look at a median or a trimmed mean, you don't get kind of those mean reversion effects as much and so it tends to be a better forecast. This is kind of weird and quanty and geeky and I'm sorry about that.

Stewart: No, no. Love it. Hey, this ain't Joe Rogan. We're here to talk inflation. I saw the other day that the term geek is derogatory and I'm like, not to me.

Michael: Not in our business.

Stewart: What about the argument that this is a supply side problem and as soon as these shortages, we've got all these, I was at a fundraiser the other day and somebody held up their phone and they said, "All these dots," it was a map of the US and they had all these green dots all over both coasts and they're saying, "this is all the ships that can't unload because of this and that." And these folks were not economists or investment folks but it had is just kind of how the general public views some of these things. Is it a supply side problem? And when these shortages are okay, will it take some tension off the rubber band? Or is it just we've had a lot of stimulus and just unavoidable?

Michael: Yeah. It's just the public, there's a lot of economists and a lot of people at the Fed who will say that, "Well, it's just a supply side. We've got a supply chain issue and we've got too many container ships are stuck at the ports and once we get that cleaned up." And again, that goes back to sort of the models, where they were taught. What you're taught in is if there's a shortage of something because demand went up then well price adjusts and supply comes out and we get to a new equilibrium. And that happens more or less instantly in the models. And the reality is that that's not how the real world happens. It takes a while for supply chains to adjust. Now, does that mean that, oh, nothing to worry about. It's all supply chain, this was just bad luck. Well, it wasn't bad luck at all.

Michael: Just think about what happens coming out of a normal recession when you don't have central banks pouring trillions of dollars onto the demand side. What happens in a normal recession coming out of a normal recession is that the people who are making stuff get paid wages and they use those wages to buy the stuff. Not necessarily the stuff they make.

Stewart: Yeah, buy other stuff.

Michael: Right. But so the two sides are kind of going up at the same pace. That as your demand is increasing, your supply is expanding because you're hiring more people and that creates more. You get this sort of cycle but those two things, national income and GDP, kind of think about what you're producing and what the income is, go up at the same pace. And so you don't have these massive supply problems. When all of a sudden you say, "Okay folks, we're just going to give you an extra trillion dollars to spend without making an extra trillion dollars worth of stuff." Hey, guess what? It's a shortage.

Stewart: And it creates a disequilibrium.

Michael: A disequilibrium. Well, that's exactly right. And moreover, again in economic theory, you don't care about disequilibriums, they resolve into equilibriums. But in the real world, what happens is partially a price response. You get inflation to ration the shortage of the lack of supply. But the other thing is that the shortage itself is unmeasured inflation. That because supply cannot fully respond to the equilibrium, neither does price. And so what will happen as the supply chain comes back online gradually is prices will keep going up because that's part of the getting to equilibrium part is that.

Michael: And so at some point when the supply chains have all resolved at higher prices than they are currently, then yes, we're going to go from 5% inflation or 6% headline inflation, we'll get over 6% in the next couple months. We'll go from five or 6% inflation back to three or 4%. But I think we have sort of permanently broken sort of the natural equilibrium we'd kind of reached at one and a half or 2% inflation and we're just going to have a higher equilibrium. But we are going to eventually the price increases will probably slow. It's just it's not going to happen this year. It's not going to happen for at least until late next year and maybe not until 2023.

Stewart: I love this stuff. I know it's it's sad. It gives you some insight into my social life. That's not true. It's great because of my wife. But so in your mind, it's an unusual recovery. What does it mean maybe for the next, I don't know, this is a crazy thing but maybe we could have you on next quarter and can you give us what you think is going to happen on the next quarter? And then do you have a kind of a longer view? Or how do you kind of put it together as to take your views into a higher level outlook?

Michael: Sure, sure. Actually the inflation derivatives market kind of allows you to get a look at sort of the monthly prints in advance, not the real monthly prints, but what the market thinks. And so based on that, we know that headline inflation is likely to be above 6% in the next couple of months. A lot of that's energy pass through. And the real question is what's core? What's the median? What are all those things going to do? In my view, core inflation is going to into early part of next year is going to be over 5%. The housing, the shelter component is going to take a while to resolve and that's going to keep an upward pressure on core and median for a while. The really interesting thing to watch will be the sort of dispersion statistics of how broadly we're seeing these price increases.

Michael: As I said, right now, 80% are inflating faster than two and a quarter. I suspect that's going to continue to be broad and to stay broad and maybe even to broaden further. And so that's what to watch because if that happens, then we're not just waiting for now shelter to adjust, that says everything has got to adjust higher. And as I said, if the supply chain thing is real, as it gets resolved, you'll see higher prices along with the resolution. And so we have a ways to go. If you increase the money supply 25, 30%, then monetary theory says that you need to have the price level go up 25 or 30%, less than that because some of that is going into actual growth but you've got to see the actual price level go up high double digits, high teens. And that won't happen in one year but that says it's a multiyear process of 5% or 6% or something like that. I think that we're going to keep having pressure well into 2022 and like I said maybe 23.

Stewart: I'm dumbfounded by that so I'm just trying to process it, but also. The way that finance is taught, the 10 year note has a real rate component and an inflation expectation, add those two together, you get the nominal yield. Happy days. You're looking at a 5% core rate of inflation, 10 year at 160 call it, real rates, negative three and a half, whatever the math is and you go, okay, now if the bond market was allowed to just trade, that would be a substantial increase in the yield of a 10 year note. And which would be, if that's an eight duration, for every percentage point increase, you've got an 8% decrease in price, ish.

Michael: It's a bad day.

Stewart: Yeah, It's a bad day.

Michael: It's a bad day.

Stewart: People would stop listening if I used the term convexity. But at the end of the day, that's rough. The central banks have to keep their thumb on the scale and hold down that rate. It would be catastrophic.

Michael: Yeah. Look, it's really hard to figure out how you get this mess in a way that is good for asset markets because if the Fed, for that matter for the US Treasury, who has to pay interest now on many trillion more bonds, if you want to keep interest rates low, then that means you have to keep buying more bonds, which puts more money into the system and that's not likely to work. One of the reasons that asset markets are as high as they are, is that the repression of the overnight rate, of various short rates, means that everybody who doesn't like 35 PEs on stocks and 1% yields on bonds, they were all hanging out in cash, which you could stomach when inflation was at 1% but now inflation is at 5% and you're like, well, holding cash at 5% inflation is a really bad idea so I've got to do something with it.

Michael: I think there's a lot of the flows you're seeing going into stocks, commodities and sustaining these levels of bond yields are coming out of deadly cash. When you think about the next step and how do you then unwind that? What makes the music stop is people have moved all the cash that they want to into the market and eventually that music stops playing and then everybody looks at value but it's very hard to figure out when that will happen. But if interest rates are allowed to get to the level where they're reflecting inflation expectations and reasonable real rates, then it's obviously really bad for bonds but it's also going to be bad for equities in that case as well.

Stewart: Let's wrap on a happy note, just tell people what you do. What's the name of your firm? You've got a new podcast. How do people get a hold of you? You do economic, you do inflation consulting, that's what you do.

Michael: I do. We do all kinds of stuff.

Stewart: All kinds of stuff.

Michael: Yeah. If it's related to inflation, that's what we do. They call me the Inflation Guy and we actually have a new app, that's the Inflation Guy app.

Stewart: Wow.

Michael: I'm still trying to figure out.

Stewart: Look at you. All right.

Michael: Yeah. You should look at it. It's got a logo that it's me in a Superman costume kind of totally anatomically correct. I'm just going to mention that when you see it.

Stewart: Whoa.

Michael: Yeah, no. I got guns, I got guns.

Stewart: I like it.

Michael: Yeah. We have that. We have the new podcast, nine episodes in. It's called Cents and Sensibility, the Inflation Guy podcast. My company is Enduring Investments so you can go to enduringinvestments.com and fill out the contact form there. I'm kind of around. I was in Business Week, recently, lots of fun stuff.

Michael: And so what do we do? We consult with corporations, insurance companies, asset managers on these things. Not as much forecasting as sort of diagnosing. Where's the leak. I kind of say we're sort of the Sloan Kettering for inflation. We specialize in the diagnosis, management and reduction of inflation related risks. I think last time I was on, I said we were inflation plumbers. I'm going to change our model here on the fly but we also manage assets ourselves. We're actually, we've got a strategy that we are in the process of deploying. I have to be careful how we say all this so I don't make everybody mad but that is effectively, the whole point of it is to give people inflation protected cash, if you will. And so it's supposed to track month on month, CPI inflation plus a little bit.

Michael: And it has a very high, a 0.7 correlation to the month on month changes in CPI, leading it by a month. And the idea is, when we didn't realize when we deployed this how popular it would be that people really do hate cash. They really do hate cash. And so you give them an opportunity to get inflation protection on their cash, meaning that they don't have to go and plunge it into stocks and right now with inflation at four, five, 6% and cash yielding zero, that seems like it's not a bad thing to think about doing. And so that's the sort of thing we do. We do strategies that involve commodities, sort of inflation FX. We also do it in non-dollar currencies as well.

Stewart: Very cool. Mike Ashton, the Inflation Guy. Thanks for being on.

Michael: I hope I come back. I hope my forecasts are good.

Stewart: Me too, on both fronts. I hope you come back too. If you have ideas for a podcast, please email us at podcast@insuranceaum.com. My name is Stewart Foley and this is the Insurance AUM Journal podcast.

The InsuranceAUM.com podcast is available on