Stewart: Welcome to another edition of the InsuranceAUM.com podcast. I am joined today by Mike Ashton, The Inflation Guy, of Enduring Investments. Mike, welcome.
Mike: Good to be back here yet again, Stewart.
Stewart: It’s so nice to see you. Normally on these podcasts, the guest has talking points or I do, or somebody does, and you and I do these things completely ad lib and it’s always fun. I guess we talked about maybe the yield curve, but before we do that, the Fed’s been aggressive to this point at… Well, I shouldn’t say. My opinion is that the Fed’s been fairly aggressive and the economic readings that they go off of, there’s a timing difference. It’s always this question of, have they gone far enough? Is it too much? I was reading an article about upcoming CPI release. Where do you think the Fed is? Where do you think they are in terms of their policy moves to this point?
Mike: The real problem we have with the Fed is that they’re kind of like the doctor from the 1840s; that they don’t really understand the body, they don’t understand how this all works, so their medicine is equal parts voodoo and wishful thinking.
Stewart: That’s a good thing no large corporation owns either one of us because that would not make it through compliance, I’m thinking, but I agree with you. I think you’re right.
Mike: The Fed has only just started tightening. Now, everyone thinks that, look, they’ve shot up interest rates several hundred basis points and that’s true, but that’s not the important part. That will do a great job at throwing people out of work and raising expenses for people who are borrowing money and things like that, but it does very little to quell inflation. Inflation is all about the quantity of money. M2 over the last month or two has been flat, but it had gone up 43% or something since the beginning of COVID. That means that all else being equal, you expect the price level to go up close to 40%.
It has really nothing to do with interest rates. Raising interest rates accelerates money and it actually makes things worse, but the Fed doesn’t know that. They haven’t cared about money since the early 90s, so they’re not addressing the right thing. They will succeed in cracking the economy, no question about it. Inflation will come down because that’s kind of what inflation does. It goes up, it goes down. If they can keep money supply going flat for a while, then eventually once we’ve moved to the new price level, then eventually inflation will slow back down, but they’re just targeting the wrong thing. If they get the outcome that they desire, it will be purely by chance. There’s a very low chance we’re going to have inflation next year down in the twos. That’s everybody’s forecast, and it’s just very unlikely to have.
Stewart: I don’t think institutional investors think this way, but I know that a lot of retail investors think this way, that the Fed sets interest rates. The Fed doesn’t set interest rates. The Fed sets the overnight lending rate; one rate they set directly. Then the idea is, and I geek out on this conversation, so the Fed sets the overnight lending rate and that determines the cost of borrowing to banks. Then that somehow or the other ripples through and impacts the cost of borrowing for lots of other people, but the shape of the yield curve is not set by the Fed’s decision on Fed funds rates.
Mike: All the stuff we’re talking about with the Fed has all changed in the last couple of decades. It used to be the Fed didn’t even set the short rate. They set reserve conditions and that caused movements in the short rate. Then they decided they don’t really need to actually change reserves. They just need to tell everyone what the new short rate is, but you’re right. That in and of itself doesn’t do anything to the shape of the yield curve into long lending rates unless, and again, the Fed has over the last decade or so done Operation Twist where they buy long bonds and sell short bonds and whatever in an attempt to affect long lending rates and things like that. They’re just kind of messing around.
Stewart: They’re kind of pulling on a tree branch. They’re holding it down, they’re pushing it up, but at the end of the day, the tree branch is the tree branch.
Mike: That’s right. Again, all of this really does… and it changes. Let’s just suppose that they could change long lending rates. What does that do for inflation? Well, okay. That increases the cost of money to banks and then banks increase then the cost, the interest rate associated with loans. Then the question becomes a microeconomic one of “Is more demand for money elastic or inelastic with interest rates?” Banks become much more eager to lend at higher interest rates. Do people become violently less willing to borrow? We don’t really know what elasticity of demand for loans is near-zero interest rates, but you wouldn’t think it’s going to be very large. You would think that the immediate response would be much less borrowing from highly levered borrowers like hedge funds, but the corporation that’s borrowing at 8% when interest rates are at zero, now they’re borrowing at 10%. That really probably doesn’t change very much.
Again, mega companies aside that very carefully manage their cost of capital, but smaller companies, individuals moving interest rates a percent or two when interest rates are kind of low, doesn’t really do a whole hell of a lot. Does it affect mortgages? Does it affect your desire to go buy a new home? Yeah, probably. It affects how much home you can buy, but again, what does that do to the price of grain? It doesn’t have any direct effect on a lot of these things.
Stewart: No, but it’s interesting though because it gets a lot of attention by the public media.
Mike: Well, let me say one other thing though because it’s an important next step. What I just said are ways that raising interest rates could affect growth. It will affect demand for houses, it will affect demand for cars if auto loans go up. How much it will, we don’t know, but it will affect growth. Although the Fed is going to cause a recession, growth is going to go down. There is no natural connection between growth and inflation. We act like there is, and the reason we think there is, is that recessions cause energy prices to go down, and therefore headline inflation goes down. If you just do a simple correlation, then because energy is most of the volatility in headline inflation, it looks like there’s a correlation between expansions and recessions and inflation. If you take away energy, that goes away. You can look at the 70s and have two massive recessions and also massive inflation with it.
By the way, as an aside, we had two massive recessions in the 70s and home prices never went up less than 3%. Raising mortgage costs and having deep recessions is no guarantee that home prices or the prices of anything go down. That’s an unspoken assumption that we’re making when we say yes, the Fed is succeeding and causing a recession. Okay, but that has nothing to do with inflation. Inflation is all about money. The price level that is tied to the amount of money, period. Full stop. If the Fed is not affecting the quantity of money in circulation, they are not going to affect the price level.
Stewart: Whenever we talk, I have to unlearn or rethink some things that I have in my head, which is supply and demand. The amount of money chasing goods changes the price level. That’s my core assumption. When people start talking about recession in the mainstream media, how much of the psychological impact of that results in a decline in demand, and does that slow inflation? Maybe this is a prehistoric term, jawboning it down.
Mike: When we start thinking about economics and supply and demand, all that stuff, we have to be careful that there’s two shortcuts that we make that we have to be very careful that we don’t make when we’re thinking about inflation. One is the micro/macro distinction. Macroeconomics is not the sum of all microeconomics. You look at aggregate supply, aggregate demand, you don’t just sum up all the supply and demand curves. That’s not how it works. That’s not how the theory works. By the way, that’s not how the aggregate economy works, but we tend to think about things. We look at the local barber shop and we say, okay, well, if we raise the price X dollars, then what’s that do to the amount of haircuts we make? Well, gee. That must then be the same effect when we make that general movement in the economy and we raise the prices for, we restrict the supply of this and the overall supply, and that doesn’t aggregate like that. That’s one mistake.
The other mistake that we make, or the shortcut we make, is that because of the way we all learned our Ps and Qs, our price and quantity curves, the supply and demand curves was in units that were never really stated, just there were dollars, prices and whatever, but they need to be real. When you’re looking at micro and all the supply and demand curves, you’re tending to talk about instantaneous shifts. In instantaneous shifts, the question of whether it’s a real quantity or nominal quantity doesn’t matter, but these aren’t instantaneous shifts. What we care about is what happens to the real supply and demand curve, what happens to the real price of something. If you have an equilibrium and you have an equilibrium at the microeconomic level, then you’d say, then the price should never change and the quantity should never change, but because it’s a real quantity, the reality is that your haircut does go up in price over time with the quantity of money. The real price of the haircut may stay unchanged, but the nominal price of the haircut goes up even if there’s an equilibrium in the microeconomic sense.
Anyway, those are things, they’re easy shortcuts we make, they’re cognitive errors and they’re cognitive errors that get made in terms of the global financial press, Wall Street economists make these mistakes. They’re very common mistakes because we learned the shortcuts. by the way, partly because for the last 25 years, it didn’t matter what your access was because nominal and real world were about the same.
Stewart: If these cognitive errors about inflation and how we think about it and talk about it are that common, is being correct important? Are we talking about it in the wrong way? Is that why we’re surprised when we get these out-sized inflation numbers, like all of a sudden? Holy smokes. How did this happen?
Mike: Absolutely. The whole transitory thing was just an error from the word go. It was immediately obvious that was wrong. Actually, I think you and I talked about it back then.
Stewart: We did.
Mike: Obviously, it wasn’t transitory, but the only reason you would think it was transitory is that you saw there were supply constraints. Okay. Well, as soon as we clean up those supply constraints, but that was because there was huge amounts of demand because they flushed lots of money in the system. It was really obvious what was causing it. By the way, if you look at a supply and demand curve and you figure out if you move the demand out, then you get higher price and higher quantity. It was obvious it was a demand shift, not a supply shift, but that was a really super common error that the Federal Reserve, largest single employer of economists in the world, made that mistake.
It was super easy to see that was wrong. It was wrong on day one, and yet so many people made that mistake. I guess you can be cynical and say maybe the Fed didn’t really think it was. They were trying to, like you say, jawbone it down, but the other mistake that they tend to make, by the way, and the reason they spend a lot of time jawboning, is that they believe that inflation expectations play a major role in setting inflation. There’s no evidence that that’s true either.
Stewart: I love to give credit where credit is due. On your last podcast, you said inflation would not come down, prices would not go down when these supply chain issues cleared up, and you were right as rain. In the Allstate commercial, a guy said, tens and tens of views. Whoever heard that needs to send you an email and give you some props because you were right on the money.
Mike: Well, I appreciate that. Look, individual markets, in individual markets, you have supply constraints that get cleared up and then prices do come down. Part of it is supply, obviously, but you knew they wouldn’t go back to the former level. Right now we’re seeing used car prices decline, but they went up an enormous amount. If they go down 10% because you’re clearing up some supply constraints or you’ve got too much whatever, that’s in the normal ebb and flow. The absolute price level has changed, so the net result is you should expect all prices at the end of this episode to be 30% to 40% higher on average than the prices were at the beginning of the episode because that’s where money is.
Stewart: When they pumped all this money in the system, and you’re saying that inflation is tied directly to the amount of money that’s pumped in, why are we messing around with raising rates? Is the more straightforward answer to suck some of that money back out?
Mike: The way it always was done until the last 15, 20 years was that we would change the quantity of money. The Fed would go in and do match sales. They would make outright sales from their portfolio and then take in the money, which essentially takes it out of circulation, or that they would do match sales, which is a reverse repo where they repo out bonds and take money off the street. That’s the way they always did it, and now they don’t do that anymore, but that is how you manage the money supply and that is what we should have been doing and it’s what we should be doing going forward if what we want to do is to rein in inflation.
Now, this rapid increase in interest rates, it has coincided anyway with the money supply growth going to zero for the last couple of months. The year-on-year money supply growth rate has declined quite a bit. Is it something close to stability if they were able to keep that going? It’s unclear how much of that’s really related to the fact that they changed the price of money. Again, I guess the way to think about this is the Fed is concentrating on the price of money when they should be concentrating on the quantity of money, and changing the quantity of money does change its price, but it’s not at all clear that changing its price causes a change in the quantity, if that makes sense.
Stewart: Why do you think the Feds stopped worrying about the quantity of money, I think you’ve said 15 to 20 years ago? What was the catalyst for that change?
Mike: We have to remember for the last quarter century there were all these positive demographic effects and globalization effects and things that kept the overall level of inflation lower than it otherwise would have been for the amount of money growth we had. For many years we had money growth 6%, 7%, 8%, which absent those one-time but large effects would have resulted in more inflation than we actually got. When inflation was low and stable, the correlation between money growth and inflation goes down. That’s a quantitative effect when you’re talking about small changes in things and it becomes mostly noise and less signal. And so, they came to believe that the movements and the quantity of money were not all that important. Maybe for really small changes, it isn’t all that important.
All major inflations that have happened anywhere, let’s leave aside hyper-inflations, which often have other causes, but all major inflations, the teens, those all are associated with an increase in the quantity of money. Maybe the Fed believed that we were in this permanently low inflation level, so wiggles in the money supply didn’t matter very much. I don’t know. I know some guy just won a Nobel Prize for his discovery that helicopter money was good. It was Ben Bernanke, for those listeners who have not heard that Ben Bernanke just won a Nobel Prize.
Stewart: I saw that this morning. It was along with somebody from Washington University and my alma mater, the University of Chicago. Sure enough, Ben Bernanke, helicopter Ben. Helicopter Ben is his nickname, right? It was his nickname?
Stewart: He got a Nobel Prize for this paper that he wrote I think in 1983. Is that the one?
Mike: I think that’s right. The Nobel Prize is always awarded for something in particular, but it’s also kind of a lifetime achievement award in a lot of cases. Bob Shiller was awarded it for an early 1980s paper, but he really got it because of a lifetime achievement award of discovering lots of things. With Ben Bernanke, it’s more like a Nobel Peace prize. Thank you, Ben, for saving us. Here’s a Nobel Prize. All you did was prove that throwing lots of money at banks during a financial crisis means the system doesn’t collapse. Well, yeah. We kind of knew that.
Stewart: He proved it. He did. Let’s talk about currencies for a second. What’s going on with the pound sterling and all that business? Huge moves. What’s driving all this currency business?
Mike: Well, if I knew exactly what was driving all the currency moves, then I wouldn’t be talking to you because I would just be sitting on a beach somewhere as a billionaire.
Stewart: Just trading it on your phone. I like it.
Mike: Exactly. There’s sort of two effects with currencies. It took me years to get my arms around this. In the long term, what drives relative currency valuations is essentially the relative quantities of those two currencies. The reason that diamonds are so expensive relative to water isn’t because you need diamonds more, but because there’s great scarcity of diamonds relative to water. The same thing happens in currencies. If you want to see if you can deep depreciate the XYZ peso, then print scads of them and they will depreciate. The reason that the Zimbabwe dollar is not worth very much is that there’s a whole lot of Zimbabwe dollars out there. For developed countries, that long run doesn’t tend to be a major move because our money supplies don’t tend to diverge a ton. The US doesn’t have a 30% money supply growth, while Japan has a 10% money growth. Oh, wait. We did briefly, but over a long period of time, that doesn’t tend to happen in developed countries.
In the long run, that’s how you get currencies that diverge quite a ways from other currencies. That’s partly what’s happening in the UK and in Europe. Part of what’s happening is the long-term effect that right now they have a very high inflation rate, but the relative quantities of money haven’t changed a ton. Some of that is sort of temporary, but that’s part of what’s happening is losing a little bit of confidence in what that outcome is going to be. In the short run, a lot of what drives currencies, and this is the part that was always hard for me to understand and to get my arms around, is relative short-term interest rates. Right now the Federal Reserve has been much more aggressive in terms of the price of money than other central banks have, so that has strengthened the US dollar relative to all these other central banks. At the point where the federal reserve starts to taper and everyone else is still tightening, then the dollar is going to reverse that and give up at least some of what it has gained against other currencies.
The UK has another whole kettle of fish that I think will end up resolving itself. You do worry about it. That’s that you have the government and central bank doing things which look sort of spastic and which will tend to lower your confidence that they know what the hell they’re doing. I think that’s part of what you’re seeing in the UK specifically and you can see at the interest rate market is a loss of confidence that the people in charge know what they’re doing. Again, I think that’ll probably eventually calm down in the same way that the whole Brexit scare eventually washed out.
Stewart: We’re coming up on time here. What’s your prognostication, your forecast, your next… you’ll be back next quarter, I hope. Where are we today and what do you see in the next three months here for the economy and what are you expecting on the inflation print? Give us a look into your crystal ball and give us a little bit of outlook, please.
Mike: Sure. Growth-wise, there’s no question we’re in a recession or heading for a recession, and I’ve said this for a while, we’ve never had energy prices go up like energy prices did and interest rates go up like interest rates have gone up and not had a recession. We’re going to have a recession. If we’re not already in one, we’re heading towards it. I kind of thought it would really bite in the early part of next year, but maybe we’re already getting to it sooner. I’m not exactly sure on the timing of it. No question about that. We’re going to end core inflation or median inflation in the 6%’s for this year, and I think it’s going to be in the 5%’s for next year. Maybe it’ll be the high 4%’s, but it’s not going down to 2% because we haven’t yet fully adjusted the price level.
Now, in the meantime, rents are starting to slow down a little bit. The thing which is most concerning when you look at the CPI report and you look at the breakdown of what’s causing inflation to be high, there’s been sort of this evolution. We started and it was core goods, it was those used cars, it was all those things clogged up at the ports that made people think transitory. That was the first thing that happened, and that’s because we were all shut down and we were mostly buying goods and the easiest thing to do with money is to go buy goods, so that was the first thing that happened.
As that ebbed, then the eviction moratorium ended, so rents started catching up to where they should have been. Home prices were skyrocketing. Rents have been coming up, and rents are a nice slow stable part of that. They’ve gone up more than most people were expecting. They’ll eventually come down, but not immediately. They won’t keep going up at the rate they’ve been going up, but they’re not going to go down to 2% either. What’s happened recently, the most recent potential handoff, and we’ll see if this is in the CPI we’re about to get, that I guess we will have already gotten when this podcast drops, and over the next couple months, is core services X rents. I’ll tell you why that matters in a second, but that category is… Well, it’s core services X rents of shelters, so it’s things like medical care, household services, services you pay people for. That has started to accelerate after a long, long time of being low and gradually decelerating over the last decade or so. Now it has started to go up progressively.
Now, why does that matter? Why is that potentially interesting? If you were going to see a wage-price spiral, I always put that in quotes because I’m not sure exactly what that means, but if you’re looking for a feedback loop where high inflation causes higher wages, which then causes more inflation, that’s the part you’d see it in. You wouldn’t see it in goods. You would see it in core services X rents. When you look at what median wages have been doing, they’ve been going up and they had been going up for a little while and then we started to see this increase, this acceleration in core services X rents. That’s the part that’s carrying the ball now, I think. Again, to be confirmed. If that’s the case, then that means that that adds more momentum to the whole process and will be something where, by January of next year, you’ll finally have economists saying, well, maybe we won’t come down to 2% in 2023. That’s what I’m watching right now. I think inflation is going to stay uncomfortably high for a while. Not 9%, but in the 4%’s and 5%’s for a while.
Stewart: Great advice, man. I love it. I always get a great education when we talk and I really appreciate it. I feel like I know what I’m doing when it comes to this kind of stuff, and I often find that I’ve got a lot to learn. I will just say to you, it’s the first time I’ve ever heard of Core Services X Rent. Is that what it’s called?
Mike: Yeah, there’s a couple of different ways. There’s lots of ways you can slice the CPI number, but the way I like to do it is food and energy, so these are all roughly a quarter, a little bit more, a little bit less, but these four pieces are food and energy, core goods, that’s goods X food and energy, core services, other than rents, and rents. That’s kind of the four big pieces, with rents being the slowest moving and the easiest to forecast of them all. Honestly, core services X rents being something which… it’s very heterogeneous. There’s lots of weird things which don’t move together. A lot of core goods move together. Core services X rents don’t necessarily move together. When they start to move together like they are now, it’s generally because of things like wages pushing everything up together, but that’s the reason that it matters. Ordinarily, honestly, 9 times out of 10, I don’t pay attention to that part of CPI hardly at all because I look at medical care and that’s it. It’s starting to become more interesting, and not in a good way.
Stewart: Great education, man. I love it. Mike, thanks for being on. Mike Ashton, known as The Inflation Guy from Enduring Investments. Mike, thank you.
Mike: Thanks very much, Stewart. I’ll see you again next quarter.
Stewart: I sure hope so. Thanks for listening. If you have ideas for podcasts, please email me at email@example.com. My name’s Stewart Foley, and this is the InsuranceAUM.com podcast.