Category Archives: inflation vs deflation

Quantitative easing II: pros and cons

November 1, 2010 By in inflation vs deflation, Recent Market Action, securities markets Tags: , , , , , , , , , , , Leave a comment

It looks like the US Federal Reserve will start a second round of Quantitative Easing (dubbed QE II) later this week.

what it is

conventional policy

Under normal circumstances, the Fed–or any other national monetary authority–conducts it money policy by controlling the price of the overnight loans it provides to commercial banks.  When it wants to slow the economy down, it raises the price of such loans (meaning the interest rate it charges for them) ; when it wants to boost economic activity, it lowers the price.

What happens, though, when the price hits zero–in effect, where it is now?  In theory, by this time the Fed has done all it can.  If this isn’t enough, it steps aside and the country looks to the president and congress to introduce fiscal stimulus (that is, temporarily boost government spending or lower taxes) to get activity moving at a more rapid clip.

But what if Washington is dysfunctional and can’t get it together to do anything?

an analogy

A doctor sees a man lying on the side of the road, bleeding.  He stops, administers first aid and calls for an ambulance.

Two ambulances show up.  The crew of one says the best thing to do for the ailing man is to leave him there to heal himself.  The crew of the other says the best thing is to arrange for insurance that will cover him in the case of a future accident.  A fist fight between the two crews breaks out.

What should the doctor do?

unconventional policy action

The doctor probably doesn’t walk away.  He probably does something unusual, something that substitutes for the ambulances and that he thinks will help the person lying by the side of the road.

This is the position the Fed believes itself to be in.

what to do

What it has decided to do is to buy longer-dated fixed income securities that the banks have on their balance sheets.  This will put even more money into the hands of banks to lend to customers.  This is QE II because the Fed has already done this once during the early days of the financial crisis, buying up, in particular, highly illiquid bonds whose presence on banks’ balance sheets was thought to have paralyzed their new lending departments.

In theory, QE II would also tend to lower longer-term interest rates and possibly weaken the currency.  And in fact, after the Fed first said it stood ready to start QE II operations several months ago, the interest rates on longer-dated Treasury securities has declined and the US$ has fallen by about 10%.

why the Fed feels comfortable

Maybe “comfortable” isn’t quite the right word.  “Willing” might be better.  It thinks there’s a need for faster economic growth to reduce the unemployment rate.  It knows Washington won’t do anything.  It understands that if it pumps too much money into the system and keeps it there for too long, inflation will result.  But it doesn’t see inflation as a threat anytime soon.  In fact, it would like a little more inflation than we have now, because it thinks deflation is a greater possibility.  And deflation is always the greater threat.

In short, the Fed would probably prefer not to use unconventional means, but it sees no near-term downside.

why not everyone else is

Bond fund managers are very clearly opposed.  The head of PIMCO, the largest such organization in the US, calls QE II “somewhat of a Ponzi scheme.”  Why?  QEII may well help accelerate an anemic domestic economy.  If not, it will at least raise the worry that inflation will resurface in a way the Fed doesn’t expect and can’t easily control.  Neither is good for bond prices, nor for their management fees.

Some economists fear that because unconventional measures are just that, they are poorly understood.  They may have unintended negative consequences.  Even conventional Fed measures can have unintended negative consequences, they point out, in the way that too loose money policy in the early part of the decade led to a housing bubble with devastating consequences for the US.  Others worry that the Fed may leave money too loose for too long, either because it makes a mistake or because it feels political pressure.

So is China.  For bond funds, the worry is that the marketing promise of an economic moonscape–bereft of economic growth or inflation for as far as the eye can see–that will keep their shareholders from ever losing money will prove to be a pipe dream.

For China, on the other hand, where everything is part of political struggle, QE II will likely be seen, not as the result of Washington’s ineptitude but the conclusion of a Machiavellian scheme to create inflation.  The point of doing so?  –to reduce the real value of the trillions of dollars in treasury securities the Middle Kingdom holds.

my thoughts

QE II is on the way, whether we like it or not.  This forces us as investors to be sharply on the alert for signs of either inflation or of a pickup in economic growth.  Both run counter to the Fed’s suppositions.  They would signal a potential sea change in the character of the financial markets that would require portfolio reorientation.

Stay tuned.



No reversion to the mean?: El-Erian (II)

September 17, 2010 By in Constructing a Portfolio, Current Market Thoughts, growth vs value, Industry Analysis, inflation vs deflation, Investment firms, Strategy Tags: , , , , , , , , , , , Leave a comment

In yesterday’s post, I outlined the Pimco investment case, contained in a Financial Times article, which boils down to:  we’re in a time of great uncertainty, so buy government bonds.

my thoughts

For what it’s worth, I think the world is a lot less uncertain place than it was two years ago.  In a way, uncertainty is old news.  That isn’t to say our situation is good, but we now know:

1.  world governments will act to avoid the worst economic outcomes (this is the #1 worry in any macroeconomic crisis)

2.  financial regulators in the US and the EU have been doing a terrible job

3.  banks are weaker companies than we thought, and generally poorly managed, to boot.

In my opinion, a lot of this news is already reflected in security and currency prices.

What uncertainties still exist?

1.  Economically speaking, the developed world is still a fragile place.  The effects of the large excess supply of housing and business space created in the US and UK over the past few years, and of those countries stopping adding to it, are still with us.

2.  The steps that policymakers may take, and the economic effects of those actions, are hard to foresee.  The world has used up much (all?) of its safety margin for dealing with mistakes.

3.  The econometric models that economists use in predicting how our economic future will play out–essentially, elaborate trend-following devices–don’t work well in times of economic transition.  They also didn’t predict the financial meltdown.   So a major tool (bond) portfolio managers have wielded in plying their trade is out of action.  Managers are now working in a room whose lights have been turned out.  (If you believe Nobel laureate Joseph Stiglitz, however, these models were radically flawed from the outset–and were a contributing cause to our economic woes.)

3.  The behavior of economic agents, especially portfolio investors, is harder to predict.  In particular, the chances of extreme, far-from-consensus, and really bad, outcomes has increased.

What does the article conclude from this litany of sorrows?  –we are in a “world where the realized return rarely (emphasis added) equals the expected valuation.”

a curious argument

Okay.  Now comes the weird part.

We’re in a world where no one can tell how the world economy will play out and where investment managers’ portfolios are going to blow up in their faces.  But luckily for us, Mssrs. Clarida and El-Erian are affected by none of this.  They know (no explanation given) how the US economy will develop–very low growth and structural unemployment for as far as the eye can see.  They also know that while virtually every other investment strategy founders on the rocks of uncertainty, one–buy government bonds–will not.  Again, no explanation given.  Just by coincidence, both authors happen to work for a bond fund manager and have this product available for sale to us.

Another point:  The thrust of the Clarida- El-Erian argument is that economic circumstances demand that investors carefully rethink their investment strategies, because macroeconomic conditions today are radically different from what they’ve been before.  Their actual conclusion, however, is far different.  It is that investors will almost never (rarely) be able to figure things out.  In the paragraph above, I’ve pointed out that they think this situation applies to everyone except them.

My  point here is that they provide no support for the actual conclusion they draw.  What they write looks like an argument in support of a conclusion, followed by the conclusion as a logical consequence of what they said before.  But that’s just a kind of sleight of hand.  The idea that no one (except themselves) will be able to figure out what’s going on is a bald assertion, no more.

extreme outcomes don’t all favor bonds

I think it is right to give extra thought to the possibility of extreme outcomes.  In can imagine three, although I’m sure there are more:

1.  The US and EU play out like Japan since 1990.  This would mean bonds would be fine   Stocks would have a period of stability followed by maybe another 30% decline.

2.  The US and EU recover faster than we now think.  Stocks might go up by 25%.  Government bonds would fall, maybe by 15%.

3.  The rest of the world loses faith in the US and EU.  Their currencies fall by 15% vs. the rest of the world and their bond yields rise.  In this case, safety would lie in stocks, not bonds.  Stocks +35%, bonds -15%.

To me, it seems that the possibility of extreme outcomes is an argument for diversification, not  concentration in one asset class.

the authors seem to know nothing about stocks

If we exclude financial Armageddon, equity investors can operate successfully under a wide variety of economic conditions.   In particular:

Value investors do use reversion to the mean, but in a narrower sense than is used in the Pimco article.  The value investor looks for assets that are worth $100 that he can buy for $30 and hopes to sell for $60-$70.  Given that stocks are the cheapest they’ve been vs. bonds (a proxy for the cost of financing purchase of such assets) in about sixty years, this should be a fertile ground to work in.

Growth investors do have deep economic concerns, but they’re  generally microeconomic, not macro.  Will, for example, well off thirty- and forty-somethings continue to buy iPhones and iPads?  Will TIF continue to sell jewelry to Europeans trading down or to newly affluent Asians trading up?  Will the casinos in Macau keep on booming?

Yes, if world economies implode again, equities will be in trouble, at least for a while.  But equity investors don’t need to understand the entire globe to be successful.  All they need is a stable playing field and one or two places where they’re ahead of the consensus.

inflation as politics

June 28, 2010 By in Basic Concepts, China, Current Market Thoughts, economics, inflation vs deflation, Strategy Tags: , , , , , , , , , , , , Leave a comment

I’m going to write here about what I perceive the political dynamics of inflation in the United States to have been in the past century.  I presume, but don’t know, that the same process can and has occurred elsewhere.

early days

The latter part of the nineteenth century and the first half of the twentieth were times of what amounts to class struggle in the US between business and labor.  Issues ran the gamut from child labor and workplace safety to wage levels and unionization.

The sides coalesced around two political parties, the Democrats representing labor and the Republicans defending business.

(This struggle is basically over today, I think–leaving both major parties trying without a great deal of success so far to redefine themselves.  For good or ill, most Americans no longer draw a sharp distinction between management and labor.  This is partly because the nature of work has changed, partly because most Americans consider themselves part of management.)

During the time when workers were fighting for what we would now regard as basic, and self-evident rights, inflation became a significant weapon in the battle.  How so?

inflation and bonds

A conventional bond is a series of interest payments made to the holder plus return of principal at the end of the bond’s term.  The present value, or value today, of the bond is the sum of all these payments by discounting each back to the present using an appropriate interest rate.  The higher the interest rate employed, the lower the present value.

the holder

A rising inflation rate erodes the present value of a bond.  If, for example, when the holder purchases it, inflation is at 3% the buyer may be content with a 6% coupon.  He receives $60 a year in interest payments and his $1000 back a the end of the bond’s term.   The interest payments offset inflation and provide a real return of 3% annually.

Suppose the inflation rate rises to 7% immediately after the holder purchases the bond.  Suddenly, he is no longer receiving a real return on his money.  Part of the purchasing power of his investment is disappearing, due to the higher rate of inflation.

the seller

Conversely, the seller benefits from an increase in the inflation rate, since that results in a real decline in the value of the payments he has agreed to make to the holder.

back to politics

It seems to me that during the late nineteenth and early twentieth centuries a basic assumption of the Democrats, the party of labor, was that its constituents held no physical or financial assets.  In fact, many might be net borrowers, or, as the financial world would put it today, be “short” financial assets.  Their main source of economic worth was their ability to sell their labor.

In contrast, Republicans thought of their constituents as the “longs,” wealthy bond-coupon clippers, with ownership of vast amounts of physical and financial assets.

two opposing agendas

These differences set the agendas of the two parties.  If the Democrats were in power, they could attempt to transfer wealth from business to labor overtly by increasing taxes on the wealthy and/or by raising benefits provided by the government to workers.  Or they could do so covertly by establishing economic policies that induce inflation.  That would decrease the wealth of the old time robber barons–and at the same time it would lessen the real value of the loans workers had taken out from them.

When the Republicans were in power, they would start to undo the policies initiated by the Democrats, by trying to balance the government’s books and by fighting inflation with restrictive economic policies.

I think this is the way Washington worked even through the 1970s.

the new order

Not any more, though.

The nineteenth century model was one of massive capital investment in plant and equipment (think: blast furnace steel) operated by manual labor.   Accelerating rates of technological change have destroyed that economic model.  Who are today’s economic heroes?–Google, Apple, Amazon, Pixar, biotech…  They are relatively small groups of highly educated people creating service businesses that require little physical capital, many of them using the internet as a substitute for having a large advertising budget and extensive physical distribution facilities.

the old dynamic reborn

At present, most domestic economists are praying for any sign of inflation to emerge, simply to give the US some breathing room against the possibility of deflation.

Beyond this, however, inflation has reemerged as a political issue in the US.  The new dynamic has arisen from the fact that Washington has borrowed heavily from foreign governments–notably Japan and China–as well as from domestic sources.

So the drama of the first half of the twentieth century has been recast, with the Chinese in the role of big business and Washington in the role of labor.  It is certainly tempting to lawmakers to attempt to repay foreign creditors in inflation-diminished dollars rather than to have to have tax revenues large enough to generate the entire real amount owed.  On the other hand, China, sensing this line of thought, has been increasingly vocal over the past year or so in its concern that Washington protect the purchasing power of the dollar through economic orthodoxy.

This new drama is still in rehearsals.  The collapse of the euro has meant it won’t need to open on Broadway any time soon.  But it will still be important to monitor how the play is shaping up.


inflation vs. deflation: where are we now?

June 27, 2010 By in Basic Concepts, economics, inflation vs deflation Tags: , , , , , , , , 2 Comments

Because the two words, inflation and deflation, look alike, they invite the conclusion that there’s a single phenomenon– -flation–that has two varieties, de- and in-.  As a practical matter, despite the similar names, inflation and deflation are actually quite different in how they affect an economy.   In the US at present, knowledgeable politicians (an oxymoron?) and economists have their fingers crossed that inflation somehow resurfaces and that deflation will not become an issue.

inflation

An economy with inflation is one where the price of things in general is rising.  It isn’t enough that some prices are rising–even very visible prices like gasoline or movie tickets.  In an inflationary economy, overall prices have to be rising, so that the cost of living steadily goes up. (I wrote about inflation more extensively in a post from May 25, 2009.)

In a developed economy like the US, the only price that really counts for inflation is the price of labor.

If inflation had a tendency to stay well-behaved, at a constant, low rate, it wouldn’t be much of a problem.  But it usually doesn’t do either.  One way to think about what happens is this:

in an inflationary environment, some people underestimate inflation.  They think prices will rise by, say, 3% in the coming year.  They ask for and get a 3% wage increase.  But inflation turns out to be 4%, so in real (i.e., adjusted for price-level changes) terms they are making less than they used to.  So the following year, they ask for a 6% raise.   Others ask for and receive a 5% raise, so they’re better off in real terms than before.  So they try to do the same thing the following year.  As a result, the rate at which prices are rising tends to increase.

At some point, expectations change. Companies start to raise the prices of their output and individual wage earners up their wage demands in anticipation of, and as protection against, future inflation increases.  In doing so, they create the increased inflation they fear.

As inflation accelerates, people start spending more and more time defending against future price increases and trying to work the situation in their favor.  This means less time doing productive work.  At more advanced stages, capital investment in long-term projects slows, because figuring out its profitability may depend on forecasting accurately what inflation will be ten years hence–which has become impossible.  For the same reason, no one wants to hold fixed income securities, including government debt.

In the worst case, hyperinflation (think:  Japan or Germany close to a century ago, or Brazil twenty years ago), the economy comes close to collapse.

The (relative) good news about inflation is that it’s a well-understood phenomenon.  Any government knows what to do to remedy the situation:  restrictive policy (higher interest rates, plus maybe less government spending and higher taxes) until inflation begins to decline and expectations in the economy change.   The real stumbling block to an inflation cure is having the political will to implement it and a Paul Volcker-like central banker to oversee the process.

deflation

In its definition, deflation is the opposite of inflation.  It’s a steady, general fall in the price level.  To my mind, three factors make deflation something different from a mirror image of inflation.

1.  Deflation is weird. Other than the Great Depression or the Weimar Republic, it hasn’t occurred very often in the contemporary world.  Other than maybe the PC industry, no one is set up either psychologically or institutionally for deflation.  Suppose prices were falling at a steady annual rate of 2%.  What would you think of a government bond where you paid $1000, received no interest income and got back $900 in ten years?  Me, too.  Credit creation, and all the economic activity that depends on it, would stop dead in its tracks.

2.  Deflation makes outstanding debt that carries a positive nominal interest rate (in other words, all of it) a crushing burden.  Prices dropping 2% per year means, among other things, wages dropping 2% annually.  Let’s change the rate to 5% just to make the point easier to see.  At the end of five years, you’re making 77% of what you were before deflation hit (ignore the fact that falling wages suggests widespread unemployment and other horrible economic problems).  Yes, the cost of food and clothing has probably fallen in line with your income, but your mortgage and credit card payments haven’t.  If your credit payments were 25% of your income pre-deflation, they’re a third–and rising–of your income now.

The situation is worse for companies with operating leverage, whose profits can quickly disappear.  Imagine, too, the state of private equity or commercial real estate, which depend on high levels of financial leverage for their viability.  They’re toast.

This, of course, has knock-on negative effects on the banking system.  Look at the Thirties.

What a mess!

3.  Traditional money policy becomes ineffective.  The orthodox central bank response to recession is to lower short-term interest rates until they’re negative in real terms.  The fact that finance is in effect free is supposed to stimulate borrowing, and therefore reinvigorate economic activity.  But the central bank can’t push nominal (i.e., not adjusted for inflation/deflation) short rates below zero.  So in a deflationary environment, the central bank can’t achieve the “free money” outcome.

This means that a country depends completely on fiscal stimulus–increased government spending–to help the economy improve.  But legislative action may be slow.  There’s huge potential for spending programs to be applied in pork barrel ways that will do little more than run up the government’s debt burden (think:  Japan since 1990).

where are we now?

There’s good news and bad news, in my opinion.  Bad news first.

Government stimulus programs seem to me to have so far been focussed on whatever is “shovel ready,”  without much thought about addressing long-term structural problems like education.  Maybe that will change.  But to date Washington looks scarily like Tokyo circa 1990.

The good news–

Europe’s pain is our gain.  US government spending depends on the continuing willingness of foreigners, notably China, to lend Washington money.  Prior to the Athens-induced collapse of the euro, Beijing appears to be warming up to shift its lending activity away from the US.  Not any more.  So no matter how inefficient government stimulus may be, at least it does something positive, and it won’t come to a screeching halt.

Also, lots of companies are announcing that business has become good enough that they are beginning to raise wages again and reinstitute benefits cut during the recession.  Given that wages are the most important element of changes in the price level in the US, this suggests that the current near-zero inflation rate is a cyclical low point and that the price level will rise from here.  To some extent, this movement in the private sector will be offset by changes in state and local government workers’ payrolls (some studies claim that municipal employees are now paid 20% more than private sector workers for the same jobs).  Still,  I think the private sector trend is grounds for a loud sigh of relief.