The Beatings Will Continue Until Morale Improves

By: Michael Ashton | Mon, Jun 6, 2011
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There was no new growth-related news today, but the markets continued to adjust to last week's news. After getting smacked twice last week on the same news, markets seem to be shrinking from contact. Oil prices fell 1.5%, and other commodities besides metals (notably Softs and Grains, each down about 3%) were weak. Stocks dropped 1.1% and seem anxious to re-test the lows for the year which lie a mere 3% away and coincide with the 200-day moving average on the S&P.

Nominal and inflation-indexed bonds were both essentially unchanged, and volumes overall were light.

News off the Continent was also anti-climactic, but stocks in Peru dropped 12.5% on the victory of Hugo-Chavez-Facebook-Buddy (and former rebel) Ollanta Humala won a runoff election. This would seem like a one-off affecting only Peru, and perhaps it should be. Indeed other emerging markets ignored the first 9% or so but ended up closing lower. From a practical standpoint the vehicle for contagion is the fact that investors often participate in EM via funds and those funds will take a (small) hit because of Peruvian investments. To the extent that investors scale back EM positions as a result, it will affect many related (perhaps I should say "associated") markets. Fortunately, Peru's weight in the indices is pretty small, so even the 18% fall from the highs of last month will have only a small direct impact and the bigger effect is likely to be emotional. But this bears watching.

In a week with little in the way of scheduled economic news, it isn't surprising to see previously-established trends following through. There is no economic data due tomorrow either, so I expect the beatings to continue.

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I read an article recently entitled "Inflation as a Redistribution Shock: Effects on Aggregates and Welfare" that is interesting because of the non-intuitive conclusions it draws. Although the paper is five years old, it comes from the respectable NBER and one of its authors was in the Federal Reserve System when the article was written.¹

The paper concerns the effects of unanticipated inflation. We all know that unanticipated inflation transfers wealth from lenders to borrowers (although anticipated inflation does not - if the inflation is anticipated, it is reflected in the nominal interest rate), and that also implies that unanticipated inflation causes medium-wealth households - who tend to be borrowers - to gain at the expense of higher-wealth households, and for domestic households as a group to gain at the expense of foreign (nominal) bondholders. The authors also found several redistributive effects among age cohorts, and overall; for example, even though unanticipated inflation has a 'persistent negative effect on output,' it surprisingly improves the weighted welfare of domestic households. From the paper,

"Despite the fact that inflation-induced wealth changes sum to zero across agents, the responses of winners (net borrowers) and losers (net lenders) do not cancel out. Among households, the key asymmetry is that net borrowers tend to be younger than net lenders."

This leads to various effects on the supply and demand of labor and of savings that flow from the fact that a windfall received by the young causes different behavior changes than the (opposite) effect of a negative wealth shock paid by the aged.

But the really interesting part of the result is that most of the losers in a period of unintended inflation can be compensated fairly easily from the windfall that the government experiences (since the government of course is a huge lender). Again, from the paper:

"Thus, while the poor as a group experience a negative direct redistribution effect, this loss turns out to be easy to compensate, precisely because it does not take much in terms of transfers to improve the well-being of the poor.

"From a political economy perspective, these findings lead us to conclude that the government can adopt simple fiscal policies in reaction to an inflation shock which imply that the shock benefits a majority. Thus, policymakers may be tempted to inflate the economy not just because they take some direct interest in the fiscal position of the government, but also because such a policy may actually have wide support if the losers from inflation receive some compensation. It is intriguing to observe that the U.S. inflation episode in the 1970s started right after Social Security was first indexed to inflation in 1972. While this policy change is unlikely to have been the main cause of the episode, it certainly lowered the political cost of inflation..." [emphasis added]

And in their conclusion:

"Our findings therefore lead to some doubts regarding the conventional wisdom that low inflation is always in the best interest of the domestic population. There is a sizeable fraction of the U.S. population which would stand to gain if another inflation episode such as the one in the 1970s were to occur...

"One of our key findings is that the cohort welfare effects are highly sensitive with respect to the fiscal policy regime followed by the government...If the windfall is used to raise pensions, ...the poor as well as the old middle class are compensated for all their losses, and most groups, apart from the very rich, stand to gain from inflation."

Well, oh my as my sainted aunt might have said. This is an interesting thought process, because the conventional wisdom (and what the Fed has said many times through many different mouthpieces) and research generally holds that aggregate social effects of an inflationary period are negative, at least partly because of economic frictions created by rapidly-changing prices. But these authors illustrate that isn't necessarily true when one considers the different effects that inflation has on different economic actors, and the way government can respond.

It isn't like the Fed needed any more ammunition to risk an inflationary debacle; they're doing that already. But it is worth thinking about whether we might have it all wrong, and that all the talk is mainly meant to ensure that the inflation remains unanticipated. What if the Fed was actually trying to cause a general inflation? Especially if you're one of the "very rich" who would be sacrificed in that situation, it is worth considering that possibility!

 


¹Although in itself this isn't particularly noteworthy. The Federal Reserve System is far and away the most popular single U.S. destination for economics PhDs.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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