Chutzpah

By: Michael Ashton | Tue, May 21, 2013
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It has been a busy couple of weeks on the business side, which is why I haven't been writing many articles. However, I wanted to be sure and pen a quick one today.

The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.

It is that "occasional Fed speaker" that I want to mention today.

St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue "aggressive" QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.

What word am I searching for here...would it be "chutzpah?"

I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn't written in real time by bloggers. It's written by historians, years later.

But hasn't the Fed, after all, been really successful? Isn't a victory lap deserved? Haven't they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.

Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one's fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we'll hold our applause until you stick the landing if you don't mind.

There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.

But in fact, inflation doesn't respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves...which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.

Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It's not the only thing that matters, but it's pretty important, as the chart below suggests (I think I have run something like this chart previously).

5-Years Treasury Yields versus M@ Velocity Chart since 1994

Now, ordinarily when the Fed is raising rates, they're also draining reserves - so the increase in money velocity is balanced by the decline in money to some degree. That won't happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.

I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don't have to put me on the cover of a magazine.

To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation...literally within a couple of months from now, judging from the historical lag patterns.

But, again, I should return to my main point: it isn't that the Fed is wrong, it's just that they are so completely certain that they are right even though the difficult part of the trick - unwinding the extraordinary policy without any adverse effects - lies ahead.

Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!

 


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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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