Friday, September 29, 2017

Janet in Wonderland?

Earlier this week, Ed Yardeni posted an interesting blog comment, Janet in Wonderland (added emphasis is mine):
Borio vs Yellen. Last Wednesday, Fed Chair Yellen, in her press conference following the latest FOMC meeting, reminded me of Alice in Wonderland. She wondered why inflation remained so curiously low. In the world that she knows, ultra-easy monetary policy should stimulate demand for goods and services, lower the unemployment rate, and boost wage inflation, which would then drive up price inflation.

Since the time Yellen became Fed chair on February 3, 2014 through today, the unemployment rate has dropped from 6.7% to 4.4% (from February 2014 through August 2017). Yet over that same period, wage inflation has remained around 2.5% and price inflation has remained below 2.0%. Yellen expected that by now wages would be rising 3%-4%, and prices would be rising around 2% based on the inverse correlation between these inflation rates and the unemployment rate as posited by the Phillips Curve Model (PCM)—which apparently doesn’t work on the other side of the looking glass.

Last Friday, Claudio Borio, the head of the Bank for International Settlements’ (BIS) Monetary and Economic Department, presented a speech explaining to Janet in Wonderland that the real world no longer works the way she believes. The speech was titled “Through the looking glass.” The BIS chief economist started with the following quote:
“‘In another moment Alice was through the glass … Then she began looking about, and noticed that … all the rest was as different as possible’ – Through the Looking Glass, and What Alice Found There, by Lewis Carroll.” He might as well have replaced Alice’s name with Janet’s.
I agree with Borio’s underlying thesis that powerful structural forces have disrupted the traditional PCM, which logically posits that there should be a strong inverse relationship between the unemployment rate and both wage and price inflation. I have been making the case for structural disinflation for almost all 40 years that I’ve been in the forecasting business. I’ve discussed how globalization, technological innovation, demographic changes, and Amazon have subdued inflation and continue to do so.

The central bankers have been late to understand all this. Most still don’t, including Yellen. So it’s nice to see at least one of their kind showing up at the structural disinflation party, which has been in full swing for a very long time.

Yellen’s Mystery. Meanwhile, Fed Chair Janet Yellen is still trying to come up with the answer to the following question: “What determines inflation?” She first asked that in a public forum on October 14, 2016. She did so at a conference sponsored by the Federal Reserve Bank of Boston titled “Macroeconomic Research After the Crisis” that should have been titled “Macroeconomic Research in Crisis.” She still doesn’t have the answer, as evidenced by a review of what Janet in Wonderland said at her press conference last Wednesday about inflation:
(1) Transitory. “However, we believe this year’s shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions. …. [T]he Committee continues to expect inflation to move up and stabilize around 2 percent over the next couple of years, in line with our longer-run objective.”

(2) Imperfect. “Nonetheless, our understanding of the forces driving inflation is imperfect, and in light of the unexpected lower inflation readings this year, the Committee is monitoring inflation developments closely.”

(3) Mysterious. “For a number of years there were very understandable reasons for that [inflation] shortfall and they included quite a lot of slack in the labor market, which [in] my judgment [has] largely disappeared, very large reductions in energy prices and a large appreciation of the dollar that lowered import prices starting in mid-2014. This year, the shortfall of inflation from 2 percent, when none of those factors is operative is more of a mystery, and I will not say that the committee clearly understands what the causes are of that.”

(4) Lagging. “Monetary policy also operates with the lag and experience suggests that tightness in the labor market gradually and with the lag tends to push up wage and price inflation….”

(5) Idiosyncratic. “So, you know, there is a miss this year I can’t say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I’ve mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. The fact that inflation is unusually low this year does not mean that that’s going to continue.”

(6) Persistent. “Of course, if it, if we determined our view changed, and instead of thinking that the factors holding inflation down were transitory, we came to the view that they would be persistent, it would require an alteration in monetary policy to move inflation back up to 2 percent, and we would be committed to making that adjustment.”

(7) And again, mysterious. “Now, inflation is running below where we want it to be, and we’ve talked about that a lot during this, the last hour. This past year was not clear what the reasons are. I think it’s not been mysterious in the past, but one way or another we have had four or five years in which inflation is running below our 2 percent objective and we are also committed to achieving that.”
Borio’s Solution. The man from the BIS has the answer for Fed Chair Janet Yellen and all the other central bankers who have a fixation with their 2% inflation targets: “Fuggetaboutit!” In his speech, Borio sympathized with their plight: “For those central banks with a numerical objective, the chosen number is their credibility benchmark: if they attain it, they are credible; if they don’t, at least for long enough, they lose that credibility.” His advice to just move past the quandary rests on many of the points I’ve been making on this subject for some time:
(1) Inflation is neither a monetary nor a Phillips curve phenomenon. He starts off by challenging Milton Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon.” He also acknowledges Yellen’s confusion: “Yet the behaviour of inflation is becoming increasingly difficult to understand. If one is completely honest, it is hard to avoid the question: how much do we really know about the inflation process?” He follows up with two seemingly rhetorical questions: “Could it be that we know less than we think? Might we have overestimated our ability to control inflation, or at least what it would take to do so?” The rest of the speech essentially answers “yes” to both questions.
As Exhibit #1, Borio shows that, for G7 countries, “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero. In other words, inflation no longer appears to be sufficiently responsive to tightness in labour markets.” If the PCM isn’t dead, it is in a coma (click on images).

Borio mentions, but doesn’t endorse, former Fed Chairman Ben Bernanke’s view that central bankers have been so successful in lowering inflationary expectations that even tight labor markets aren’t boosting wages and prices. In a 2007 speech, Bernanke explained: “If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity—that is, the conventional Phillips curve will be flatter.”

So according to Bernanke, the PCM isn’t dead, but in a coma because inflationary expectations have been subdued.

(2) Globalization is disinflationary. Borio, who seems to be the master of rhetorical questions, then asks: “Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015.” Sure enough, the percentage of the value of world exports for the G7 countries fell from 52.4% at the start of 1994 to 33.1% in April, as the percentage for the rest of the world rose from 47.6% to 66.9%.

I am getting a sense of déjà vu all over again. In my 5/7/97 Topical Study titled “Economic Consequences of the Peace,” I discussed my finding that prices tend to rise rapidly during wars and to fall sharply during peacetimes before stabilizing until the next wartime spike. I wrote: “All wars are trade barriers. They divide the world into camps of allies and enemies. They create geographic obstacles to trade, as well as military ones. They stifle competition. History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary.” I called it “Tolstoy’s Model of Inflation”.

Borio logically concludes that measures of domestic slack are insufficient gauges of inflationary or disinflationary pressures. Furthermore, there must be more global slack given “the entry of lower-cost producers and of cheaper labour into the global economy.” That must “have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge.” That all makes sense in the world most of us live in, if not to the central bankers among us with the exception of the man from the BIS.

(3) Technological innovation is keeping a lid on pricing. Borio explains that technological innovation might also have rendered the Phillips curve comatose or dead, by reducing “incumbent firms’ pricing power—through cheaper products, as they cut costs; through newer products, as they make older ones obsolete; and through more transparent prices, as they make shopping around easier.”

Wow—déjà vu all over again! In the same 1997 study cited above, I wrote: “The Internet has the potential to provide at virtually no cost a wealth of information about the specifications, price, availability, and deliverability of any good and any service on this planet. Computers are linking producers and consumers directly.” I predicted that alone could kill inflation. Online shopping as a percent of GAFO retail sales rose from 9.1% at the end of 1997 to 30.3% currently.

Borio concludes, “No doubt, globalisation has been the big shock since the 1990s. But technology threatens to take over in future. Indeed, its imprint in the past may well have been underestimated and may sometimes be hard to distinguish from that of globalisation.”

(4) The neutral real rate of interest is a figment of central bankers’ imagination. Borio moves on from arguing that the impact of real factors on inflation has been underestimated to contending that the impact of monetary policy on the real interest rate has been underestimated. In the US, Fed officials including Fed Chair Yellen and Vice Chair Stanley Fischer have contended that the “neutral real interest rate” (or r*) has fallen as a result of real factors such as weak productivity.

Borio rightly observes that r* is an unobservable variable. Ultra-easy monetary policies might have driven down not only the nominal interest rate but also the real interest rate, whatever it is. Last year, in the 10/12 Morning Briefing, I came to the same conclusion, comparing the Fed to my dog Chloe barking at herself in the mirror when she was a puppy:
“In any event, in their opinion, near-zero real bond yields reflect these forces of secular stagnation rather than reflect their near-zero interest-rate policy since the financial crisis of 2008. …. Their ultra-easy policies have depressed interest income, reducing spendable income and also forcing people to save more. Cheap credit enabled zombie companies to stay in business, contributing to global deflationary pressures and eroding the profitability of healthy companies. Corporate managers have had a great incentive to borrow money in the bond market to buy back shares as a quick way to boost earnings per share rather than invest the proceeds in their operations.”
(5) Ultra-easy monetary policies are stimulating too much borrowing. Borio concludes that central banks should consider abandoning their inflation targets and raise interest rates for the sake of financial stability. He is concerned about mounting debts stimulated by ultra-easy money. I am too, and I’m also concerned about a potential for stock market melt-ups around the world.

The risk he sees is a “debt trap … [which] could arise if policy ran out of ammunition, and it became harder to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates.”
Great comment, take a minute to read Claudio Borio's speech, Through the looking glass, which is available here.

Earlier this month, I wrote my most important macro comment of the year, discussing why deflation is headed for the US, citing the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

In that comment, I also linked deflation to the ongoing US pension crisis:
More importantly, when deflation strikes America, it will have devastating effects on risk assets across public and private markets and it will decimate private and public pensions, especially those that are already chronically underfunded.

[Remember, pensions are all about managing assets and liabilities. Deflation strikes both, especially liabilities which will soar to unprecedented levels when the pension storm cometh and rates decline to new secular lows.]

There are a lot of people reading this comment who will roll their eyes and dismiss this as total nonsense. These are the same people who believe in the Maestro and others warning of a bond bubble ready to burst. They simply don't understand there is no baffling mystery of inflation deflation, the latter is clearly gaining on the former.

These people are in for a very rude awakening, one that will decimate the bulk of DB and DC pensions across the world and decimate the retirement accounts of millions of people as they get ready to retire and succumb to pension poverty.

It pains me to see the Fed and other central banks ignoring the risks of global deflation. It equally pains me to see policymakers unable to address things on the fiscal front. More worrisome, it pains me to see pensions taking on dumb risks across public and private markets at a time when they desperately need to hunker down and really think carefully of their long-term strategy to make sure they have enough assets to meet the needs of their beneficiaries.
In my last comment discussing Canada's pension overlords, stated the following:
I recently wrote two important comments on why deflation is headed for the US and why all of you, institutional and retail investors alike, need to prepare for the worst bear market ever.
I know, stocks soared on Wednesday to record highs as the Trump administration's proposed tax cuts leaked to the media, everybody is getting excited, there is a global bond rout going on, it seems Jeffrey Gundlach is right as yields on 30-year Treasuries are having their biggest two-day rise since December (click on image):

What is going on? Was Warren Buffett right earlier this year to ask who in their right mind would buy a 30-year bond? Was Beijing behind the whole move on US Treasuries to drive the US dollar lower and halt the yuan from appreciating (which exacerbates deflation in China)?

All a bunch of smoke and mirrors. I remain staunchly in the global deflation camp and note deflation is picking up everywhere and even in Germany, inflation failed to accelerate in September, reflecting the euro area’s continued struggle to restore price stability (click on image):

The appreciation of the euro since the beginning of the year didn't help stoke inflation in the Eurozone but there are structural factors at play here too.

Importantly, now is the time to be loading up on US long bonds (TLT), especially if you're a chronically underfunded pension. It's the best bang for your risk buck, bar none, and I would be viewing any selloff in US long bonds as a golden opportunity to load up before we suffer the worst bear market ever as deflation strikes the US.
In that last comment, I also stated this:
I recently noted the Bank of Canada is flirting with disaster but it looks like Mr. Poloz is coming back to his senses (for now). I can't say the same for the Liberal hypocrites running our country to the ground with their insane tax policies which they claim are fair but will set us back years.
In his speech, Bank of Canada Governor, Stephen Poloz, highlighted the "'unknowns". The Bank of Canada press release states this (added emphasis is mine):
While growth in the second quarter far exceeded expectations, and showed the expansion becoming more broadly based and self-sustaining, “recent data point clearly to a moderation in the second half of the year,” the Governor said.

The challenge for the Bank now is to weigh the upside and downside risks to inflation as the economy approaches its capacity. In the current environment, several unknowns are preventing the Bank from thinking mechanically about the outlook for interest rates, the Governor said.

In particular, as the economy nears its potential, business investment can have the effect of pushing out its capacity limits, either through increases in productivity or the workforce, giving the economy more room to grow in a non-inflationary way, he said.

Other unknowns that are clouding the outlook for inflation include the impact of the digital economy, which may be placing downward pressure on inflation, ongoing weak wage growth, and the sensitivity of the economy to higher interest rates given elevated levels of household debt.

“We need to keep updating our understanding of the economy in real time,” the Governor said, as he highlighted the work done by the Bank’s regional offices to gauge business sentiment and gather intelligence from the business community.
“There is no predetermined path for interest rates from here,” the Governor concluded. “Monetary policy will be particularly data dependent in these circumstances and, as always, we could still be surprised in either direction. We will continue to feel our way cautiously as we get closer to home, fostering economic growth and keeping our inflation target front and centre.”
I strongly doubt the Bank of Canada will proceed with another rate hike this year but you never know with Mr. Poloz, he likes to keep people guessing.

Either way, it doesn't matter, when deflation strikes the US, Canada and the rest of the world are in for a long, hard road ahead.

But for now rejoice as the number of millionaires in Canada shot up 11.3% in a year.  Good times, good times, until the music stops and those paper millionaires see their fortunes dwindle and crumble faster than they can say "Oh Canada!".

So maybe this comment shouldn't be Janet in Wonderland. Maybe it should be called Canada in Wonderland.

Below, Stephen S. Poloz, the Governor of the Bank of Canada, speaks before the St. John’s Board of Trade on The Meaning of “Data Dependence”: An Economic Progress Report. I also embedded the press release following this speech.

Needless to say, my inflation forecast is well below anyone else's and I truly believe this time next year, the Fed and Bank of Canada will be entering into QE Infinity. I know, Leo in Wonderland!

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