Inflation and Interest Rates

Let's trace interest rates vs inflation rates.  

Monetary theory suggests that interest rates need to be greater than inflation rates in order to reduce inflation.   Two assumptions: (1) the Fed will raise interest rates (Fed Funds Rate), (2) Inflation, especially as measured by Core-PCE will decrease.  When these rates are equal monetary policy will be close to "neutral", i.e. the real inflation rate (adjusted for inflation) will be zero.

Two questions.   The length of the x-axis, i.e. when will interest rates be neutral; and the value of the y-axis, what will the rates be.

If inflation persists, then the neutral rate may be 4% (or higher) and the Fed will continue to raise rates until the end of 2022 (or beyond).  

If inflation begins to recede then the Fed may stop raising rates earlier and stop at a lower neutral rate, e.g. 3.5% and stop 4th quarter 2022.

Update: Jan 13

Inflation continues to come down and the Fed continues to raise the Fed Funds rate.   Still a way to go.  There is hopeful news.  The job market remains strong even as inflation eases.  This increases the possibility of a "soft landing" meaning that the inflation continues to ease, the Fed stops raising rates and this all occurs without a recession.

Recession can be measured in multiple ways- the primary metric is a decline in GDP but this is of little interest to me.  The more important metric would be a material increase in unemployment.  If we can get inflation down, without a big spike in interest rates, and keep unemployment under 4.5% that would certainly qualify as a soft landing.

As far as the stock market goes there are two factors to consider.  One is the interest rate.  The higher the interest rate the lower the P/E multiple.  So, the questions are what is the terminal interest rate, and how long will the Fed keep the interest rate at that level?

The second is factor is earnings.   Will there be an earnings "recession" which would be defined as a dip in nominal earnings?   

Economy, Inflation, Pandemic, War and the Investment Outlook

It's really different this time.

I will try to use this post to break down what's happening in the economy, where it's heading and the impact on investments. 

Any attempt to summarize and categorize where the economy is headed is fraught with almost impossible challenges.

Let's start with the present situation.   The economy is growing, probably in the 2-3% range.   The job market is tight.  We have historically low unemployment with impressive job gains each month and the ratio of job openings (11 million) to unemployed (6 million) at historic highs.  But we still have 800,000 less workers than pre-pandemic.  At the current rate of job creation, we might see those 800,000 workers added in 2-3 months.  When new jobs are created then overall demand is increased which should lead to continued economic growth, decreases in federal government deficits, and improvements in state budgets.  

We have high inflation.   There are many causes.  Let's start with the demand-supply imbalance.  The pandemic shifted demand from services to goods.  The government stimulus checks whetted demand.  At the same time supply  for goods was constrained by pandemic related shutdowns and supply side bottlenecks (shortage of container/container ships/truck drivers).   

The federal fiscal policies related to the pandemic were clearly inflationary.  The biggest culprit was likely the helicopter money that was doled out to everyone with no pragmatic means testing.  This combined with the Federal Reserve Board (the "Fed") monetary policy of zero interest rates, huge balance sheet increases and intervention into secondary credit markets added fuel to the inflation fire.

The symbol of inflation is the price of oil (or more prosaically the price of gas at the pump).  The 2020 pandemic related shutdowns decimated the demand for oil which led to a decrease in the price of oil.  Many US drilling operations became unprofitable and shutdown.  Global investment in exploration and drilling evaporated.   As the world emerged from the pandemic demand increased, OPEC+ suppressed supply and other sources or supply didn't materialize.  Then we add the Russian invasion of Ukraine.  The world consumes about 100 million barrels of oil a day(!) and Russia produces about 10% of that total.   

Potential future government policy of fossil fuels will continue to constrain investment and therefore supply.  As the world emerges from pandemic shutdowns (especially China) demand will increase and it seems likely that the price of oil will continue to increase.  I've heard estimates of $150/barrel leading to $5-$6 for a gallon of gas.  As consumer spending shifts to paying to drive cars and heat homes spending on other goods and services will be impacted.   

A secondary impact of the Russian invasion is the cost of food.  Russia and Ukraine are huge exporters of wheat.   Wheat, like oil, is a global commodity.   The war will have an impact.   I heard recently (Bloomberg radio) that 70% of the cost of food is related to energy. 

All this inflation has resulted in the Fed's belated switch in monetary policy.    The Fed has moved off of zero interest rates and is now shrinking their balance sheet.  The idea is that these policies will be "transmitted" to the real economy by "tightening market conditions".   What does that mean?  Raising interest rates will make business investments more costly.   The Fed hopes this will lead to a reduction in demand.  The increase in interest rates will directly lead to an increase in new home mortgage rates which should also lead to a reduction in demand.   The point is to reduce demand so that the demand-supply imbalances that currently exist and lead to inflation will abate.  

The secondary impact of Fed monetary policy is on stock prices.   Most stock prices are calculated bases on earnings and valuations.  Valuations are inversely related to interest rates.  The higher the interest rates the lower the valuations.  Lowering valuations, all else being equal, will lead to lower stock prices.  Lower stock prices are linked to consumer spending through what's thought to be a wealth effect.  When investors see the increases in their investments the theory says they become more optimistic and spend more.  The converse should also be true.  The theory is that the Fed policy should restrain demand of market participants.

How high will the Fed raise rates?   Projections range from 2.5% to over 4%.

Will the decrease in demand related to inflation offset the increase in demand related to job creation?

Will unemployment have to increase before inflation subsides?  Or will inflation decrease as pandemic supply side constraints are alleviated?   This would allow the Fed to moderate their policy.

Is stagflation a possibility?  High inflation (oil, food) leading to demand destruction for other consumer goods leading to higher unemployment. 

What asset classes will work best in this changing environment?   Stocks, bonds, cash, real estate, commodities?

Positive conditions for each asset class

Stocks - growing economy, interest rate increases moderate, inflation a key factor
Bonds - lower inflation, interest rate increases moderate,  recession or slow growth

Cash - lower inflation, higher interest rates
Commodities - higher inflation, weak dollar, global economy grows

Real Estate - ??

The Market for College Education

Note:   This is not a deeply researched post.  Mainly a thought experiment.

Micro-economics teaches that if there are lots of suppliers and customers for a specific good or service then we should expect the competition to improve the product over time.  The product may become cheaper or have better quality or both.  

One typical example is observable in digital technology - CPUs, memory, disk storage, data communication have all shown remarkable improvements over time.  The market I'd like to focus on is college education.    

There are lots of suppliers and lots of customers.   But over time the "product", education, has become more and more expensive in real, inflation adjusted terms.  Why?  Doesn't micro-economic theory predict lower prices and/or improved quality?

I'd like to compare this to the auto industry.  Let's look at the similarities.  In both cases there are lots of suppliers and lots of customers - so we have competition.  The consumer has lots of information about the product.   Cars have become cheaper and better.  It's hard to make a judgement about whether college education has become better.  It certainly has not become cheaper.

One other similarity.  There's not one market for cars and one market for college education.  There are lots of markets.  For cars there are markets for compact cars, family sedans, SUVs, pick-ups, luxury cars.  A Honda Civic does not compete with a Lexus or a Ford F-150.  But in all these submarkets the car manufacturers are producing better and/or cheaper products.

College education also has a number of submarkets.   The product of an elite school is an education and a credential.  The product of a large state university includes a broad array of services including expansive sports programs.  Small liberal arts college offer a more intimate educational experience.  Alabama does not compete with Harvard or with Amhearst.  The offer different "products".  But it's hard to argue that any of these submarkets are producing better and/or cheaper products.  Interesting to me is that there is one submarket that only sells education - community colleges.   No fancy dorms, not much of an athletic program, no extravagant library or student activity center - their product is essentially education.  

As an aside I started this thought experiment around a discussion of big-time college sports programs.  There's a nagging question as to why colleges pay huge salaries to their football and basketball coaches.  It turns out that these big-time programs are profitable, and the profits are used to subsidize other sports, e.g. women's field hockey, archery, etc.   Still the question is why do they spend any money on sports and the answer is that this is part of the "product" that large state universities sell.  They sell the "total college experience" including the option of competing in minor sports or attending exciting football and basketball games.

So we see similarities but what's different about this market.

One is that most colleges are non-profit.  This doesn't mean they don't make money.  Private non-profits have the same need to compete for paying customers as for-profit companies.  They need revenues to exceed expenses.  And, they do.  An extreme example is Princeton.  Revenues and unrealized capital gains exceeded expenses by $20 billion last year.   Of course, they pay no taxes.  What does Princeton do with money?  The answer is not much.   A for-profit business would probably use the money to expand their business, i.e. attract more customers.  Princeton doesn't care about that.  They are content to teach 8000 students each year. 

This suggests a second difference.  Barriers to competition.   Some schools like the Ivies don't compete for students they select students.   As long as revenues exceed expenses they lack the market-based incentives to innovate.  So supply is intentionally limited by the suppliers!  Kinda like OPEC.  Limit supply so that there is always sufficient demand to charge higher and higher tuition and fees.

The other barriers to competition may be (a) the obstacles for creating new accredited colleges, and (b) space limitations that prevent urban schools from expanding, e.g. NYU.  Not sure about this.  

The third difference is that the customers/students have access to the money needed to pay the increased costs via grants and federal and private student loans.  Students can borrow lots of money with little or no income, little or no credit history and no collateral.  Imagine someone in their early 20's with the same credit profile as a college student applying for a bank loan to start a small business.  No chance.  But students can borrow and borrow a lot.  This ties into the current debate on student loan forgiveness.  Colleges don't need innovations that reduce costs as long as there is an increasing amount of customers willing and able to pay higher and higher tuition and fees.   

Starfish - Part 2

To continue the thread are there certain acts intended to be helpful but instead are a waste of time and money?

Looking again at the food bank example.  If the objective is to solve food insecurity even for a single individual much less a family then donations don't achieve the objective.    If the objective is incremental not fundamental then the donations aren't a waste.  

To refer back to Bill Gates's perspective of global warning.   He asserts that the goal should be for the rich countries (e.g. US, EU, Britain, Japan) to get to net zero emissions by 2050 and with solutions that can be implemented by middle class countries (e.g China, Latin America) by 2060 and poor countries (e.g. India, sub-sahara Africa) by 2070.

I'm not a climate scientist I accept his assertions.  

I also accept that this will be very expensive.

I also accept that the free market cannot get us to net zero.  It will take tax dollars and lots of them.

I also accept that tax dollars are finite and should be spent efficiently.

With that in mind does it make sense to convert a coal power plant to natural gas?  If so, should it be subsidized by our taxes? 

The answer depends on how you frame the problem and what are the goals.   If the goal is to reduce emissions by 2030 as much as possible then the answer is Yes.   If the goal is to get to net zero by 2050 then the answer is very likely No.

Similar to the food bank how one sees the frames the objective - incremental or fundamental matters.   In the case of global warning I'm told that incremental reduction of green house gases is insufficient.   The only sensible objective is net zero.   So subsidizing conversion from coal to gas is actually counter-productive as it spends scarce tax payer dollars on something that isn't part of a net zero future.

Starfish - Part 1

 Most have heard one version of the Starfish story.   If you've forgotten, I'll provide one version.

There was a fierce storm on the Oregon coast.   It caused a huge ocean storm surge.   The next morning after the tide had ebbed there were thousands of starfish stranded on the beach far from the water line.  They were all destined to die on the beach.  A young woman came to walk the beach - something she did daily.  As she walked with every step she reached down, picked up a starfish and tossed it into the water where it would now survive.

A man watched her. (In this story the hero is almost always female, and the cynic is almost always male.)  He calls to her "Why bother?  There are thousands of starfish.  You can't help them all.  You can't make a difference."

She called back as she reached down, picked up and tossed another starfish, "I made a difference to that one."

So, this is about individual voluntary acts that are intended to promote some greater good.  The question is whether these acts are like the starfish story or are, indeed, futile.

Let's look at some examples.

We all know the damage to the environment caused by plastic waste.   We've all read and seen pictures of the Pacific Ocean Garbage Patch.   It's awful.  I refrain from using plastic.  I bring my own bags to the grocery store.  I never buy water in plastic bottles.  When I order water in restaurants, I always make a point to tell the server not to bring a straw.   

Does it matter?  

The answer is clearly no.  No individual volunteer actions will stop the spread of plastic waste.  My actions will have no impact on the plastic waste in all of the oceans.   Even if the action is replicated by thousands of others, it will make essentially no difference.

Another example.

There are lots of folks who go hungry every night.  We've all worked in soup kitchens, donated to food banks, etc.  Does our voluntary action matter?   If the goal is to end systemic hunger the answer once again is clearly no.

Another example.

There are lots of folks who lack decent housing.  I've donated to Habitat for Humanity for decades and worked HFH projects in the past.  Does it matter?  In this case we do have a starfish.  Homes get built one at a time and each time one is completed a family's life is transformed forever.

Getting back to the examples without starfish.  If the voluntary actions have no negative consequences, then even though they don't do anything to solve the systemic issue there are no drawbacks to the actions.   However, if the actions with no starfish and these acts have a cost should they be avoided?   Should we consider these acts without starfish simply vanity efforts?  Are these acts that psychologically benefit the actor while making little or no difference to the issue at hand.    

Put more harshly, are they a waste of time?  If they have no cost it doesn't matter.  The avoidance of plastic presents no dilemma.  The food bank donation is not so easy.  Clearly there are both costs and benefits.  Do the benefits justify the cost or could the resources be used more efficiently elsewhere?  

What is the Fed Doing?

 A brief note on the Federal Reserve Bank monetary policy.

For context the Fed has two monetary policy goals which are mandated by Congress.  The traditional goal and the goal of all central banks is to facilitate a stable currency, i.e., control inflation.   This doesn't mean no inflation.   In fact, the goal of most central banks is not to have no inflation but to have a steady inflation rate close to 2%.

 The second goal which is specific to the US Fed is to encourage full employment.   Note that the other major central banks; ECB, Bank of England, Bank of Japan don't have this as a specific objective.   

The basic tools of central bank monetary policy are to manage short term interest rates.  In times of low inflation or a weak economy the Fed aims for negative real interest rates.  This means that the nominal rate is less than the inflation rate.   However, when inflation is low and had been low for decades before the pandemic the Fed was constrained by the "zero lower bound".   That is, if inflation rate is very low - say 1.5% and the ideal real interest rate should be -2% then the zero lower prevents the central bank from achieving this.  This has been the situation for the ECB from the Great Financial Crisis up to the pandemic.

So, when the zero lower bound limitation arises the central bank uses two other monetary policy tools - Quantitative Easing (QE) and Forward Guidance.    QE is when the central bank buys long duration bonds the idea is to add liquidity to the economy and to lower longer duration interest rates.  In the US example the interest rate on 10-year Treasury Bonds is the main focus of QE.

Forward Guidance is less important.  It is merely the "promise" of the central bank that it will keep interest rates for an extended period of time.

Historically when the economy approaches full employment and inflation approaches the 2% goal the Fed would increase interest rates.  The idea is to slow demand in the economy and avoid "over-heating" which could lead to persistent inflation over 2%.

Because of the pandemic the Fed changed its policy tools.    They predicted inflation would be "transitory" due to pandemic related supply change disruptions.  They also thought that even though unemployment levels were low there was still "slack" in the labor market.  The labor participation rates have not recovered to the pre-pandemic levels.   Measured by historical unemployment rates and current inflation rates the Fed should have started to use their tools to slow demand.   They didn't.  Instead, they left short-term interest rates essentially at zero and continued to use QE to lower long term rates and add liquidity to the economy and the financial markets.  They also announced that they would slow the QE bond purchases (Quantity tapering) and only after they ended QE would they begin to raise interest rates.

Inflation was close to 7%, unemployment rate was less than 4% and the Fed was implementing expansive monetary policies rather than slowing demand.  The current phrase being used is that the Fed is "behind the curve".  Since they are moving slowly to curb demand there is a possibility of inflation rising well above 2% and staying there.  Then the Fed will have to raise interest rates to such a level that they may cause a recession.