A familiar finance fable in UK bonds

Guy Adams in the Daily Mail has an intriguing story of what's going on in UK bond markets.  It's intriguing because it's so utterly familiar. And it reveals that all the masses of regulation and armies of regulators aimed at preventing exactly this sort of thing from happening again and again have failed again. 

UC pensions take in contributions when people are young, invest them, and then pay out fixed amounts when people get old. They hold large quantities of government bonds, currently 1.5 trillion pounds per Adams. That's a good strategy: if you have fixed payments to make, invest in risk free assets that provide fixed payments, and ignore the mark to market. But it fell apart in a classic way. 

Leverage

As often is the case, however, they didn't have enough assets to pay out the promises. So... Lever up! Pensions used their government bonds as collateral, borrowed money, and invested that money in more government bonds or, to a lesser extent, in stocks or other investments. 

Supply and inflation

 Mark Perry recently updated a fabulous chart: 

Not all inflation is the same. 

Some interpretations, from Mark. Tradeable (international competition) / non tradeable; government intervention / free market; durable goods / services: 

a. The greater (lower) the degree of government involvement in the provision of a good or service the greater (lower) the price increases (decreases) over time, e.g., hospital and medical costs, college tuition, childcare with both large degrees of government funding/regulation and large price increases vs. software, electronics, toys, cars and clothing with both relatively less government funding/regulation and falling prices. As somebody on Twitter commented:

Blue lines = prices subject to free-market forces. Red lines = prices subject to regulatory capture by government. Food and beverages are debatable either way. Conclusion: remind me why socialism is so great again.

b. Prices for manufactured goods (cars, clothing, appliances, furniture, electronic goods, toys) have experienced large price declines over time relative to overall inflation, wages, and prices for services (education, medical care, and childcare).

c. The greater the degree of international competition for tradeable goods, the greater the decline in prices over time, e.g., toys, clothing, TVs, appliances, furniture, footwear, etc.

d. From Twitter comments this week (2022).

*Thank goodness the government doesn’t subsidize TVs or toys, or toy TVs.

*Almost every line that went up, has had some type of government involvement, while the lines going down have more to do with capitalism.

*And as always, the more regulated, the more expensive things become.

There is a big distributional impact here. Less well off people buy more blue stuff, rich people more red stuff. 

The implications for greater protection, less immigration, industrial policy, and subsidies are pretty clear. 

Update:

I have been sloppy, about one of my own pet peeves. This graph is about relative prices, not about inflation.  

 

 

WSJ stability oped -- full text

Now that 30 days have passed, I can post the full text of "Nobody Knows How Interest Rates Affect Inflation" in the Wall Street Journal August 25. A previous post has a summary with pretty pictures. 

***

A grand economic experiment is under way. Can the Federal Reserve contain inflation without raising interest rates much higher than they are now?

Conventional wisdom says that as long as interest rates are below the rate of inflation, inflation will rise. Inflation in July was 8.5%, measured as the one-year change in the consumer price index. The Fed has raised the federal funds rate only from 0.08% in March to 2.33% in August. According to the conventional view, that isn’t nearly enough. Higher rates are needed, now.

This conventional view holds that the economy is inherently unstable. The Fed is like a seal, balancing a ball (inflation) on its nose (interest rates). To keep the ball from falling, the seal must quickly move its nose.

In a newer view, the economy is stable, like a pendulum. Even if the Fed does nothing, so long as there are no more shocks, inflation will eventually peter out. The Fed can reduce inflation by raising interest rates, but interest rates need not exceed inflation to prevent an inflationary spiral. This newer view is reflected in most economic models of recent decades. It accounts for the Fed’s projections and explains the Fed’s sluggish response. Stock and bond markets also foresee inflation fading away without large interest-rate rises.

So which view is correct? In normal times, it’s hard to tell. Whether seal or pendulum, inflation and interest rates move up or down together in the long run, and they jiggle around each other in the short run.

Advocates for the conventional view argue that the Fed raised interest rates too little in response to inflationary shocks in the 1970s. Only when the Fed raised interest rates substantially above inflation for several years in the early 1980s, provoking two deep recessions, did inflation finally subside. The sooner we get to it, they say, the better.

Advocates for the stable view point to recent decades of steady inflation at zero interest rates in the U.S., Europe and Japan. When deflation appeared and central banks couldn’t move rates much below zero, conventional analysts warned of a “deflation spiral.” It never happened. Why should an inflation spiral break out now?

In both theories, expected inflation matters: If people expect higher inflation next year, they buy or raise prices today. The central assumption behind the unstable inflation-spiral theory is that people expect next year’s inflation to be pretty much the same as last year’s inflation—what economists call “adaptive expectations.” A driver who looks in the rearview mirror to judge where the road is will quickly veer off to one side or another.

The central assumption behind the stable theory is that people think more broadly about future inflation. They’re not clairvoyant, but they don’t ignore useful information and aren’t much worse at forecasting inflation than, say, Fed economists are. If a driver looks forward through the windshield, even a dirty windshield, the car tends to get back on the road.

Economists don’t know for sure whether the economy is stable or unstable, whether inflation can fade away without interest rates substantially above inflation. In that light, the Fed’s actions make some sense. If you really don’t know how interest rates affect inflation, it’s natural to raise rates slowly. Inflation may subside on its own. If not, you can keep raising rates.

If inflation fades, the conventional view will be seriously undermined. If it spirals, absent other shocks, the new view is in trouble. But a good experiment requires everyone to leave the test tube alone. Unfortunately, we are likely to see some new shock: a virus, a war, a financial crisis or a fiscal blowout. Inflation will then rise or fall for reasons having nothing to do with spirals, stability and interest rates.

Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar of the Cato Institute. His book “The Fiscal Theory of the Price Level” is out in January.

Update: 

Economists wondering what the heck I'm talking about and where are the equations should read "Expectations and the Neutrality of Interest rates."

Brexit might not have been such a bad idea after all -- EU insanity

I was for Fixit, not Brexit. The EU is a great idea. They put together articles of confederation, empowering an out of control bureaucracy. OK, we did that too, minus the bureaucracy part. Try again, with a real constitution, a real federal government, clear separation of powers, checks and balances, and a careful list of limitations, not long vague aspirations. 

Europe has not taken that suggestion, nor the hint offered by the Brits leaving. The latest evidence is a tiny puff in this hurricane of hot air, which I found on this tweet. 

That sounds interesting, in a waste time on twitter while procrastinating getting to work sort of way. And I was encouraged--EC bureaucracies looking for outside advice, breaking out of the bubble seems like a good idea. Hey, maybe I'll apply, I thought. 

I followed the link to the official announcement and it offers in a nutshell what's going on in EU "policy-making," (and a hint why I hate that word)

The latest communication on industrial policy strategy (COM(2021) 350final) has shifted the attention towards an ecosystem approach to industrial policy, focusing on industrial ecosystems and their complex interconnections related, among other things, to entrepreneurship (and SMEs), innovation, skills, value creation and social impact.

After mulling over the obvious reality of war, supply chains, etc. 

..a reactive stance is not sufficient and needs to be complemented by a forward-looking reflection aimed at properly considering externalities and risk factors to be prepared for - and therefore more and more resilient against - possible additional challenges (for instance in terms of disruptions and shortages but also new, far from impossible health crises), remaining consistent with crucial long-term objectives. Progress is more than innovation and EU competitiveness, more than continuous growth and geopolitical predominance. [Who are you kidding?] It is also quality of life, sustainable production and energy generation, digitally advanced (but also digitally safe and fair) infrastructure, “enlightened” decision-making at corporate level eventually influenced by well-informed choices at consumer level.

My emphasis. The subject is a bit mysterious in all these passive sentences, but I believe it is "EU industrial policy." I'm glad it will take on scare-quote enlightened decision making at the corporate level and allow eventually for some "well-informed" choices "at the consumer level." That's you with the pitchforks.  

This may imply putting into question traditional policy yardsticks such as the focus on industrial sectors as done with the shift towards an ecosystem approach, [the focus on] on the overarching principle of economic efficiency as a first best for resources allocation e.g. by factoring in risks associated to critical strategic dependencies, or the focus on traditional stakeholders (for instance, by including a wider set of actors, in a truly ecosystem mindset going beyond industrial activity and including other relevant players, such as universities, research centres, and even the role of local communities). This may be more effectively inspired by policy missions, rather than sectoral or even social cleavages.

Well, no wonder they need some outside economists if they're going to perfectly foresee "critical strategic dependencies" in the "ecosystem," such as, oh, maybe Russia might turn off the gas some day.  "Policy missions, rather than sectoral or even social cleavages?" I have no idea what that means. 

This may also imply some reshuffling in policy priorities, for instance by having some ethical yardsticks considered upfront (namely, but not only, with respect to innovation),

"by having ethical yardsticks considered upfront." Don't you love passive voice? "namely... with respect to innovation" is truly chilling. That means, before you can innovate, the great directorate of industrial policy will decide if your innovation is "ethical," as it affects "stakeholders" and the "industrial ecosystem." What is the chance James Watt's steam engine will make it past that? 

by enshrining sustainability considerations (and related externalities often ignored in the past) in trade-offs underlying corporate choices, by thoroughly considering social impact of public and private investment as a major element of choice.

Passive means us. Can any investment get past this? Oh yes, 

“Social cheerleading” and “greenwashing” should become strictly unfeasible, starting from becoming easily detectable. This may imply rethinking the incentives and mechanisms to better align public goals and private behaviour. It may also imply refining our metric to measure progress.

Heavens, we wouldn't want to have any greenwashing here. 

If addressed only from a national perspective, all the challenges and reflections above would seem and would be unsurmountable. A truly coordinated European approach exploiting the potential of the Single Market would be of the utmost importance...

Now you know why the Brits left. 

What follows is a non-exhaustive list of examples of themes of interest to DG GROW within the broad areas defined above: [edited here]  

• Industrial policy in the Single Market: moving forward avoiding fragmentation and minimising short-term losses

Aha, so industrial policy involve "short term" losses! 

• A mission-oriented Single Market to increase ownership, generate momentum and help prioritising actions aimed at improving its functioning

Ownership can be transferred, but how can ownership be increased? Otherwise as empty a sentence as I've seen in a long time. 

• Strategic dependencies, monitoring risks and building supply chains resilience

Yes, you did such a great job on that one by banning fracking and decommissioning nuclear power.

• Dependencies and the search for new economic models

• Alternative purposeful business practices

Just savor the empty words. Or are they Orwellian and full of meaning? 

• Unlocking the green business case; the role of the Single Market

• Investment needs to leap forward

A Great Leap Forward? How are you going to leap forward given the previous page that says, basically, all investment must stop? 

• New metrics to measure economic progress

We haven't dug ourselves into a 20 meter hole. It's only a tenth of a furlong!  

I am tempted to apply. I offer this: "Cut the BS, get out of the way, quit and get some real jobs. The pretense of technocratic competence to understand and manipulate such a huge Rube-Goldberg view of the world is just laughable." Send the 15,0000 euro check to Hoover. 

I originally thought this would be illegal. But on a little research, the Lisbon Treaty, which was supposed to improve the EU, takes a big step backwards. 

The Lisbon Treaty introduced in its Art. 3 new language into primary law that expresses the ambition to give the EU a stronger social dimension.1 In comparison to its predecessor provision of Art. 4 (1) of the Treaty Establishing the European Community, which solely relied on the ‘principle of an open market economy with free competition’, the basic objectives of the EU were broadened. Art. 3 TEU now includes objectives that come across as a promise to rebalance market and non-market values through the foundational provisions of the European Union. In line with other wide-ranging objectives, like fighting social exclusion, this article includes the eye-catching sentence that the EU aims for ‘a highly competitive social market economy’ that seeks to achieve ‘full employment and social progress’

Liz Truss may struggle to convince the UK that to fix supply you have to fix supply (great WSJ commentary by Joe Sternmberg here) but at least she knows where to go. Europe still seems lost in the fog.  

This is of course likely to go nowhere, to just employ PhD economists to write reports nobody reads. But who knows, having missed a real estate bust, a sovereign debt crisis, a pandemic, an energy crisis and a war, the ECB is doubling down on climate change stress tests, so you never know what foolishness can actually make it into policy. 

And it's not all so bad. Ukrainians look East vs. West. A bunch of bureaucratic tomfoolery looks a whole lot better than what Vlad the Impaler has to offer. Go Europe. Some day, fixit.

Gramm, Early and the Unfixable Problem

Phil Gramm and John Early have a new WSJ oped, based on their smashing new book. Both are based on an astounding fact: The numbers used by the Census Bureau, and countless following researchers, to define income inequality and poverty do not include taxes, which reduce income of the rich, and transfers, which increase income of the poor. The latter, obviously, matters to just how many Americans fall in the Census Bureau's definition of poverty.

Specifically, in the oped, the new refundable tax credit cannot, by arithmetic, do anything to alleviate measured child poverty because 

"the income numbers used to calculate the official poverty rates don’t count refundable tax credits as income to the recipients. "

This is wonderful for advocates of ever larger transfer programs, as it creates a problem that can never be measured to be fixed! 

The more general issue 

The Census Bureau fails to count two-thirds of all government transfer payments to households in the income numbers it uses to calculate not only poverty levels but also income inequality and income growth. In addition to not counting refundable tax credits, which are paid by checks from the U.S. Treasury, the official Census Bureau measure doesn’t count food stamps, Medicaid, the Children’s Health Insurance Program, rent subsidies, energy subsidies and health-insurance subsidies under the Affordable Care Act. In total, benefits provided in more than 100 other federal, state and local transfer payments aren’t counted by the Census Bureau as income to the recipients

The book goes on to show how this startling omission overturns just about everything you've heard from the hyperventilating classes about income inequality. Granted, spending zillions on rotten health insurance that people value much less than a dollar per dollar is not quite the same as cash, but there are lots of cash or cash equivalent transfers in there. 

A question I do not know the answer to: Do means-tested programs count as "income" the transfers from other means-tested programs? If a program is only available to, say, those with less than $50,000 per year income, does that figure include any other means-tested programs?  Even the ones that send cash, rather than in-kind transfers such as rent, energy, and health insurance subsidies? I suspect largely no. If not, the incentives for means-tested programs are far worse than even they appear. Facts welcome.

One might easily respond that ok, but evil capitalism created wider pre-tax pre-transfer inequality, and only by the grace of larger and larger transfers has some measure of stability been restored. Well, which is the cause and which is the effect -- wider pre-tax pre-transfer inequality, or the large expansion of means-tested programs, all of which add to the stupendous marginal tax rates facing Americans with less opportunity? The book goes on to argue convincingly the latter. I'll cover that later. Noting here, they anticipate the argument. 

Fisherian Intuition

Interest rate neutrality is easy to state in equations but hard to digest intuitively. 

The equation says that interest rate = real rate plus expected inflation, \[i_t = r + E_t\pi_{t+1.}\]In one direction this is easy: If people expect a lot of inflation, then they demand higher nominal \(i_t\) interest rates to compensate for the declining value of the dollar. That leaves the real \(r\) interest rate unchanged. 

(Note: this post uses mathjax equations. If you can't see them, come to the original.) 

But in our economy the Fed sets the nominal interest rate and the rest must adjust. In the short run with sticky prices and other frictions the real rate may change, but eventually the real rate is set by real things and expected inflation must rise.  We can study that long run by leaving out  the sticky prices and other frictions, and then expected inflation rises right away. Rises. Higher interest rates raise inflation. How does that really work? What's the economic force? 

Standard intuition says overwhelmingly that higher interest rates cause people to spend less which lowers inflation.  The equations seem like they're hiding some sort of sophistry. 

(Fed Chair Powell explains the standard view well while sparring with Senator Warren here. The clip is great on several dimensions. No, the Fed cannot increase supply. No, none of what Senator Warren talks of will make a dent in supply either. The elephant in the room, massive fiscal stimulus, is not mentioned by either party. Just why each is silent on that is an interesting question.)

This is a lovely case that individual causality goes in the opposite direction of equilibrium causality. That happens a lot in macroeconomics and can cause a lot of confusion. It also is an interesting case of mistaking expected inflation for unexpected inflation. Along with confusing relative prices for inflation, that's common and easy to do. Hence this post. 

Email feed restored

A while ago, Google turned off the ability to receive the Grumpy Economist, and all the other blogger blogs, by email. I have now figured out how to restore it. I moved over to follow.it. If the import of the old email feed worked as it is supposed to, you're receiving this in your email once again. If not, you can click on the huge button to the right to get Grumpy by email. (I'll figure out how to make that prettier sooner or later.) I also announce each new blog post on twitter, and if you prefer that you can click the twitter link to follow me there. 

Follow.it encourages me to pass along all the "great additional features" you can use, here. You can now "define filters and more delivery channels, e.g... receive your news via Telegram, news page etc. (many others to follow soon)."

Thanks to several devoted readers who wrote to complain, nudging me to figure this out. If it still doesn't work, either comment here or email me directly. 

If I link "Feedburner alternative" and "Feedburner replacement" to follow.it,  they give me a $10 USD credit. Done!  

More substance on the way soon! 

Update

You will receive an email that looks like this. It invites you to click a link. This is a legitimate email. 

Energy Agony

Two era-defining articles popped up in today's Wall Street Journal. 

In "the coming global crisis of climate policy," Joseph Sternberg writes 

...Anyone who still thinks climate change is a greater threat than climate policy to financial stability deserves to be exiled to a peat-burning yurt in the wilderness.

...the world’s central banks and other regulators are in the middle of a major push to introduce various forms of climate stress testing into their oversight. ...The fad is for quantifying, with preposterous faux-precision, the costs of reinsuring flood risks, or fire, or the depressed corporate profits of a dystopian hotter future.

Well, if you seek “climate risk” to financial stability, look around you. It has arrived, although in exactly the opposite manner to what our current crop of eco-financiers predicted....

The U.K. may be facing a wave of business bankruptcies exceeding anything witnessed during the post-2008 panic and recession...The culprit is energy prices...Matters are probably worse in Germany,...

Banks and other financial firms inevitably will find themselves right at the edge of the water if or when a tsunami of energy-price bankruptcies washes ashore.

Expectations and the Neutrality of Interest Rates

Expectations and the Neutrality of Interest Rates is a new paper. It's an essay, really, expanding on a lunch talk I was privileged to give at the Minneapolis Fed "Foundations of Monetary Policy" conference in honor of the 50th anniversary of Bob Lucas' 1972 "Expectations and the Neutrality of Money." 

Abstract: 

 Lucas (1972) is the pathbreaking analysis of the neutrality and temporary non-neutrality of money. But our central banks set interest rate targets, and do not even pretend to control money supplies. How is inflation determined under an interest rate target? 

We finally have a complete theory of inflation under interest rate targets, that mirrors the long-run neutrality and frictionless limit of monetary theory: Inflation can be stable and determinate under interest rate targets, including a k percent rule, i. e. a peg. The zero bound era is confirmatory evidence. Uncomfortably, long-run neutrality means that higher interest rates eventually produce higher inflation, other things (and fiscal policy in particular) constant. 

With a Phillips curve, we have some non-neutrality as well: Higher nominal interest rates raise real rates and lower output. A good model in which higher interest rates temporarily lower inflation is a harder task. I exhibit one such model. It has the Lucas property that only unexpected interest rate rises can lower inflation. A better model, and empirical understanding, is as crucial to today's agenda as Lucas (1972) was in its day. 

Much of this is contentious. The issues are crucial for policy: Can the Fed contain inflation without dramatically raising interest rates? Given the state of knowledge, a bit of humility is in order. 

 The link also has slides, if you like those. In one slide, I managed to put together the 54 year project to (finally) produce a full theory of inflation under interest rate targets: 

Apartment inflation

 

This beautiful graph comes from calculatedriskblog.com. (Courtesy Andy Atkeson who used it in a nice discussion of a great paper by Ivan Werning at the Minneapolis Fed Foundations of Monetary Policy conference.) 

The central lines that don't move so much are the average rent. This is the quantity used by the Bureau of Labor Statistics to compute the consumer price index. The blue and yellow lines are the rent of new leases. 

The first thing this informs is the economic theory of "sticky prices." Apartment rents are a classic "sticky price;" the rent is fixed in dollar terms for a year. So, landlords deciding how much rent to charge, and people deciding how much they're willing to pay,  balance rents now vs. higher rents in the future. If everyone believes that inflation will be 10% over the next year, then it makes sense to raise the rent 5% now, and to pay the 5% higher rent, because  the savings at the end of the year balance the cost in the beginning. (Obviously, the economics are much more subtle than this, but you get the idea.) And Voila', you see it. 

The graph also says there is some predictability and nomentum to inflation. Inflation should not be a surprise to forecasters. If you see rents on new leases much above average rents, it's a pretty good bet that average rents will be rising in the future! This kind of phenomenon may be under exploited in formal inflation forecasting. 

And, on the continuing speculation whether inflation will go away with interest rates still substantially below current inflation, the graph does seem a leading indicator that the rational expectations model is winning.  

Clarification: Of course, the graph says nothing about causality; did new leases rise sharply because people expected inflation in average leases, or did new leases rise for other reasons, and we're just seeing the old theorem that marginal  > average when average is rising. But it is consistent with the expectations story, and illuminates that story nicely.