5/12/2018
Much to my surprise, Trump's appointment to the Federal Reserve announced he's going to raise interest rates but, in the end, the stated plan will not be enough. The basic story is that if you want to manage inflation with the FedRate it needs to be around 2% above the then current inflation rate. In contrast, the Fed's stated plan is to take this year to raise interest rates to a level of inflation we had last year - a move that is, in fact, better than nothing. However, if allowed to continue it may lead to a situation where the economy is contracting and inflation continues to rise (stagflation) which will almost necessarily lead to 1970s level interest rates (think 13%).
I had already been thinking & writing about this in February but stopped around 3/25/2018. I took a long break, sold my house, (other assets,) and moved to another state - you'll have to follow me on twitter for more timely market updates. Evenso, I can no longer in good conscience forestall it any longer and have been working on putting this out there. To that end needed to be broken into 3 parts to be adequately explained and understood (there's no shortage on financial minutia here). Primer on Fiat Currency was the minimal amount of knowledge required to understand this post on the Fed's plan which adds to and builds on the concept of currency and relates it to that plan and the current economy. The third, and potentially the most useful for those in the markets, concerns itself with Positioning when interest rates are less than inflation.
If you continue, I'll assume you have a reasonable grasp of the concepts of: Fiat currency, inflation, money pool, prevailing interest rate, return on investment, devaluation, negative interest rates.
The correct move would likely be aggressive interest rates well above the rate of inflation which would be bad news for the Melt-up but good news for the broader market as it would likely prevent runaway inflation. The current plan is not that though. So I expect the markets to continue in a sideways-ish timber-saw-tooth fashion until it's all too clear a new plan is needed i.e. too late.
By the end of the year, the Fed plans to raise interest rates (now 1.75%) to less than the current rate of inflation (2.54%). The slow rise in the Federal funds rate's is designed to curb inflation - an interesting but failed hypothesis - so as not to spook the market. The market will likely be spooked regardless. While the incremental increases may temporarily decrease the rate that inflation increases for a time (to 0.08% from 0.2% per month for example,) it will not stop the increase. Further, I expect inflation will not only continue but accelerate in the setting of low unemployment and a stimulated economy as outlined in Primer on Fiat Currency This inflation will initially be termed "growth" or "healthy growth" but will ultimately require even higher interest rates. And we may already be about to hit that point as the Trump administration is excluding energy and food costs to state that the inflation is at 2% and 2% is somehow the Fed's goal.
However, the policy of the Fed is to keep inflation between 0 and 2%, and it has about 3 tools to do that one trick: Determine the Federal funds & Discount rates, act in the market to set that rate, and set reserve requirements. The Fed and most economists would like inflation to be: as near zero as possible, not negative, and less than 2%. The idea that reaching 2% is a "goal" is ridiculous. The goal isn't to take 4 grams of Tylenol every day, that's the maximum that's probably safe. Exceeding it is commonly regarded as bad in a way orders of magnitude greater than exceeding the daily limit of ibuprofen. And to tweak the data and claim to still be within that 4g limit by not counting the Tylenol when you turned the lights in the morning and another, when you had lunch, is delusional at best. In some cases even approaching the safe guideline is probably not good. While the theoretical limit of human G tolerance might be 50 horizontal Gs's and "eye-balls out" might be 46Gs - not testing that limit is the best way not lose your eyeballs due to G-force. Which one is inflation? We don't know. We're reasonably confident exceeding 5% is bad, maybe that's 50Gs bad, and exceeding 2% is Tylenol's 6 grams bad.
While all this isn't generally good, in the short-term it will probably help the Trump administration during the 2018 mid-term by spinning inflation as "growth" with a hidden option to considerably increase interest rates afterward. An option that may not be exercised even as inflation creeps past 3% because this administration never follows a stated plan and may not be hiding its rationality.
(Skip to Fed plan or conclusion)
Let's talk about Low-interest rates and inflation
The classical economic idea: 'If inflation and wages are low businesses will make capital investments or hire more people,' has proven false. Or if true, there is a hidden yet critical indicator (not merely low wages & low inflation) that the actual economy waits for. This was easily shown in the great depression, but you need only look to our own great recession for evidence. Similarly, the idea that a government can deficit spend its way out of a recession is false (Keynesian economics). While low-interest rates will increase growth when other conditions (or viable investment opportunities) are met it necessarily increases the amount of money in the economy. Unchecked, the expanding monetary pool contributes to inflation later as we zoom past the nebulous divide between downturn and prosperity. Directly manipulating interest rates, therefore, is a crude but important tool that has the possibility to yield results when other conditions are met. Importantly, however, increasing the money supply when we're near full employment, inflation is up, and the rate inflation rises is increasing further accelerates inflation.
As illustrated in the Primer on Fiat Currency, inflation is effectively a negative interest rate for cash on hand. March's rate of inflation was 2.3% meaning the value of money is decreasing by 2.3%/year and in order for cash to maintain its value, it must be invested productively at a rate of return greater than 2.3% simply to maintain it's real value. A nominal return of 7% would be a real return of 5.7% if inflation remains constant. However, this is merely a snapshot in time as inflation continues to increase. If you were to bank on June 2017's rate of 1.6% without considering the rate of change, namely, that it'd be 1.9% in August, and 2.2% in September you prepared for a future that didn't happen. The rate of change or rate of increase is a crucial consideration beyond the absolute rate of inflation or interest.
If the prevailing interest rate is effectively zero, putting cash in a box will basically preserve it's value unless inflation provides a negative interest rate. Inflation, as a constant eroding force, creates pressure to find reasonable stores for cash that will maintain real value. Relatedly, low and negative interest rates make parking money in a bank an undesirable option. When these situations occur together this means there are a lot of people with cash looking to for places to put it. Keynes believed low-interest rates would trigger investments in businesses and cause money to flow back into the working economy however this doesn't really occur in historical examples. Why? Well, it's commonly conjectured that the prospect of loss in lending is higher than the projected loss from inflation. Losing 2.5% of real value in a year is preferable (and probably not noticeable compared) to losing 30% to 120% in a bad investment. Keynes' idea may stem from the idea that if someone believes a business or a plan will create a real return this incentivizes investing, the low interest rates lower the threshold necessary to realize a return on any borrowed money, and inflation remains a pressure to find investments with a positive return e.g. lend. So while in principle the idea has merit in reality little money is actually lent or borrowed to invest in tangible ventures. Instead, financial institutions often borrow money to spend on financial instruments with little more than an emotional effect on the real economy. Further, this money follows it's peers and asset bubbles develop (like BitCoin) providing a comforting illusion of growth.
If the economy is perceived to be doing well, or an edge is glimpsed, cheap money will find a way to directly enter the economy. This does indeed increase growth for a time but as more people are hired or buildings and equipment are bought (capital improvement) that money either goes to existing costs (re-entering the economy later by this same mechanism), more capital improvement (this same mechanism) or that money seeks to store or increase in value. The money, in this way, stays in circulation. If the prevailing interest rate is high enough bonds, bills, and notes are seen as an effective store of value, or savvy investment, which removes that money from the positive feedback loop of money entering the economy/remaining in the global money pool.
All of this means that if interest rates are not higher than inflation there is no reason for cash not to reenter the pool of available money. And since too much money already exists letting it freely circulate allows for significant inflation. While reinvesting in growth assets is a smart and correct move individually and consumption is easier, en mass these contribute to inflation and erode all returns, balancing the true monetary supply with that in circulation - different terms. The interest rate shields us from realizing the true value of our fiat currency.
Low-interest rates with inflation increases inflation.
Low-interest rates concurrent with inflation causes additional inflation (in most fiat currency circumstances), and there is almost no limit to the degrees this can illustrate how valueless our money's fundamental value has become. If it reaches a point where "it's not worth the paper it's printed on" congratulations, we've reached hyperinflation and we'll be the focus of a history lesson on economics one day. They'll say that while your real assets and abilities might've been worth something (in a broader sense) there was no way to easily transact exchanges of goods, services, and assets when the intermediary of local currency was deemed worthless and something like the barter system was needed. Long monologues about the ramifications of the barter system will ensue or some nonsense about the intrinsic value of gold, but at the end of the day exchange is stifled as bartering itself is a challenging high friction process - even when what is bartered is gold. There are no coherent, well-reasoned arguments advocating for the barter system over a stable and solid currency. Though, as an empiricist, I must admit that here I'll have to sweep the concept of a "stable and solid currency" under the rug or perhaps suggest I'll address it at another time.
How to curb inflation.
With this new understanding perhaps it is now evident that stopping inflation quickly is of paramount importance. A crude but effective tool is increasing interest rates to affect the money supply by providing a store of value outside of the economically active monetary pool and remove it to the float or, better yet, the dark recesses of finance in an asset so illiquid and intangible our generation will never hear of it again. It's difficult to tell how much higher interest rates must actually be than inflation to move money from general circulation into treasuries. If your experience is that bread is $3 today and will be $3.30 tomorrow how great a return must be provided to make you store the money instead of immediately buying bread today? It turns out quite a lot. People tend to require significant rates of return to delay gratification. Although at some point, if you put $3 in the bank today, bread may cost $3.30 tomorrow but you'll have $4 in the bank. Why bother buying a new car (that immediately loses 20% of its value), putting money in REIT with 4% dividend, or putting money in the SPY with an annual probabilistic return of 5-7% when a T-Bill will get you 10% APY "guaranteed"? The smart financial move will always be to store your money in a place that it will be more valuable to you later, and for our considerations, hidden from the economy for some time.
Conclusion
Economies are like a provoked, pink, bull elephant. You might be able to control them with subtle pressure given enough time, but once you've noticed they are out of control there will be the impetus to apply large amounts of pressure quickly which will likely lead to an unexpected outcome. On the flip side, if the pressure isn't significant enough then the elephant will just do what comes naturally and turn you into jam. If interest rates aren't raised above inflation then they may not curb it, and if inflation starts to get away from us then we'll have to suddenly spike interest rates. By that time, it'll be too late, we'll have spooked an angry elephant in it's shadow.
Producer prices have climbed to 3.1% as of the end of 2017. These half-measure rate hikes may give the elephant mental pause, but he's already coming right for us. Volatility will be the name of the game in my view. The fact that the XIV (Inverse of the volatility index VIX) went to zero while I was inundated with other life obligations should've been a big clue to anyone paying attention.
The price of oil will most likely nominally increase as an asset for which there is inelastic demand however as the value of the US dollar decreases the term "oil speculators" may well return as cash seeks to maintain it's real value. This effect will be compounded by the propensity for asset bubble formation when real stores of value are rare and money is plentiful.
Unfortunately, this is nothing like the 1970s. We haven't just come off the gold standard and being forced to play an impossible catch up game with a new low-value dollar. It's been nearly 50 years, the dollar is magic, and in no way did the Fed create billions out of thin air to buy toxic assets. Seriously though, it'd be even more ridiculous to issue T-bills in Deutsche Mark in 2018 than it was in 1978 (Carter bonds). And probably not as profitable for anyone who bought them, Germany joining the EU has hit that economy in an unfortunate way.
(Skip to Fed plan or conclusion)
Let's talk about Low-interest rates and inflation
The classical economic idea: 'If inflation and wages are low businesses will make capital investments or hire more people,' has proven false. Or if true, there is a hidden yet critical indicator (not merely low wages & low inflation) that the actual economy waits for. This was easily shown in the great depression, but you need only look to our own great recession for evidence. Similarly, the idea that a government can deficit spend its way out of a recession is false (Keynesian economics). While low-interest rates will increase growth when other conditions (or viable investment opportunities) are met it necessarily increases the amount of money in the economy. Unchecked, the expanding monetary pool contributes to inflation later as we zoom past the nebulous divide between downturn and prosperity. Directly manipulating interest rates, therefore, is a crude but important tool that has the possibility to yield results when other conditions are met. Importantly, however, increasing the money supply when we're near full employment, inflation is up, and the rate inflation rises is increasing further accelerates inflation.
As illustrated in the Primer on Fiat Currency, inflation is effectively a negative interest rate for cash on hand. March's rate of inflation was 2.3% meaning the value of money is decreasing by 2.3%/year and in order for cash to maintain its value, it must be invested productively at a rate of return greater than 2.3% simply to maintain it's real value. A nominal return of 7% would be a real return of 5.7% if inflation remains constant. However, this is merely a snapshot in time as inflation continues to increase. If you were to bank on June 2017's rate of 1.6% without considering the rate of change, namely, that it'd be 1.9% in August, and 2.2% in September you prepared for a future that didn't happen. The rate of change or rate of increase is a crucial consideration beyond the absolute rate of inflation or interest.
If the prevailing interest rate is effectively zero, putting cash in a box will basically preserve it's value unless inflation provides a negative interest rate. Inflation, as a constant eroding force, creates pressure to find reasonable stores for cash that will maintain real value. Relatedly, low and negative interest rates make parking money in a bank an undesirable option. When these situations occur together this means there are a lot of people with cash looking to for places to put it. Keynes believed low-interest rates would trigger investments in businesses and cause money to flow back into the working economy however this doesn't really occur in historical examples. Why? Well, it's commonly conjectured that the prospect of loss in lending is higher than the projected loss from inflation. Losing 2.5% of real value in a year is preferable (and probably not noticeable compared) to losing 30% to 120% in a bad investment. Keynes' idea may stem from the idea that if someone believes a business or a plan will create a real return this incentivizes investing, the low interest rates lower the threshold necessary to realize a return on any borrowed money, and inflation remains a pressure to find investments with a positive return e.g. lend. So while in principle the idea has merit in reality little money is actually lent or borrowed to invest in tangible ventures. Instead, financial institutions often borrow money to spend on financial instruments with little more than an emotional effect on the real economy. Further, this money follows it's peers and asset bubbles develop (like BitCoin) providing a comforting illusion of growth.
If the economy is perceived to be doing well, or an edge is glimpsed, cheap money will find a way to directly enter the economy. This does indeed increase growth for a time but as more people are hired or buildings and equipment are bought (capital improvement) that money either goes to existing costs (re-entering the economy later by this same mechanism), more capital improvement (this same mechanism) or that money seeks to store or increase in value. The money, in this way, stays in circulation. If the prevailing interest rate is high enough bonds, bills, and notes are seen as an effective store of value, or savvy investment, which removes that money from the positive feedback loop of money entering the economy/remaining in the global money pool.
All of this means that if interest rates are not higher than inflation there is no reason for cash not to reenter the pool of available money. And since too much money already exists letting it freely circulate allows for significant inflation. While reinvesting in growth assets is a smart and correct move individually and consumption is easier, en mass these contribute to inflation and erode all returns, balancing the true monetary supply with that in circulation - different terms. The interest rate shields us from realizing the true value of our fiat currency.
Low-interest rates with inflation increases inflation.
Low-interest rates concurrent with inflation causes additional inflation (in most fiat currency circumstances), and there is almost no limit to the degrees this can illustrate how valueless our money's fundamental value has become. If it reaches a point where "it's not worth the paper it's printed on" congratulations, we've reached hyperinflation and we'll be the focus of a history lesson on economics one day. They'll say that while your real assets and abilities might've been worth something (in a broader sense) there was no way to easily transact exchanges of goods, services, and assets when the intermediary of local currency was deemed worthless and something like the barter system was needed. Long monologues about the ramifications of the barter system will ensue or some nonsense about the intrinsic value of gold, but at the end of the day exchange is stifled as bartering itself is a challenging high friction process - even when what is bartered is gold. There are no coherent, well-reasoned arguments advocating for the barter system over a stable and solid currency. Though, as an empiricist, I must admit that here I'll have to sweep the concept of a "stable and solid currency" under the rug or perhaps suggest I'll address it at another time.
How to curb inflation.
With this new understanding perhaps it is now evident that stopping inflation quickly is of paramount importance. A crude but effective tool is increasing interest rates to affect the money supply by providing a store of value outside of the economically active monetary pool and remove it to the float or, better yet, the dark recesses of finance in an asset so illiquid and intangible our generation will never hear of it again. It's difficult to tell how much higher interest rates must actually be than inflation to move money from general circulation into treasuries. If your experience is that bread is $3 today and will be $3.30 tomorrow how great a return must be provided to make you store the money instead of immediately buying bread today? It turns out quite a lot. People tend to require significant rates of return to delay gratification. Although at some point, if you put $3 in the bank today, bread may cost $3.30 tomorrow but you'll have $4 in the bank. Why bother buying a new car (that immediately loses 20% of its value), putting money in REIT with 4% dividend, or putting money in the SPY with an annual probabilistic return of 5-7% when a T-Bill will get you 10% APY "guaranteed"? The smart financial move will always be to store your money in a place that it will be more valuable to you later, and for our considerations, hidden from the economy for some time.
High-interest rates also exert a pressure on equities by this mechanism, and it's a very human decision to try to avoid raising them overmuch if you like high stock prices. Moving the attention of the masses from equities and business ventures to bonds diminishes the value of equities, a very predictable side effect. Raising interest rates does create a problem for businesses as borrowing money becomes much more expensive (as the rate of risk-weighted return must outperform the high-interest rate) and the actual business environment is perceived as riskier as the pool of disposable money evaporates. While you might buy bread today if your money becomes worthless tomorrow (inflation), a high-interest (or deflationary) environment means saving money today will allow you to buy more loves in the future.
Deflation is the monster in the corner for a business. Briefly, if the bread you sold yesterday for $3 can now only be sold for $2.80 the miller isn't going to go back in time and reimburse you for the flour you already bought and your workers won't tolerate daily or retroactive wage reductions. Deflation then is worse for business than high-interest rates for that reason, but in both cases, the total pool of money is being reduced (albeit by different mechanisms).
So while high-interest rates from a certain perspective do hurt businesses and slow growth it's the least worst alternative to deflation and the worker's problems with high inflation. This is why it's currently accepted inflation should be as close to zero as possible, probably less than 2%, and never negative (deflation).
Slow growth & Inflation
If interest rates are not raised quickly enough the negative effect of rising interest rates, marginal economic outlook, and high inflation can lead to Stagflation. Stagflation is term derived to apply generally to the period of 1979 to 1982, a period of "stagnant economic growth" combined with high "inflation" and the introduction of high interest rates.
Inflation had been ignored because it was falsely thought that this would only lead to low unemployment. Instead, inflation reached 12%, unemployment continued to rise, GDP was falling into negative territory, and the price of oil had spiked due to OPEC. In this scenario, the cash in your hand is effectively at a negative 12% interest rate and the real and nominal price of oil is rising by various mechanisms which all contribute in different ways to increased costs for the delivery of many goods and services. It's really not good for anyone.
The stated position of the Federal Reserve chair is essentially to allow inflation to continue increasing
. . . seeming only to target inflation's rate of increase rather than it's current value. Presumably hoping that by preserving some of the money supply growth can also be preserved. However, as described above not providing an incentive for money to leave the pool is an incentive to return it to the positive feedback loop of the money pool. Cash will continue to find its way to anything promising returns including asset bubbles created by the low-interest rates themselves. Without higher interest rates in CDs, Bonds, Treasury notes, and T-Bills there is nowhere for the excess money to go but back to anything in the economy promising higher rates. Inflation will therefore continue, likely accelerate, and require even faster rates of interest rate increase to outpace increasing inflation rates. Inflation is harder to catch and curb the longer the addressable issues aren't addressed, it needs to be stopped well before anyone even thinks the elephant might charge. For perspective, one time we just let inflation rise too long and so in 1981 the average 30-year mortgage had an 18.5% interest rate.
To reiterate, in 2017 inflation was 2.5% (over 12 months) the portion in excess of 2% was attributed to the 10.8% increase in energy prices (largest rise since 2011) and the rise in food prices. The goal of the Fed is to increase the Federal Funds rate to 2% by the end of 2018 and it is not worried about inflation because of growth. Thereby I believe that, in nominal dollars, the US might actually achieve more than 3.5% growth but in real dollars, that number will be much less than 1.5%.
Deflation is the monster in the corner for a business. Briefly, if the bread you sold yesterday for $3 can now only be sold for $2.80 the miller isn't going to go back in time and reimburse you for the flour you already bought and your workers won't tolerate daily or retroactive wage reductions. Deflation then is worse for business than high-interest rates for that reason, but in both cases, the total pool of money is being reduced (albeit by different mechanisms).
So while high-interest rates from a certain perspective do hurt businesses and slow growth it's the least worst alternative to deflation and the worker's problems with high inflation. This is why it's currently accepted inflation should be as close to zero as possible, probably less than 2%, and never negative (deflation).
Slow growth & Inflation
If interest rates are not raised quickly enough the negative effect of rising interest rates, marginal economic outlook, and high inflation can lead to Stagflation. Stagflation is term derived to apply generally to the period of 1979 to 1982, a period of "stagnant economic growth" combined with high "inflation" and the introduction of high interest rates.
Inflation had been ignored because it was falsely thought that this would only lead to low unemployment. Instead, inflation reached 12%, unemployment continued to rise, GDP was falling into negative territory, and the price of oil had spiked due to OPEC. In this scenario, the cash in your hand is effectively at a negative 12% interest rate and the real and nominal price of oil is rising by various mechanisms which all contribute in different ways to increased costs for the delivery of many goods and services. It's really not good for anyone.
As repeated throughout this treatise, the Fed has a powerful tool to fight inflation: Interest rates. And Stagflation is still better than unchecked inflation. Stagflation happens when inflation isn't fought early enough, the economy slows, and interest rates still need to be raised. The Fed has created trillions with a few keystrokes that no one actually wants to see in circulation.
The stated position of the Federal Reserve chair is essentially to allow inflation to continue increasing
. . . seeming only to target inflation's rate of increase rather than it's current value. Presumably hoping that by preserving some of the money supply growth can also be preserved. However, as described above not providing an incentive for money to leave the pool is an incentive to return it to the positive feedback loop of the money pool. Cash will continue to find its way to anything promising returns including asset bubbles created by the low-interest rates themselves. Without higher interest rates in CDs, Bonds, Treasury notes, and T-Bills there is nowhere for the excess money to go but back to anything in the economy promising higher rates. Inflation will therefore continue, likely accelerate, and require even faster rates of interest rate increase to outpace increasing inflation rates. Inflation is harder to catch and curb the longer the addressable issues aren't addressed, it needs to be stopped well before anyone even thinks the elephant might charge. For perspective, one time we just let inflation rise too long and so in 1981 the average 30-year mortgage had an 18.5% interest rate.
To reiterate, in 2017 inflation was 2.5% (over 12 months) the portion in excess of 2% was attributed to the 10.8% increase in energy prices (largest rise since 2011) and the rise in food prices. The goal of the Fed is to increase the Federal Funds rate to 2% by the end of 2018 and it is not worried about inflation because of growth. Thereby I believe that, in nominal dollars, the US might actually achieve more than 3.5% growth but in real dollars, that number will be much less than 1.5%.
Conclusion
Economies are like a provoked, pink, bull elephant. You might be able to control them with subtle pressure given enough time, but once you've noticed they are out of control there will be the impetus to apply large amounts of pressure quickly which will likely lead to an unexpected outcome. On the flip side, if the pressure isn't significant enough then the elephant will just do what comes naturally and turn you into jam. If interest rates aren't raised above inflation then they may not curb it, and if inflation starts to get away from us then we'll have to suddenly spike interest rates. By that time, it'll be too late, we'll have spooked an angry elephant in it's shadow.
Producer prices have climbed to 3.1% as of the end of 2017. These half-measure rate hikes may give the elephant mental pause, but he's already coming right for us. Volatility will be the name of the game in my view. The fact that the XIV (Inverse of the volatility index VIX) went to zero while I was inundated with other life obligations should've been a big clue to anyone paying attention.
The price of oil will most likely nominally increase as an asset for which there is inelastic demand however as the value of the US dollar decreases the term "oil speculators" may well return as cash seeks to maintain it's real value. This effect will be compounded by the propensity for asset bubble formation when real stores of value are rare and money is plentiful.
If runaway inflation is the name of the game TIPS are a related answer, while probably providing no real return. However, the alternative is a significant devaluation of any cash reserves you might have. So if a 30% plus correction is coming, "no real return" will certainly be better than a 30% loss in value, or a -3% APY. A better bet would be to pick an economy that won't get fucked and invest in their stocks or bonds, which will be discussed in Positioning when interest rates are less than inflation.
Predicting the future is hard. Plus, the Fed could be lying.