Occam\'s Razor - Inflation (Sept. 2009)

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McLean Asset Management\'s Occam\'s Razor newsletter on inflation.

McLean Asset Management\'s Occam\'s Razor newsletter on inflation.

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  • 1. SEPTEMBER 2009 ……………………………… Introduction Examining Present and Future Inflation What is Average Inflation? What does the market expect infla- tion to be? Introduction Monetary Policy In a swift reaction to the tech bubble, 9/11, and significant corporate scandals that rocked the integrity of many public corporations, the Fed took decisive ac- Fiscal Policy: Making it Reconcile tion and significantly cut interest rates. Although, coupled with other govern- Interaction between Fiscal and ment interventions, the Fed’s actions seemed to be warranted and even ap- Monetary Policy plauded. However, one of the most scathing criticisms of Alan Greenspan was that he left interest rates too low for too long and by doing so exacerbated the ……………………………… recent financial collapse by facilitating easy money and subsequent credit. As the US economy stabilizes from the crisis of the last two years, can a reasoned argu- WHAT IS OCCAM’S RAZOR? ment be made as to whether this intervention is sowing the seeds for the next recession? Occam’s Razor is a principle attributed to William Occam, Right now the counter argument to “the economy seems to be recovering” is a 14th century philosopher. He “yeah, but wait until inflation kicks in.” This article will try to detail why this counter argument is being made and whether there are valid reasons for being stressed that explanations must wary of inflation in this environment. Although we will not address it now, a not be multiplied beyond what follow up article will detail how we intend to accommodate for various scenarios is necessary. Thus, Occam’s Razor within the context of your investment portfolio. is a term used to “shave off” or dismiss superfluous explanations Before beginning this article I will also like to point out that our clients are the for a given event. This concept intended audience. Hence in the interest of readability, I will try and simplify and is largely ignored within the at times err on the side of comprehension. As long as our clients can understand investment management landscape. the logical stream of events and their significance, than I am willing to sacrifice This newsletter will “shave off ” being completely precise in my explanation of economic theory. (The data for popular investment misinformation this article was derived from DFA’s L. Jacobo Rodriguez, Will Exiting From the and present what is important for Great Recession Take Us to the Great Inflation?) achieving long-term investment The problem with inflation is that it erodes the purchasing power of money. In success. the last 15 years, a period during which inflation in the United States has been low and stable by most standards, the purchasing power of $1 has decreased by DISCLOSURE The Company only transacts nearly one-third. It now takes $1.50 to purchase what $1.00 used to buy. business in states where it is properly registered, or excluded or exempted from registration requirements. Please click below to see our disclosure page on our website for further detail. What is Average Inflation? ……………………………… There are two types of inflation measures, a general measure and a core measure. This newsletter is published by: General inflation measures are based on an average basket of goods that can be McLean Asset Management Corp. purchased from one year to the next by a consumer. For example, if your trip to 8200 Greensboro Drive Target, the Safeway, and Chevron is more expensive this year than last year, you most likely had inflation. The core measure of inflation excludes food and en- Suite 1150 ergy. So if you just went to Target and it was still more expensive then the previ- McLean, VA 22102 ous year, you experienced core inflation. Phone: (703) 827-0636 www.mcleanam.com www.investmentsignal.net
  • 2. Over the last 50 years, inflation and core inflation has been in the low 4%, as measured by the Consumer Price Index (CPI). But this is not a static average rate. The mid 1960s and early 1980s were periods of considerably higher-than-average inflation; and the early 1960s and 2000s were periods of lower-than-average in- flation. Also, differences between the general and core measures of inflation have also differed considerably for periods of time. This may occur if gas and or food prices deviate significantly from the basket of goods. It is because of this down- turn in the core headline measures that many thought that, in the short term, pos- sible deflation was a bigger problem than inflation. What does the market expect inflation to be? One can observe market expectations of inflation by observing the yield difference between a government bond and an equivalent government bond that is indexed for inflation. This means that if a government bond is yielding 5% and a similar government bond indexed for inflation is yielding 2%, then the 3% difference between the two bonds is the markets expectation for inflation. This TIPS spread is often used as a market-based proxy of inflation expectations. Currently, the spread remains firmly anchored around the Federal Reserve’s unofficial inflation target of 2%, and although slightly higher, survey-based measures of near-term inflation expectations generally support this figure. So if recent readings of inflation have been moderate and the market’s expectation of future of inflation is well anchored near 2%, why should we be worried about inflation? There are three reasons to keep an eye on possible inflation. Monetary policy- the government’s ability and processes in controlling the amount of available money, and thus the cost of money (i.e., interest rates). Fiscal policy- the government’s ability to influence the economy through govern- ment spending and revenue collection (i.e., taxes). Serving two masters. Although the Fed’s focus has traditionally been monetary policy, it has crossed into the realm of fiscal policy and thus could compromise its independence and limit its ability to promote stable inflation in future years. Monetary Policy Keeping a controlled money supply is a good thing because it enables government fiscal stability. If the amount of money in circulation increases significantly, so will the prices of goods. Therefore, long run changes in the money supply deter- mine changes in the price level—that is, the rate of inflation. As Milton Friedman put it, “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In a nutshell, traditional monetary policy works as follows: The Federal Reserve has a policy target for the short-term nominal interest rate and for inflation. To hit those targets, the Fed trades government securities with the public. When the Fed buys government bonds, the sellers are flush with cash and subse- quently bank reserves increase. All else being equal, the fed funds rate falls because there is no incentive to pay high interest rates. The increase in bank reserves in- creases the amount of potential money in circulation. Before the fall of 2008, banks lent out their reserves into circulation because banks had no incentive to keep any excess reserves deposited at the Federal Reserve, where they earned no interest. As the financial crisis worsened, from September 2008 to December 2008, banks needed to drastically increase their reserves. Through various Federal Reserve programs, the monetary base increased from approximately $850 billion to over $1.6 trillion, from September 2008 to June 2009, to accommodate a bank’s increasing need to offset potentially toxic assets with cash. That increase has had a limited impact on the amount of currency in circulation because the banks kept it in their books. Excess bank reserves increased from about $2 billion in August 2008 to over $750 billion in June 2009. 2
  • 3. In normal times, banks would not keep a large amount of excess reserves— certainly far less than $750 billion—sitting idly at the Federal Reserve. They would have loaned out those reserves, which would have led to a massive increase of the money supply, which in turn would have been very inflationary. But, given the extraordinary conditions in the fall of 2008, the increase in excess reserves most likely reflected a sharp increase in money demand that was accommodated by the Federal Reserve. Hence the phrase, “Banks are not lending money.” To try and prevent banks from eventually flooding the market with “consumer loans” that will work its way into the money supply, the Fed started paying inter- est on reserves in order to incentivize the banks to hold excess cash reserves at the Fed. In essence, the Fed is aiming for controlled growth. In addition, Fed asked the Treasury to borrow money on its behalf. Through June the amount was about $200 billion. By lending money to the Treasury and not to consumers banks are able to lend money and the Fed keeps the money supply in check. As the economy improves, the Fed will have to ask itself: How high will the rates paid on excess reserves have to go to prevent undesired increases in bank lending? This payment of interest in reserves creates a second complication- it essentially continues to increase in those reserves. So, while the payment of interest on excess reserves may make the Fed’s job more manageable in the short term, it could ac- tually make it more difficult in the long term. There are still other options available to the Fed for reducing bank excess reserves. 1) It can turn those reserves into term deposits with different maturities and inter- est rates- like CDs. 2) The Fed could sell securities from its portfolio to those institutions and agree to purchase them back at a later date at a higher price- essentially buying back the toxic assets that the government bought from them in the first place. 3) The Fed could ask the Treasury to issue more debt on its behalf and deposit the proceeds with the Federal Reserve- have the banks use their cash reserves to buy government bonds. Fiscal Policy: Making it reconcile Until now, we have alluded to the budget situation of the US government without providing any detail on how it is related to the Fed’s job or how it could impact inflation. A brief review of public finance will make our task easier. The valuation equation for government debt states that the net present value of the government’s tax revenues and the revenue from printing money must equal the net present value of its expenditures plus the real value of its total outstanding debt. The government must raise sufficient revenue, in today’s value, to pay for its fu- ture planned expenditures and repay its existing debt. When the government has current outstanding debt, the government must run, in today’s value, primary surpluses in the future. Those surpluses can be obtained by adjusting the level of taxes, expenditures, or printing money. Hence the budget equation is made whole through either- taxes, spending, or printing money. If legislators are reluc- tant to raise taxes or make cuts to popular government programs, they are more likely to pressure the Federal Reserve to produce inflation to bring the fiscal valua- tion equation into balance. And inflation essentially becomes a tax that everyone bears. Are we in a precarious state? Depending on the time of day or what cable channel is on, these numbers may differ drastically but according to the federal budget and if the President’s policy proposals are implemented in full for fiscal year 2010, the federal government’s deficit is projected to be 13% of gross domestic product in 2009, a peacetime record. For 2010, the deficit is projected to be equal to almost 10% of GDP. As a result, the debt held by the public will rise from 41% of GDP in 2008 to 57% of GDP in 2009 and to 82% of GDP in 2019. (I will leave it at that as the numbers don’t get any better.) Time will tell if and when the federal government reaches its fiscal limit, but it is clear that the fiscal position of the United States is more precarious now than it was before. Will the Fed be able to withstand the pressure? 3
  • 4. Interaction between Fiscal and Monetary Policy The historical evidence indicates that central bank independence is an important factor in promoting low and stable inflation. Although a strong argument can be made that it was needed, many of the actions undertaken by the Federal Reserve during the financial crisis are likely to have compromised its ability to conduct monetary policy independently of political pressures and short-term political considerations in the future. Although we do not know whether high inflation is inevitable in the medium or long term, there are valid reasons to be concerned about such a scenario. The Federal Reserve has increased the potential monetary base on an unprecedented scale; the Fed’s exit strategy may be more difficult to carry out successfully than the Fed anticipates; and, in the process of responding to the financial crisis, the Fed has compromised its independence. All these factors make it more difficult for the Federal Reserve to be able to fulfill its primary mission of creating an en- vironment of low and stable inflation. In addition, the fiscal position of the US government is rather uncertain. There is considerable evidence that large, persis- tent deficits cannot be financed without inflation. To prevent high inflation in the future, the Fed must go back to focusing on price stability rather than credit allocation, the Fed must be able to conduct monetary policy free of political pres- sures, and policymakers must take steps to put the fiscal balance of the United States on a sustainable path. A follow up article will detail how we are preparing for various scenarios within the context of your investment portfolio. REFERENCES 1. For other recent Dimensional studies that address the topic of inflation, please see David G. Booth, “Asset Allocation,” Dimensional Fund Advisors white paper, June 2009; and James L. Davis, “Inflation, Living Standards, and Returns,” Purely Academic, Dimensional Fund Advisors secure site, available at https:// my.dimensional.com/articles/purelyacademic/2009/08/inflatio/. 2. For more information about monetary policy, fiscal policy, and the interaction between the two, see, for instance, Carl E. Walsh, Monetary Theory and Policy, 2nd edition (Cambridge, MA: The MIT Press, 2003). For an analysis of the current US macroeconomic situation and the federal government’s response to the financial crisis that uses the fiscal valuation equation, see John H. Cochrane, “Understanding Fiscal and Monetary Policy in 2008-2009,” available at http:// faculty.chicagobooth.edu/john.cochrane/research/Papers/ fiscal_crisis_princeton.pdf. 3. Congressional Budget Office, “An Analysis of the President’s Budgetary Pro- posals for Fiscal Year 2010,” June 2009, available at http://www.cbo.gov/ ftpdocs/102xx/doc10296/06-16-AnalysisPresBudget_forWeb.pdf. 4. See, for instance, Alberto Alesina and Lawrence H. Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking 25, no. 2 (May 1993): 151-62. To stay current with MAMC’s thoughts on capital markets, please sub- scribe to our blog at www.investmentsignal.net To learn more about MAMC, please visit our website at www.mcleanam.com 4