Originally posted Nov 5 for Premium members
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Part 3- How Inflation Was Kept In Check, Really.
KEY POINT SUMMARY
QE was not inflationary because it directed where money was spent.
There ‘s more money, but velocity slowed. It was kept in Bank hands.
Pandemic changed that.
CPI is a cooked number since the 1980s
The 1970s may be back...
To the financial community, U.S. Treasury bonds are considered "risk-free" assets. That is to say, while many investments entail risk — a company can go bankrupt, for example, thereby wiping out the value of its stock — Treasury bonds are backed by the full faith and credit of the United States. Since people believe the United States will not default on its obligations, lending money to the U.S. government — buying Treasury bonds that effectively pay the holder an interest rate — is considered a risk-free investment.Getting it out of the way. But before we go any further, it might help to get the headline out of the way. Here is a a synopsis of the thesis on why we cannot go back.
Comparing the 1970s to Today
Just as the pendulum swung too far in the 1970s with Labor “blackmailing” capital, so has Capital reversed that trend “too far” the other way. We believe this is the beginning of a reversal of that extreme. You will see more strikes, more wage hikes, more inflation, and smaller ROI for Capital. Until it goes to too far the other way again. At that point we may just need Paul Volker’s Grandson.
Income as a portion of GDP was heavily skewed towards Labor back then as a result of: policy, a more socialistic environment, and a desire to keep the peace.
About the time of Reagan and Volcker, that was seen as unsustainable. Labor had to make concessions and Capital became incentivized to play again.
Now we are at the other extreme. And as we show later on, the parallels are eerily similar to why we stayed the easy money course much longer than we needed to. The outcome is again being ideologically baked into the cake.
How many years until this gap narrows again nobody knows. But if it coincides with a secular decline in the USA, and a demographic plunge as some warn, then we may head towards a point of no return. It is hard to tell what is cyclical and what is secular, frankly. Now back to the meat of it all.
What Risk-Free Means
The definition of Treasury bonds as "risk-free" is not merely by reputation, but also by regulation. Since 1988, the Switzerland-based Basel Committee on Banking Supervision has sponsored a series of accords among central bankers from financially significant countries. These accords were designed to create global standards for the capital held by banks such that they carry a sufficient proportion of low-risk and risk-free assets. The well-intentioned goal of these standards was to ensure that banks don't fail when markets go down, as they did in 2008.
The current version of the Basel Accords, known as "Basel III," assigns zero risk to U.S. Treasury bonds. Under Basel III's formula, then, every major bank in the world is effectively rewarded for holding these bonds instead of other assets. This artificially inflates demand for the bonds and enables the United States to borrow at lower rates than other countries.
The Economy Supports This
The United States also benefits from the heft of its economy as well as the size of its debt. Since America is the world's most indebted country in absolute terms, the market for U.S. Treasury bonds is the largest and most liquid such market in the world. Liquid markets matter a great deal to major investors: A large financial institution or government with hundreds of billions (or more) of a given currency on its balance sheet cares about being able to buy and sell assets while minimizing the impact of such actions on the trading price. There are no alternative low-risk assets one can trade at the scale of Treasury bonds.
Global Confidence and The Fed
The status of such bonds as risk-free assets — and in turn, America's ability to borrow the money necessary to fund its ballooning expenditures — depends on investors' confidence in America's creditworthiness. Unfortunately, the Federal Reserve's interference in the markets for Treasury bonds have obscured our ability to determine whether financial institutions view the U.S. fiscal situation with confidence.
Clinton and the Bond Vigilantes
In the 1990s, Bill Clinton's advisors prioritized reducing the deficit, largely out of a concern that Treasury-bond "vigilantes" — investors who protest a government's expansionary fiscal or monetary policy by aggressively selling bonds, which drives up interest rates — would harm the economy. Their success in eliminating the primary deficit brought yields on the benchmark 10-year Treasury bond down from 8% to 4%.
In Clinton's heyday, the Federal Reserve was limited in its ability to influence the 10-year Treasury interest rate. Its monetary interventions primarily targeted the federal-funds rate — the interest rate that banks charge each other on overnight transactions. But in 2002, Ben Bernanke advocated that the Fed "begin announcing explicit ceilings for yields on longer-maturity Treasury debt." This amounted to a schedule of interest-rate price controls.
The Great Financial Crisis Creates the QE Monster
Since the 2008 financial crisis, the Federal Reserve has succeeded in wiping out bond vigilantes using a policy called "quantitative easing," whereby the Fed manipulates the price of Treasury bonds by buying and selling them on the open market. As a result, Treasury-bond yields are determined not by the free market, but by the Fed.
The combined effect of these forces — the regulatory impetus for banks to own Treasury bonds, the liquidity advantage Treasury bonds have in the eyes of large financial institutions, and the Federal Reserve's manipulation of Treasury-bond market prices — means that interest rates on Treasury bonds no longer indicate the United States' creditworthiness (or lack thereof).
Meanwhile, indications that investors are growing increasingly concerned about the U.S. fiscal and monetary picture — and are in turn assigning more risk to "risk-free" Treasury bonds — are on the rise.
Who Owns Our Bonds Now?
One such indicator is the decline in the share of Treasury bonds owned by outside investors. Between 2010 and 2020, the share of U.S. Treasury securities owned by foreign entities fell from 47% to 32%, while the share owned by the Fed more than doubled, from 9% to 22%.
Put simply, foreign investors have been reducing their purchases of U.S. government debt, thereby forcing the Fed to increase its own bond purchases to make up the difference and prop up prices.
The Doom Scenario
Until and unless Congress reduces the trajectory of the federal debt, U.S. monetary policy has entered a vicious cycle from which there is no obvious escape. The rising debt requires the Treasury Department to issue an ever-greater quantity of Treasury bonds, but market demand for these bonds cannot keep up with their increasing supply.
In an effort to avoid a spike in interest rates, the Fed will need to print new U.S. dollars to soak up the excess supply of Treasury bonds. The resultant monetary inflation will cause increases in consumer prices.
Where Did the Inflation Go?
Those who praise the Fed's dramatic expansion of the money supply argue that it has not affected consumer-price inflation. And at first glance, they appear to have a point.
In January of 2008, the M2 money stock was roughly $7.5 trillion; by January 2020, M2 had more than doubled, to $15.4 trillion. As of July 2021, the total M2 sits at $20.5 trillion — nearly triple what it was just 13 years ago. Over that same period, U.S. GDP increased by only 50%.
[EDIT- Some argue this implies the diminishing returns of adding debt now. 300% the debt for a 50% ROR isn’t so good etc- VBL]
And yet, since 2000, the average rate of growth in the Consumer Price Index (CPI) for All Urban Consumers — a widely used inflation benchmark — has remained low, at about 2.25%.
How Is Inflation So Low?
The answer lies in the relationship between monetary inflation and price inflation, which has diverged over time. In 2008, the Federal Reserve began paying interest to banks that park their money with the Fed, reducing banks' incentive to lend that money out to the broader economy in ways that would drive price inflation. [EDIT- this was the part of QE that kept inflation in check]
But the main reason for the divergence is that conventional measures like CPI do not accurately capture the way monetary inflation is affecting domestic prices.
In a large, diverse country like the United States, different people and different industries experience price inflation in different ways. The fact that price inflation occurs earlier in certain sectors of the economy than in others was first described by the 18th-century Irish-French economist Richard Cantillon. In his 1730 "Essay on the Nature of Commerce in General," Cantillon noted that when governments increase the supply of money, those who receive the money first gain the most benefit from it — at the expense of those to whom it flows last. In the 20th century, Friedrich Hayek built on Cantillon's thinking, observing that "the real harm [of monetary inflation] is due to the differential effect on different prices, which change successively in a very irregular order and to a very different degree, so that as a result the whole structure of relative prices becomes distorted and misguides production into wrong directions."
Good Inflation Only
In today's context, the direct beneficiaries of newly printed money are those who need it the least. New dollars are sent to banks, which in turn lend them to the most creditworthy entities: investment funds, corporations, and wealthy individuals.
As a result, the most profound price impact of U.S. monetary inflation has been on the kinds of assets that financial institutions and wealthy people purchase — stocks, bonds, real estate, venture capital, and the like.
Meanwhile, low- and middle-income earners are facing rising prices without attendant increases in their wages. If asset inflation persists while the costs of housing and health care continue to grow beyond the reach of ordinary people, the legitimacy of our market economy will be put on trial.
This is why the price-to-earnings ratio of S&P 500 companies is at record highs, why risky start-ups with long-shot ideas are attracting $100 million venture rounds, and why the median home sales price has jumped 24% in a single year — the biggest one-year increase of the 21st century.
So why, beyond the numbers and statistics must the 1970's repeat themselves? Ideology is why. The stubborn refusal to change opinions because one has an idea in their head and they ignore the math until it is too late. Here are the parallels between the 1970s and now.
Back to The 70's
The similarities between the 1970s and now are very creepy.
(Stated then- Happening now):
Philosophical and political changes - MMT, ESG, authoritarian forms of capitalism, definitions of words like “real” and “fact"in flux
Desire for a more interventionist govt - Same as today
Unevenly spread prosperity - Caused in no small part by previous Fed Policies for the past 50 years
Substantial societal tensions - Witness the riots continuing now
Reflexive embedded societal expectations- Stimulus will likely not end all at once
Overwhelming goal of full employment - Powell has said almost the same thing overtly telling us inflation is the lesser evil. Even calling it a mandate itself at one point
Environmental policies added to the inflation.- Do we think ESG is free? Does copper grow on trees?
Entitlements diminished the work ethic- Stimulus makes it easier for people to wait
Fed had tools to stop the inflation, but chose not to use them because it had been caught up in the social movements of the day - Powell et al have stated mandates outside their real ones like social justice and climate change as their priorities. This just underlines their concern with political optics rather than their real job.. and worse. Their polices do the exact opposite of the changes that need to be effected even while they pay lip service
Fed is beholden to Congress, how could it stand in they way of societal changes that Congress was attempting to enact - Which is why we see the Fed echo current congress mandates
Understand what the appropriate level of "full employment” was - As it is now, where they do not know what people are trained to do in the accelerated virtual economy with a rapidly changing demographic
Central Banks can’t stop politically driven inflation. They have the tools, but not the will - They are politically driven now as well. What they say is not what they do, ever.
Inflation was fed by high unemployment, deficits, money creation - All 3 boxes checked.
Translation: Strikes, Taxes, and Inflation are coming back. It, sadly has to happen. Hedge accordingly- End Part 3