Tag Archives: deflator

In The Fed We Trust – Part 1

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.  

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

Whether its yen, euros, wampum, bitcoin, dollars or any other currency, as long as society is accepting of such a unit of exchange, trade will occur. When TRUST in the value of a currency wanes, commerce becomes difficult, and the monetary and social prosperity of a nation falters. The history books overflow with such examples.

Maslow and Currency

Before diving into the value of a currency, it is worth considering the role it plays in society and how essential it is to our physical and mental well-being. This point is rarely appreciated, especially by those that push policies that debase the currency.

Maslow created his famous pyramid to depict what he deemed the hierarchy of human needs. The levels of his pyramid, shown below, represent the ordering of physiological and psychological needs that help describe human motivations. When these needs are met, humans thrive.

Humans move up the pyramid by addressing their basic, lowest level needs. The core needs, representing the base, are physiological needs including food, water, warmth and rest. Once these basic needs are met, one then seeks to attain security and safety. Without meeting these basic physiological and safety needs, our psychological and self-fulfillment needs, which are higher up the pyramid, are difficult to come by. Further, as we see in some third-world countries, the social fabric of the nation is torn to shreds when a large part of the population cannot satisfy their basic needs.

In modern society, except for a few who live “off-the-grid,” fiat currency is the only means of attaining these necessities. Possession of currency is a must if we are to survive and thrive. Take a look back to the opening paragraphs and let’s rephrase that last sentence: possession and TRUST of currency is a must if we are to survive and thrive.

It is this most foundational understanding of currency that keeps our economy humming, our physical prosperity growing and our society stable. The TRUST backing the dollar, euro, yen, etc. is essential to our financial, physical and psychological welfare.

Let’s explore why we should not assume that TRUST is a permanent condition.

Deficits Don’t Matter…. or Do They?

Having made the imperative connection between currency and TRUST and its linkage to trade and commerce along with our physical and mental well-being, we need to explore the current state of the United States government debt burden, monetary policy, and the growing belief that deficits don’t matter.

Treasury debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond is paid in full at maturity, however, to secure the funds to pay that holder, the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand, swelling the amount of debt outstanding. Think of this arrangement as taking out a new credit card every month to pay off the old card.

The chart below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.

Data Courtesy: St. Louis Federal Reserve

Continually adding debt at a faster rate than economic growth (as shown above) is limited. To extend the ability to do this requires declining interest rates, inflation and a little bit of financial wizardry to make debt disappear. Fortunately, the U.S. government has a partner in crime, the Federal Reserve.

As you read about the Fed’s methods to help fund deficits, it is important to consider the actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST in the currency and allows it to retain its functional purposes.

The Fed helps the government consistently run deficits and increase their debt load in three ways.

  1. The Fed stokes moderate inflation.
  2. The Fed manages interest rates lower than they should be.
  3. The Fed buys Treasury and mortgage securities (open market operations/QE) and, as we are now witnessing, monetizes the debt.

Inflation

Within the Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has averaged 3.11% annually. That rate may seem inconsequential, but it adds up. The chart below illustrates how the low but consistent rate of inflation has debased the purchasing power of the dollar.

Data Courtesy: St. Louis Federal Reserve

$1 borrowed in 1913 can essentially be paid off with .03 cents today. Inflation has certainly benefited debtors.

Interest Rate Management

For the better part of the last decade, the Fed has imposed price controls that kept interest rates below what should be considered normal. Normal, in a free market economy, is an interest rate that compensates a lender for credit risk and inflation. Since Treasury debt is considered “risk-free,” the predominant risk to Treasury investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The Mind Blowing Concept of Risk-Free’ier.

If the yield on the bond is less than inflation, as has recently been the case, the purchasing power and wealth of the investor declines in the future.

The table below highlights how U.S. Treasury real rates (yields less CPI) have trended lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are not properly compensated by the U.S. Treasury, the onus of government debt is partially being put upon investors. We have the Fed to thank for their Fed Funds (FF) policy of negative real rates.

Data Courtesy: St. Louis Federal Reserve

Fed Balance Sheet

The Fed uses its balance sheet to buy and sell U.S. Treasury securities to manage the money supply and thus enforce their interest rate stance. In 2008, their use of the balance sheet changed. From 2008 through 2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed securities in what is called Quantitative Easing (QE). By reducing the supply of these securities, they freed up liquidity to move to other assets within the capital markets. The action propped up asset prices and helped keep interest rates lower than they otherwise would have been.

Since 2018, they have reversed these actions by reducing the size of their balance sheet in what is called Quantitative Tightening (QT). This reversal of prior action essentially makes the benefits of QE temporary. However, if they fail to reduce it back to levels that existed before QE was initiated, then the Fed permanently monetized government debt. In plain English, they printed money to extinguish debt.

As we write this article, the Fed is in the process of ending QT. Based on the Fed schedule as announced on March 20, 2019, the balance sheet will permanently end up $2.28 trillion larger than from when QE was initiated. To put that in context, the balance will have grown 269% since 2008, as compared to 48% economic growth.

Data Courtesy St. Louis Fed

The methods the Fed employs to manage policy as described above, all involve using their balance sheet to alter the money supply and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics law; when there is more of something, it is worth less. When something of value is created out of thin air, its value declines.

At what point is debt too onerous, deficits too large and the Fed too aggressive such that TRUST is harmed? No one knows the answer to that question, but given the importance of TRUST in a fiat currency regime, it would be wise to avoid actions that could raise doubt. Contrary to that guidance, current fiscal and monetary policy throws all TRUST to the wind.

Prelude to Part 2

As deficits grow and government debt becomes more onerous, the amount of Fed intervention must become greater.  To combat this growing problem, both political parties are downplaying deficits and pushing the Fed to do more. In part 2 we will explore emerging fiscal mindsets and what they might portend. We will then define money, and with this definition, show why the difference between currency and money is so important. 

Inflation: The Fed’s False Flag

Don’t piss down my back and tell me it’s raining” –Clint Eastwood/The Outlaw Josey Wales

On April 30, 2019, one day before the Federal Reserve’s FOMC policy-setting meeting, the Wall Street Journal published an article by Nick Timiraos and Paul Kiernan entitled Inflation Is Likely to Fuel Discussions as Fed Officials Meet. We quickly recognized this article was not the thoughts of the curious authors but more than likely indirect Fed messaging.

Similar to a trial balloon, conveyances like the one linked above allow the Fed to gauge market response to new ideas and prepare the markets and public for potential changes in policy.

Based on numerous articles published over the last two weeks, we are under growing suspicion that the Fed wants us to believe we need more inflation. For their part, the Fed in the May 1, 2019, FOMC policy statement changed language from the prior statement to highlight that inflation is not running at their 2% target but it is “running below” their goal. 

Is declining inflation a legitimate concern or a false flag meant to provide cover to lower rates?

Selling Deflation

The WSJ article published the day before the FOMC policy meeting has the Fed’s fingerprints all over it. The gist of the article is that inflation is running below the two percent goal and therefore needs to be addressed.

The following quotes come from that article:

  • Lower inflation remains the fly in the ointment.
  • Officials worry that the failure to hit the inflation target could undermine its credibility over time, which could cause consumers and businesses to expect lower inflation in the future, which in turn could cause price pressures to weaken further.
  • If officials grew concerned that the (inflation) shortfall was persistent, some could push for lowering rates.

Not to be outdone, Neil Irwin of the New York Times, in discussing how the Fed might fight the next recession, stated:

“In the near term, any changes are likely to tilt policy in the direction of having lower interest rates for longer periods, with the aim of getting inflation to more consistently average 2 percent (it has been consistently below that level for years).” 

These and a slew of comments from Fed officials, the media and market prognosticators lead us to believe the Fed is now using a lack of inflation to justify lowering interest rates.

First quarter 2019 GDP was just reported at 3.2% and has grown in each of the last 12 quarters, an unprecedented string of consecutive increases in GDP growth. The unemployment rate and jobless claims are at or near 50-year lows. Despite the solid economic growth and strong labor market, the amount of monetary and fiscal stimulus being employed is immense as we have documented on numerous occasions. Fed Funds at 2.5%, while off of the zero bound, is still well below rates of the prior 50 years. The Fed’s balance sheet, despite some run-off, is still four times larger than where it stood pre-financial crisis.

Since the economy and labor markets are strong and monetary policy very easy, inflation appears to be the only factor that the Fed could use to justify adopting an easier policy stance.

The Smoking Gun

Before considering inflation data, it’s worth reviewing the Fed’s thoughts about inflation as it relates to monetary policy. On October 2, 2018, Chairman Powell stated the following:

From the standpoint of contingency planning, our course is clear: Resolutely conduct policy consistent with the FOMC’s symmetric 2 percent inflation objective, and stand ready to act with authority if expectations drift materially up or down.

Given the statement above, is Inflation or inflation expectations materially changing? 

Below are six charts to help you decide if inflation or inflation expectations are moving materially lower. If not, is inflation the Trojan horse that allows the Fed to lower rates despite any reasonable rationale?  All of the data for the graphs below are sourced from Bloomberg.

Inflation Expectations

Standard Inflation Measurements

Fed’s Own Inflation Measures

The following two graphs are inflation indicators that the Fed created. They are designed to reduce temporary blips in the prices of all goods and services within the CPI and GDP reports. The Federal Reserve believes these measures present a more durable reading that is not as subject to transitory forces as other inflation measures.

Summary

Have inflation “expectations drift(ed) materially up or down?”

Looking at the ebbs and flows of inflation and inflation expectations of the last three years, we see no consistent change in the trend. As for the dreaded fear of deflation, the United States has not experienced it since the Great Depression in the 1930’s. In our opinion, this recent talk about lower inflation is a sad case of the Fed manufacturing a story to justify easier monetary policy.

We conclude with a message for the Federal Reserve- If you want to lower rates then lower rates, but please do not feign concern about inflation trends that are non-existent as cover for such moves. You preach transparency, so be transparent.

UNLOCKED: The Curious Case of Rising Fuel Prices and Shrinking Inflation

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On Friday, April 26, 2019, the market was stunned with a much stronger than expected 3.2% rate of first-quarter economic growth. Wall Street expectations were clearly off the mark, ranging from 1.3-2.3%. The media took this as a sign the economy is roaring. To wit, a headline from the Washington Post started “US Economy Feels Like the 1990s.”

Upon first seeing the GDP report, we immediately looked with suspicion at the surprisingly low GDP price deflator.  The GDP price deflator is an inflation measure used to normalize GDP so that prior periods are comparable to each other without the effects of inflation.

The Bureau of Economic Analysis (BEA) reports nominal and real GDP. Real GDP is the closely followed number that is reported by the media and quoted by the Fed and politicians. Since the GDP price deflator is subtracted from the nominal GDP number, the larger the deflator, the smaller the difference between real and nominal GDP. 

The BEA reported that the first quarter GDP price deflator was 0.9%, well below expectations of 1.7%. Had the deflator met expectations, the real GDP number would have been about 2.4%, still high but closer to the upper range of economists’ expectations.

Fueling the Deflator

Like Wall Street, we were expecting a deflator that was in line or possibly higher than its recent average. The average deflator over the last two years is 2.05%, and it is running slightly higher at 2.125% over the last four quarters. Our expectation for an average or above average deflator in Q1 2019 were in large part driven by oil prices which rose by 32% over the entire first quarter. Due to the price move and the contribution of crude oil effects on inflation, oil prices should have had an unusually high impact on inflation measures in the first quarter of 2019.

Per the American Automobile Association (AAA), gas prices in the United States rose from $2.25 per gallon in January to $2.75 by the end of March, a gain of 22%. Gasoline RBOB futures, the most commonly quoted contract for wholesale gasoline prices, tell a similar story, rising from $1.30 per gallon to $1.83 over the quarter, for a gain of 41%.

With a good amount of digging through the BEA website, we learned that despite the substantial rise in the price of oil and gasoline in the first quarter, the BEA actually reported a decline in fuel prices. The BEA, which uses data from the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) report, reported that fuel prices fell on average by 7.8% during the quarter. The table below for fuel prices (BLS code CUSR0000SETB) from the BLS is the direct input used to account for energy prices within the GDP deflator.

The BLS is not wrong; they are just using a three-month average, and therefore their data lags by three months. Essentially, the fuel price data feeding the first quarter GDP deflator is from the fourth quarter of 2018. During this period, the price of oil and gas fell precipitously. 

With a little back of the envelope math, we conclude that had the price of oil been unchanged the deflator would have been approximately 1.45%, and Real GDP growth would have been 2.75%. Had the price risen, instead of fallen, by 7.8% the deflator would have been 1.99%, and GDP would have been 2.20% and on par with expectations. Had it risen more than 7.8%, Real GDP would have been even lower.

Implications

The BEA is not cooking the books. However, by this methodology using old data, sharp changes in fuel prices will result in flawed quarterly data. This problem is self-correcting. For instance, the sharp decline in oil prices in the fourth quarter which helped lower the deflator in the first quarter will be offset when the surge in first quarter oil prices weigh on second-quarter GDP. The graph below shows Gasoline RBOB futures to highlight the recent volatility in gasoline prices.   

It is not just the deflator that concerns us about second-quarter GDP. In this weekend’s newsletter, The Bull Is Back… But Will It Stay? we stated the following: 

Almost 50% of the increase in GDP came from slower imports and a massive surge in inventories which suggests slower consumer consumption which comprises roughly 70% of economic growth. In other words, future GDP reports will also likely be weaker. (Net Trade and Inventories was 1.68% of the 3.2% rise.)”

The ratio of inventory to sales has steadily climbed over the last 12 months. If consumption stays weak, we should see companies backing off on inventory stocking. Rising inventories increase GDP and falling inventories have the opposite effect. As a result and as stated above “future GDP reports will also likely be weaker.”

Looking ahead, we are confident that the second quarter GDP deflator will be 2% or higher. We also believe that if consumption remains frail, companies will slow their inventory growth.  While difficult to predict as we are only a month into the quarter, these two important factors are likely to weigh on second-quarter GDP. Keep in mind, these are only two of thousands of factors, but they play an outsized role in determining GDP.

Currently, and subject to change as more economic data is released, we have a strong suspicion that the positive surprise in the Q1 report will be followed with an equally surprising weak Q2 report. As stock markets probe new record highs, the question for investors is, will the market care?

Quick Take: The Curious Case of Rising Fuel Prices and Shrinking Inflation

On Friday, April 26, 2019, the market was stunned with a much stronger than expected 3.2% rate of first-quarter economic growth. Wall Street expectations were clearly off the mark, ranging from 1.3-2.3%. The media took this as a sign the economy is roaring. To wit, a headline from the Washington Post started “US Economy Feels Like the 1990s.”

Upon first seeing the GDP report, we immediately looked with suspicion at the surprisingly low GDP price deflator.  The GDP price deflator is an inflation measure used to normalize GDP so that prior periods are comparable to each other without the effects of inflation.

The Bureau of Economic Analysis (BEA) reports nominal and real GDP. Real GDP is the closely followed number that is reported by the media and quoted by the Fed and politicians. Since the GDP price deflator is subtracted from the nominal GDP number, the larger the deflator, the smaller the difference between real and nominal GDP. 

The BEA reported that the first quarter GDP price deflator was 0.9%, well below expectations of 1.7%. Had the deflator met expectations, the real GDP number would have been about 2.4%, still high but closer to the upper range of economists’ expectations.

Fueling the Deflator

Like Wall Street, we were expecting a deflator that was in line or possibly higher than its recent average. The average deflator over the last two years is 2.05%, and it is running slightly higher at 2.125% over the last four quarters. Our expectation for an average or above average deflator in Q1 2019 were in large part driven by oil prices which rose by 32% over the entire first quarter. Due to the price move and the contribution of crude oil effects on inflation, oil prices should have had an unusually high impact on inflation measures in the first quarter of 2019.

Per the American Automobile Association (AAA), gas prices in the United States rose from $2.25 per gallon in January to $2.75 by the end of March, a gain of 22%. Gasoline RBOB futures, the most commonly quoted contract for wholesale gasoline prices, tell a similar story, rising from $1.30 per gallon to $1.83 over the quarter, for a gain of 41%.

With a good amount of digging through the BEA website, we learned that despite the substantial rise in the price of oil and gasoline in the first quarter, the BEA actually reported a decline in fuel prices. The BEA, which uses data from the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) report, reported that fuel prices fell on average by 7.8% during the quarter. The table below for fuel prices (BLS code CUSR0000SETB) from the BLS is the direct input used to account for energy prices within the GDP deflator.

The BLS is not wrong; they are just using a three-month average, and therefore their data lags by three months. Essentially, the fuel price data feeding the first quarter GDP deflator is from the fourth quarter of 2018. During this period, the price of oil and gas fell precipitously. 

With a little back of the envelope math, we conclude that had the price of oil been unchanged the deflator would have been approximately 1.45%, and Real GDP growth would have been 2.75%. Had the price risen, instead of fallen, by 7.8% the deflator would have been 1.99%, and GDP would have been 2.20% and on par with expectations. Had it risen more than 7.8%, Real GDP would have been even lower.

Implications

The BEA is not cooking the books. However, by this methodology using old data, sharp changes in fuel prices will result in flawed quarterly data. This problem is self-correcting. For instance, the sharp decline in oil prices in the fourth quarter which helped lower the deflator in the first quarter will be offset when the surge in first quarter oil prices weigh on second-quarter GDP. The graph below shows Gasoline RBOB futures to highlight the recent volatility in gasoline prices.   

It is not just the deflator that concerns us about second-quarter GDP. In this weekend’s newsletter, The Bull Is Back… But Will It Stay? we stated the following: 

Almost 50% of the increase in GDP came from slower imports and a massive surge in inventories which suggests slower consumer consumption which comprises roughly 70% of economic growth. In other words, future GDP reports will also likely be weaker. (Net Trade and Inventories was 1.68% of the 3.2% rise.)”

The ratio of inventory to sales has steadily climbed over the last 12 months. If consumption stays weak, we should see companies backing off on inventory stocking. Rising inventories increase GDP and falling inventories have the opposite effect. As a result and as stated above “future GDP reports will also likely be weaker.”

Looking ahead, we are confident that the second quarter GDP deflator will be 2% or higher. We also believe that if consumption remains frail, companies will slow their inventory growth.  While difficult to predict as we are only a month into the quarter, these two important factors are likely to weigh on second-quarter GDP. Keep in mind, these are only two of thousands of factors, but they play an outsized role in determining GDP.

Currently, and subject to change as more economic data is released, we have a strong suspicion that the positive surprise in the Q1 report will be followed with an equally surprising weak Q2 report. As stock markets probe new record highs, the question for investors is, will the market care?