(I have a Patreon to support my open source projects, of which this is the one that is currently getting the most development time. I also have my stock-flow consistent modelling module, as well as my research platform that I use to generate the charts for my blog. All use Python, although I do my plots in R.)
I set up a Patreon to support my Python projects, and the agent-based model is the current focus. I wrote a few small pieces this week discussing recent work: here and here.
We had a blowout CPI print in the United States last week, which I probably should have discussed. Unfortunately for my writing productivity, I had some consulting work going as well as visiting family, so I did not have time to dig.
Since then, large numbers of electrons were spilled online discussing the inflation outlook. As I doubt that I will add any details that are novel at this point, I have decided to bow out of that discussion. Instead, I will just offer a few generic observations.
The first thing to note is that forward breakeven inflation rates (as calculated by the Federal Reserve) have risen since the pandemic lows — but are still not above the levels seen in the early 2010s. (As a technical note, one might be able to fine tune breakeven inflation calculations with access to security-level data. But the Fed H.15 data is perfectly adequate for a big picture chart like the one above.)
We need to use forward inflation since everybody accepts that there will be a run of punchy inflation data over the coming months. How long the “punchiness” lasts is the topic of heated debate. As a non-forecaster, I am staying out of that debate. That said, the TIPS market indicates that the punchiness subsides within 5 years. Say what you want, that is not exactly a secular shift in inflation pricing.
Could technicals influence the forward? Sure. The problem is that the most important technical is the demand for inflation protection by the private sector, which is really only counter-balanced by TIPS supply. If people were really worried about inflation, they would be bidding up protection versus fair value — the breakeven ought to be biased higher versus “true” expectations. If that were the case, then the “true” expectations are not elevated relative to “target” (which is vaguely defined at this point).
So unless we are convinced the market is wrong — and it could be (you pays your money, you takes your chances) — the inflation story is just about the timing of “transitory.” Even without digging into data, it seems clear to me that we need to get the flurry of holiday spending out of the way before we can see what the underlying supply chain status looks like.
The other angle is wage inflation. I think we have seen some unsustainable business models based on the availability of desperate workers, and/or hoodwinking people who were unable to account for depreciation into being “contractors” have finally hit the end of their sustainability. Such business are going to face higher wage costs. It remains to be seen whether this is a one-off shift, or sustains itself.
In any event, I hope to return to my inflation manuscript later this week. My feeling is that it will make sense to hold off finishing the book until after we see the backside of this inflation wave (or not), so if I get the bulk of the text sketched out, I will then let the text rest for some months.
My view is that the shift towards greater “transparency” by central banks since the 1990s has been a mistake. As is entirely typical, the root of the mistake was listening to New Keynesians.
I used to follow Bank of England (BoE) decisions, and so I am somewhat familiar with its institutional structure. The BoE is somewhat unusual in that it has “external” and “internal” members of the policy committee. The relations between the internal and external members (and between the external members and bank staff researchers) were not always smooth, and the external members can view themselves as outsiders within a private club. This dynamic means that policy disagreements that would be hashed out behind closed doors elsewhere get aired in public. The BoE generates a lot of relatively close policy decisions, with 6-3 or even 5-4 votes. This is different than the Federal Reserve, where you at best get a single token dissent, with the dissident having a bug up their posterior about something.
The advantage of the internal/external split is that it might help break up group think. The disadvantage is that BoE communications is a source of confusion. Given the dangers of group think, I cannot complain too loudly about the structure, even though this contradicts my preference for less transparency.
Let us assume that we have a central bank with an inflation target mandate. In which case, the communications should just state what their current policy stance is, and relate that to the inflation target if conditions warrant. If there is an ongoing financial crisis, it should note that market conditions are disturbed, but that it is taking actions to stabilise the financial system. So we are looking at three to four sentences of actual content, with maybe some boilerplate at the top that gives context for outsiders.
For example, a central bank might now have a statement that reads “The committee has set {policy variables to whatever levels}. Although current inflation rates are above our inflation target, the committee believes that inflation will return to {some level, probably the inflation target} within {horizon}, which means that policy settings did not need to be adjusted.”
The bank could also release its internal forecasts, and let people pore over them without too much guidance. Unless the central bankers are complete amateurs, the forecasts will always show inflation returning to target at the end of the forecast horizon.
This is more transparent that central banks were during earlier eras. For example, during the Monetarist money targeting stupid phase central banks went through, they did not announce what the policy settings were. However, there is no attempt to offer forward guidance.
Although I argue that instantaneous forward rates should (roughly) equal the expected path of the policy rate, that does not mean that they should go where the central bankers would like them to go. Instead, they should follow what market participants think central bankers will do in the future.
This is very different than the fantasy world of New Keynesian models. In those models, everyone can see the equilibrium forward prices for all economic variables, and central banks magically “select” what the equilibrium path will be. In addition to being obviously crazy, that does not align with the real world, where we do not have access to traded equilibrium paths of economic variables, rather only a vague idea what people’s opinions about them are.
Investment management is sadly now a highly bureaucratic endeavour. Portfolio managers are expected to dream up detailed investment management procedures that they allegedly follow. Although I was not in the allocating capital part of the business, I tagged along to offer observations to colleagues who did that job. Very simply, I would not be very happy to allocate money to investors whose procedure is “we mindlessly believe what central bankers say they are going to do, and invest accordingly.”
If central bankers are worried about a scenario where growth being low, it is in their interest to low ball where they say the policy rate will go. If the risk scenario goes away, they can then say what they actually think. It costs them nothing to do so — but investors stupid enough to listen to them would lose money.
If you want to trade the direction of interest rates (which is not necessarily a good idea), you need to trade against your forecast for the economy, not what central bankers are saying.
Given the importance that many people attach to the velocity of money, I feel that I need to offer a longer discussion of the weakness of the concept. Since it is somewhat of a distraction from the flow of this text, I have put it into this appendix section that can be readily skipped if the reader is blissfully unaware of money velocity.
