CPI Inflation, Ebola: Calling into Question  by John Mauldin, Mauldin Economics

A note has been circulating among economists, calling into question the wisdom of another group of economists who wrote an open letter to the Federal Reserve a few years ago suggesting that one of the risks of their quantitative easing program was increased inflation. Since we have not seen CPI inflation, this latter group is calling upon the former to admit they were wrong, that quantitative easing does not in fact cause inflation. To no one’s surprise, Paul Krugman has written rather nastily and arrogantly about the lack of CPI inflation.

Cliff Asness has responded with a thoughtful letter, with his usual tinge of humor, pointing out that there has been inflation, it just hasn’t been in the CPI. We’ve seen it in assets instead. That money did go someplace, and it has disrupted markets. So why is Cliff’s letter a candidate for Outside the Box, when the markets seem to be bouncing all over heck and gone?

Because, come the next crisis, there is going to be another move for yet another round of massive quantitative easing. And the justification will be that increases in the money supply clearly don’t have much to do with inflation.

I should note that while I did not agree with the original letter (I thought we were in an overall deflationary environment, and I wrote that the central banks of the world would be able to print more money than any of us could possibly imagine and still not trigger inflation – views came in for considerable pushback), my reasons for believing QE2 and QE3 were problematic dealt with other unintended consequences. And ultimately, as global debt gets restructured (which will take many years) inflation will become a problem. Did you notice how Greek debt spreads blew out yesterday? It’s not just about oil. And trust me, France is going to be the new Greece before we know it. The people who think they can control markets and direct investors like sheep are going to be in for a huge surprise, but the nightmare is going to be visited upon the participants in the market.

We then move to a few thoughts from Peter Boockvar, in a letter he writes to savers, noting that the same people who brought you quantitative easing are also responsible for the demise of any income that might possibly have come from saving.

I wish I had good advice for your savings, but I can’t advise buying stocks that have only been more expensive in 2000 on some key metrics right before you know what, and I can’t recommend buying any long term bond as the yields also stink relative to inflation. With the Fed now saying that the dollars in your pocket are now worth too much relative to money in people’s pockets overseas and thus joining the global FX war, maybe you should buy some gold, but I know that yields nothing either. You are the sacrificial lamb in this grand experiment conducted by the unelected officials working at some building named Eccles who seem to have little faith in the ability of the US economy to thrive on its own as it did for most of its 238 years of existence. Borrowers and debt are their only friends. To you responsible saver that worked hard your whole life, may you again rest in peace.

And then we finish with some thoughts from our friend Ben Hunt, who takes exception to being told how to think and believe and act by “those smart people with degrees” who only want to do what’s best for us. Not just in economics but with regard to ISIS and Ebola and everything else. After reading Ben’s essay I called him and said, “Me too!”

I am tired of being manipulated, placated, spin-lied to (if it’s not a word it should be), mutilated, spindled, and folded.

We have to keep our eyes open and entertain the possibility that central banks will “lose the narrative,” that is, their ability to control markets with simple statements. The BIS recently had this to say:

Guy Debelle, head of the BIS’s market committee, said investors have become far too complacent, wrongly believing that central banks can protect them, many staking bets that are bound to “blow up” [at] the first sign of stress.

Mr. Debelle said the markets may at any time start to question whether the global authorities have matters under control, or whether their pledge to hold down rates through forward guidance can be believed. “I find it somewhat surprising that the market is willing to accept the central banks at their word, and not think so much for themselves,” he said. [Source: Ambrose Evans-Pritchard, “BIS warns on ‘violent’ reversal of global markets”]

The 10-year US Treasury slipped below 2% earlier today, but has rebounded somewhat to 2.06% as I write. Oddly, the yen seems to be strengthening slightly as the stock markets once again fall out of bed. Oil continues to weaken. As noted above, Greeks spreads are blowing out. Super Mario needs to get on his bike and start peddling before that concern spreads to other nations almost as insolvent. France will soon be downgraded again. Don’t you just love October?

What an interesting time to hold a midterm election. Have a great week!

Your really thinking through the implications of a stronger dollar analyst,

John Mauldin, Editor
Outside the Box

The Inflation Imputation

By Cliff Asness, AQR Capital Management LLC

In 2010, I co-signed an open letter warning that the Fed’s experiment with an unprecedented level of loose monetary policy – in amount, and in unorthodox method – created a risk of serious inflation. Sporadically journalists and others have noted that this risk has not come to pass, particularly in consumer prices. Recently there has been an article surveying each of us as to why; seeming to relish in, when provided, our various rationales, presumably as they sounded like excuses. It seems none of the responses provided what the authors clearly wanted, a blanket admission of error. I did not comment for that article, continuing my life long attempt not to help reporters who’ve already made up their mind to make fun of me – I help them enough through my everyday actions, they don’t need more!

More articles of similar bent keep showing up. The authors seem to find it amusing that four years of CPI data wouldn’t get people to change their economic views, while ignoring that 80 years of overwhelming evidence has not dissuaded Keynesians from the belief that this time, if they could only run everything, not just most things, they’d really get it right.

Focusing my attention, as was predestined, Paul Krugman lived up to his lifelong motto of “stay classy” with a piece on the subject entitled Knaves, Fools, and Quantitative Easing. Some lesser lights of the Keynesian firmament have also jumped in (collectivists, of course, excel at sharing a meme). Responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary. I will, at least partially, make that error here, while mostly trying to deal with the original issue separate from Paul’s screeds (though one wonders if CPI inflation had risen in the last four years if Paul would be admitting his entire economic framework was wrong – ok, one doesn’t really wonder – and those things never happen to Paul anyway, just ask him).

Let me say up front that this essay will satisfy nobody. Those looking for a blanket admission of error will get part of what they want; a small part. Those hoping I hold the line denying any misstep will also be disappointed. I believe truth, as is often the case in similar situations, lies in the middle of these and I prefer truth, as I see it, to any reader walking away sated.

We indeed warned about the risks of inflation in 2010 and the CPI has been, to put it mildly, benign since then. First, to give the baying crowd just a bit of what it wants (I will take some of it back soon), our bad (I say “our” but obviously I speak only for myself). When you warn of a risk and it doesn’t come to pass I do think you owe the world this admission, even if you later explain what it means to warn of a risk not a certainty, and offer good reasons why despite reasonable worry this particular risk didn’t come to pass. I, and many other signatories, live in the world of economic or political prognostication, in my case money management, where if you get a bit more than half your calls right you are doing quite well, more than a bit more than half, you’re doing fabulously. I’ll put our collective record up against Krugman’s (and the Krug-Tone back-up dancers) any day of the week and twice on days he publishes.

Let’s start with the big one. We did not make a prediction, something we certainly know how to do and have collectively done many times. We warned of a risk. That’s a very specific choice people like the open letter writers, and Paul, have to make all the time, and he knows this, but that doesn’t deter him. Rather, Paul engages in the old debating trick of mentioning this argument himself and dismissing it. This technique worked for Eminem at the end of Eight Mile. But let’s not be fooled by chicanery (silly Paul, you are no Rabbit). If I had wanted to make a prediction, I would have made one. I didn’t, nor did my fellow signatories. Frankly, if there are any economists, aside from those never-uncertain-but-usually-wrong like Paul, who did not think such unprecedented Fed action represented at least a heightened risk, I think it was malpractice on their part. An honest Paul Krugman (we will use this term again below but this is something called a “counter-factual”) would have agreed with our letter but qualified that while heightened, he still didn’t think this risk would come to fruition and that he thought it was a risk worth running. Still, I will give the critics half credit here, accept half blame, and issue a demi mea culpa. By writing the letter we clearly thought this risk was higher than others did, and wished to stress it, and it has not (as most commonly measured) as of now come to bear. Our, and my, (half) bad. I hope that makes the critics (half) happy and they can stop copying each other’s articles over and over again.

Of course being able to call out risks, not just make firm predictions, is quite important. If you believe the risk of an earthquake is 10 times normal, but 10 times normal is still not a high probability, it’s rational to warn of this risk, even if the chance such devastation occurs is still low and you’ll look foolish to some when it, in all likelihood, doesn’t happen. If you can’t point out risks you are left with either silence as an option, or overly and falsely self-confident forecasts. Perhaps the latter may work for former economists turned partisan pundits but the rest of us will have to live with the ex ante and ex post ambiguity of discussing risks. It’s a real subtlety but I think there is truth somewhere in between the current attack meme of “you predicted inflation risk and were wrong and are now hiding behind the word ‘risk’“ and “we only said it was a risk so we cannot be wrong.” I think when you boldly forecast a risk you are saying more than “this might happen but either way I can’t be blamed” and something less than “this will happen and I stake my reputation on it.” We should all be mature enough to know the difference, but apparently that ship has sailed…

Not surprisingly, the above stress on risk jibes with my personal view of monetary policy, one that might not be shared by all my co-signatories. I tend to think it matters less than most think, and matters less often than most think. I tend to view it, for finance fans, in a “Modigliani Miller” (MM) framework, where most corporate financing transactions are paper-for-paper, mattering little. But, in the MM framework bankruptcy costs do matter. Therefore most corporate capital structure decisions are irrelevant, except to the extent they increase the chance of serious financial distress, in which everyone but the lawyers lose (in many models this risk must be balanced against the tax advantages of debt).

From this perspective, slight adjustments to the target Fed funds rate based on exquisitely sensitive perceptions of the probability of economic overheating or slowdown probably make little difference (and don’t even start me on the dots), but deflation or excessive inflation are important to avoid as their damage can be great. They are the bankruptcy costs of monetary policy. Thus, I think sounding the alarm, not making a prediction, that experimental and aggressive monetary policy raised one of these risks was appropriate. But, still, I think most people engaged on the topic spend a lot of time talking about monetary policy in the same way dogs spend a lot of time talking, yes in their secret dog language, about the cars they chase. The cars aren’t affected and generally don’t care.

Now, if you thought the above was an excuse on par with, continuing my canine fixation, “the dog ate my inflation,” and not the demi mea culpa I intended, you’re really going to hate the full blown non-conciliatory excuses about to come.

Economically, I think what everyone of any political or economic stripe missed, certainly including myself, was how little money would circulate, how little would be lent and then spent. In econo-geek, how low the money multiplier would be. Money kept by banks at low but positive interest rates at the Fed clearly isn’t doing much of anything, creating inflation as we feared, or helping the economy as they hoped. To the extent inflation worriers like us were wrong, so were those predicting

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