Speaker 1 (00:02):
Hello,
Speaker 2 (00:03):
And welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 1 (00:17):
Welcome back to another episode of Actively Speaking, and I'm joined once again by Kevin Hener, who was with us last time to talk about Central Bank digital currencies. And, uh, we're, we're still talking about money today, but in a different aspect of money. We're gonna talk about inflation, and it's been on a lot of people's minds lately with good reason, a lot of government spending going on, and people worrying justifiably about what the implications are gonna be for inflation. So welcome back, Kevin.
Speaker 3 (00:44):
Oh, thank you Steve.
Speaker 1 (00:46):
You and Bill, uh, priest have written a white paper about what's going on with inflation and, uh, the paper will be available on our website. I wanna start by stepping back a bit and we'll get to later. I'm talking about more specifics about where inflation is today and where it might be going in the near term, but I wanna talk a bit about, conceptually, about how we think about inflation, and particularly what drives inflation. Because, you know, my observation has been in, you know, being an adult for about 40 years now, that people's thinking about inflation has changed. And Kevin and I are about the same age. When we were younger, there was still some vestiges of a belief that, you know, inflation was this purely monetary phenomenon. And Milton Friedman, you know, became kind of a rockstar, the un unlikeliest rockstar of all time. And, and he was a strict monetarist who believed that inflation was entirely a monetary phenomenon of just complete, completely controlled by monetary policy. So Kevin, talk a bit about how the thinking about inflation has evolved since that time.
Speaker 3 (01:53):
Well, there was a brief period with, as you mentioning, Milton Friedman, particularly in the fifties when he published his monetary history, which focused on the role of money supply, particular contractions and money supply as the catalyst for recessions through the history of the United States up until that point. And so with that, Monet had a very brief period where that was the key way to think about the economy growth, including inflation. But that was quite, Milton Friedman received his Nobel Prize in 76 and is really shortly after that. That monitor, uh, I think was displaced largely because the velocity of money with the host of innovations changed so dramatically that you really couldn't be thinking about leaning on the money supply in his K percent rule. And, and using that is anyway, as a tool or even a policy tool to understand the economy or, or to drive the economy.
Speaker 1 (02:55):
So for our listeners who may not know that term, tell us what the velocity of money is.
Speaker 3 (03:00):
So velocity refers to the, the rate that money circulates in the economy. And, and clearly when you have innovations at that time, the big innovation was credit cards, ATMs were coming out and, and clearly now as we're discussing the last podcast, with so many different forms of private digital money, it's difficult to imagine the government has really any control over the velocity of money. So whatever they do on the M side, if MD equals PT thinking that somehow they can change MV will be a cause enhance pt, normal GDP will respond accordingly. Certainly no one thinks that relationship is robust anymore. And I think that's been true since the early eighties that people did not think that there was a sufficiently robust relationship through the many equation.
Speaker 1 (03:50):
Right. I mean, it's almost as if people once thought that velocity was like a, a constant of nature, you know, as opposed to really kind of a plug figure almost.
Speaker 3 (04:00):
Yeah. And, and I think you, you could have made that argument in any economy where there weren't credit cards, you know, there wasn't PayPal or Alipay or all sorts of different ways to say, but that, that certainly is really in the sixties when that process started to change. So I think it's been a long time since Monism was viewed as sort of a, a robust way to think about the economy. And certainly that hasn't been the case, at least in the last 50 years.
Speaker 1 (04:29):
Right. So it, it seems to me that the, the thing that kind of took over was the, so-called Phillips Curve, the idea that there was this inverse relationship between inflation and unemployment, that as unemployment goes down and, and companies have to in essence bid for workers in a, in a shrinking pool of workers as the unemployment rate falls, that that ends up pushing up wages and that contributes to inflation. And for a time that was viewed as a pretty solid, you know, relationship. But it seems like that has that too, that relationship too has, has not been stable over time. Is that, is that right?
Speaker 3 (05:05):
Yeah, and it happens with so many things. So Milton Friedman published his important work in the fifties, and it briefly became very popular, but then immediately you had headed into the great inflation from 65 until 82 and the whole thing fell apart. Similar with the Phillips curve, bill Phillips did his work in the late fifties, briefly key pushed very hard on the notion of particular a stable short-term Phillips curve. But certainly by the early mid seventies there were big concerns about that. And by the early eighties, the notion of sort of, I naive what's called short-term, stable Phillips curve, I think very few people believed it by the end of the great inflation.
Speaker 1 (05:53):
So where do we stand today? I mean, what would you describe the current thinking in the economics profession on the drivers? You know, what drives inflation?
Speaker 3 (06:01):
Yeah, so the workhorse now is what's called an expectations augmented Phillips curve. So you have the basic Phillips curve, which as you mentioned, describes the relationship between inflation and unemployment, for example. And then the big change was adding inflation's expectations because we had really had a change in inflation expectations, sort of a regime change from the mid late sixties as inflation expectations became unor prior to 65 inflation had been well below 2% for at least 15 years. But then for a host of reasons, which we detail in the paper that became ached, part of it was LBJs foreign poverty programs spending associated with Vietnam, and then the oil price shocks, but inflation expectations became ached. And we had inflation move well into double digit territories, in fact almost hitting 20%. And then we had inflation expectations rocketing back down. But for that to happen, we had the two voler policy induced recession in their early eighties. So there's this realization that inflation expectation is a crucial component of this part. But now even 40 years after this, our understanding of inflation expectations and the process that creates that, uh, in the minds of consumers and businesses is still not very well understood at all.
Speaker 1 (07:33):
That's interesting. It seems like many other areas of economics which have been not taken over, but there's been this growing influence of, you know, behavioral economics. It seems like that has spread to thinking about inflation as well.
Speaker 3 (07:47):
Yes, and with behavioral economics, sometimes there's natural experiments or different types of economic experiments they can run. This is a bit more challenge because you, we have a macro factor. And so what some people do, for example, is look at when there are inflation shocks that hit one region and not another region, and then see how expectations of people in one place change relative to another. But it's very difficult for behavioral economists to get any rigor and understanding of how this process works.
Speaker 1 (08:20):
Well, and that leads me to, you know, another point, which is not only is it hard for economists, but uh, it raises the question of how much control can a central bank have over this process if in fact, you know, a key part of the process is consumer expectations and we don't really understand how those are formed, you know, how much control do you think central banks can have over inflation?
Speaker 3 (08:44):
Well, overall, I would say not an enormous amount, and certainly less than you would think by listening to central bankers and how they talk and, and some of their speeches. You just have to wonder to the extent that they understand the <inaudible> regarding the drivers of inflation at all. You know, there are models, for example, the expectations augmented Phillips Curve, but then over the last 20 years we've had huge deflationary drivers, for example, imports from China, the effect of tech, and we think in particular the effect of tech, it's led to inflation probably being overstated by a hundred basis points. And this is something that central bankers don't really have any control at all. The imports we have from China are technological innovation in the economy. So I think in terms of the actual ability of central bankers to control it, and in the paper we, we show a simple model from moving the Fed funds rate to what it means for consumption to the output gap to wage growth. Conflation, there's a lot of slippage of these linkages and sometimes central bankers talk as if this relationship is, is much more mechanical, that you can engineer it, that you can fine tune it than I think is supported by the evidence. Yeah,
Speaker 1 (10:06):
Yeah, it's interesting there, there was a piece recently by Steven Roach, people may remember that name. He was for years at Morgan Stanley. Now I, he teaches at Yale and he still writes about economics and post things online. And he worked early in his career at the Fed under Arthur Burns who was fed chairman under, uh, Nixon. And that of course was when inflation was starting to get a little bit out of control in the early seventies. And of course we had, uh, wage and price controls, uh, in 1971 and so forth. But Roach tells this story about how Arthur Burns kept asking the staff to take various items out of the CPI calculation. I mean, this is sort of where we came up with the core CPI concept, that which traditionally just takes out food and energy. And the idea behind it was it burns. His rationale was, well, you know, for example, if there was bad weather and that was driving up food prices because of crop shortages or something, his feeling was, well, there's nothing we can do about that at the Fed.
Speaker 1 (11:02):
Monetary policy's not gonna matter to that. So let's see what the core inflation that's driven by things that we can control at the Fed, uh, how they, how is that behaving? But then eventually, as Roach tells the story, they were taking out, you know, about two thirds of the basket of the CPI basket. And it could have raises the point of, well, at that point, what does it really matter? Because the, you may say that, well, we can't control, you know, energy prices or food prices, but the consumer still has to pay them, you know, and if they're going up, you know, five or 10%, you know, the consumers are not gonna be mollified by saying, well, you know, that's, that's not part of the core inflation. They're still seeing that money go out the door as they're paying more for, you know, for gas or for stake or whatever.
Speaker 1 (11:42):
So yeah, it, I find it a fascinating question of, you know, how much do we know about this and how much can we actually control it? So not to go too, Russ Roberts on on us here, but for people who may not know, he's the host of a podcast called EconTalk, which I would recommend if you've never listened to it. He's an economist, but a, a very big believer that economists need to be quite humble about how much we can know and how much policies can actually affect things. But let, let's move on and let's, given all that, that humility that we start this with, tell us where we are today. People are worried about inflation picking up and certainly most recent CPI numbers, the last month or two have been higher. You know, the rate of inflation has risen, what's driving that in the short term? And in the paper you talk about a couple of possible analogies in terms of different periods in the past that you think the current situation might be analogous to. So take us through that.
Speaker 3 (12:39):
Okay, well that was a lot in terms of the question. So maybe I'll just go with the, the latter part of your question in terms of the historical, sort of qualitative analogy that we could use. And the one that has been getting a lot of attention recently is the, so-called Great Inflation, the period from 1965 until 1982. And in the paper we spent some time detailing how inflation broke out during that time period. And there were five key features that led to that. One is complacency, in particular up to 1965, we had a very long time period in which inflation was benign. And really from 1953 to 1965, it averaged 1.5%. And that's similar to where we are now, where we've had inflation being quite benign, say for the last three decades. The second feature of the great inflation was accelerated government spending, and particular from 1964 with ob BJ's warm poverty, and then the escalation of the Vietnamese war that occurred.
Speaker 3 (13:48):
And, and clearly there's an analogy to that now, with increase in bending both under Trump and now under President Biden, at that time, there was the Fed prioritized employment over inflation. The Fed in the sixties did that, at least until 1979 when Volker took over. But as you're mentioning, burns the Fed chair, uh, under Nixon, Ford and Carter, very much favored employment growth jobs relative to inflation. So the, the first three features of the great inflation, there's a lot in common today, but the next two are different and so crucial to getting inflation up into a double digit territory, almost to 20% in the seventies were the two supply shocks. The energy crises of 73 and 79, they were mistakenly to have only a temporary impact on inflation. So the Fed accommodated them. That has kept policy very loose during that time period. And we do have bottleneck in the economy today affecting semiconductors in a couple areas, but nothing on the, the same order of magnitude.
Speaker 3 (15:00):
During the seventies, we had the price of wt I going from $3 and 50 in 1973, it increased over tenfold by the end of the decade. And energy was a big part of both the consumer basket and, and certainly input into a lot of businesses. So nothing of that magnitude. And, and then the final point is the great inflation took an extended period of time. There are lots of catalysts, numerous policy errors, so inflation expectations didn't become emerge quickly in the span of a couple quarters, even a few years. It took the good part of a decade. So when we're looking at today, we think the first three aspects of the great inflation, certainly you could point to them existing today, but the latter two, the big supply shocks and an extended period of policy errors in which households and businesses just didn't believe the Fed and politicians fiscal policy makers anymore. It could be that things would keep going wrong and we'll get there, but I think it's way too early to say that we're in a similar situation that maybe we're in a similar situation to say 1968, but certainly not to 1970s when inflation got into double digit territory.
Speaker 1 (16:17):
Okay. Well, I mean, when you talk about policy errors, let's throw out a wild card, modern monetary theory, you know, believers of modern monetary theory gain more sway, you know, in in the administration or the Fed or both, would that constitute a policy error, possibly that could send inflation higher?
Speaker 3 (16:35):
Well, it's certainly a big change, and I think certainly MMT is becoming more popular among policy makers, and I think that's among both democratic and Republican policy makers. Essentially. The Trump tax cuts three years ago were, I think was an example of MMT, but what's happened in terms of people's thinking, the consensus view among economists and policy makers was that the economy typically operated near full employment. And you could certainly make the case in the fifties and sixties that that was the situation. And that implied fiscal stimulus is dangerous as it's gonna crowd out the private sector, including private sector investment and spur inflation. So you have to be really careful about fiscal stimulus. But if we're looking from the perspective of 2020 or 2021, we now have 30 years in which the dog hasn't barked. We've had lots of fiscal stimulus, we've had qe, we've had zero rates for a long time period, and there hasn't been any inflation.
Speaker 3 (17:38):
So this view, the old consensus view has been turned on its head and, and the growing view is that the economy typically operates well below full employment. So there's lots of room to crank up fiscal spending on hosted government programs, at least until inflationary pressures build. There's a host of problems with this. What's certainly one problem is we have no idea where the point is where inflationary pressures will build and we won't know where it is until we're well beyond it. Inflation inflation's accelerating, and the only way to get inflation expectations back down to 2% would be a severe policy induced recession.
Speaker 1 (18:15):
Okay. So if the great inflation of the sixties and seventies you think is not a perfect analogy, tell us about an even earlier time period that you think might be a better roadmap to what's happening now?
Speaker 3 (18:26):
Yeah. In, in the paper we mentioned that one peer that we think does make a lot of sense to look at was the Korean War experience. It involved a big ramp up, uh, in spending in 1950 and 1951, you had a, a massive output gap. In fact, the, the output gap during the three years, 1950 to 1952 was the biggest it's been in the post World War II experience, even including up to 2021. With that, we did get inflation driven higher through 19 50, 19 51, but by 1952, spending was being brought back in and inflation came back into 2%. And then at least for the next 13 years, inflation expectations was well behaved. There doesn't seem to have been any systemic damage to the economy during the Korean War. Equity markets were fact up 36% during that three year period of hostilities. So that strikes me as a better qualitative analogy rather than the great inflation, because, you know, if in fact we're getting a one-off in spending and so we're gonna have a big boost to growth, the up and caps gonna become big, but then in a year or two, it's all gonna come back down and inflation will then normalize back towards 2% where it's been for a long time.
Speaker 1 (19:43):
Okay, so what, what should we looking for, you know, what sort of signposts, uh, or uh, should we be looking for to see whether this in fact does turn out to be a transitory rise in inflation? And, and, and where do you think we will be in a year vis-a-vis inflation?
Speaker 3 (20:01):
So in terms of specific signs to be thinking about, you know, I think there's three that we should be keeping in mind. One is longer term inflation expectations as are measured by some derivative markets like the five year, five year inflation swap. And we've seen short term measures like the two year break even, they've headed towards 3%. But longer term measures like the 10 year break even, or the five year five year so far remained anchored closer to 2%. But if we do see this start to rise up above two half percent moving towards 3%, then the market's telling us they're becoming increasingly worried. A second specific sign to look at is wages. And once inflation becomes embedded into wages as occurred in the 1970s, then a wage price spiral, highly likely. And the only way to exit such a spiral is a policy induced recession, such as the two that we experienced under Volker. The third specific thing that I would look for would be rents. People aren't talking much about this, but with home prices increasing at their fastest pace since 2005, this is definitely something to watch out for and has a very high weighting both in the CPI and PCE measures of inflation.
Speaker 1 (21:24):
Okay. And finally, let's close with, you know, a practical question for listeners, which is, if you're an equity investor, how do you play inflation? What does, well, what does poorly during periods of higher inflation in the stock bar?
Speaker 3 (21:38):
So we have some analysis in the paper and we show that equity markets view rise in short term inflation expectations such as the two year break event moving up. Typically that's good news. The market views that as an improving cycle. And during that time period you get value outperforming growth. And for example, banks outperforming tech. So that's when you get initially inflation, sort of what people call reflation, and that's shown by two year breakevens moving up. But you get a very different result when this gets into longer term expectations, 10 year breakevens, or the five year, five year that are mentioned before, when those start to move up, equity markets typically tumble. The view then is that they're thinking, we're late cycle inflation's getting too high, the fed's gonna have to come in and to stomp on the economic recovery. And, and then in that situation, pretty much all styles and sectors exhibit negative performance over recent decades. You the really only exception that's been the energy sector, but I'm not sure how robust that result is. So is this dichotomy short-term increase in inflation? You can view that as good news because the cycle's getting better, but that gets into longer measures, then the markets starts to worry, inflation's getting outta control, the fed's gonna end the party. And in fact, pretty much everything has negative performance.
Speaker 1 (23:05):
<laugh>. Okay. Yeah, it is just getting back to the, the subject of, of humility about what we can know. It is true that, you know, our, our data over the last 50 years, you know, includes this one period of a big run up in inflation and then a big reduction in inflation. And as, as you say, regarding the performance of energy stocks, yes they did well, but it was because of, you know, the rise in oil prices was in fact one of the drivers of inflation in that episode. Doesn't mean it's gonna be the case in a subsequent episode of inflation. So we do have to, uh, you know, understand that our data history is somewhat limited. So anyway, so thanks, thanks again for joining and I promise we will find a different guest for the next episode. Give you a break. And listeners, if you enjoy, uh, the podcast, please give us a, a good review on whatever platform you're getting the this podcast from and we will be back again with another episode soon.
Speaker 2 (24:00):
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Speaker 4 (24:15):
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