What's going on with inflation?

I recently posted an article on the Poole College Thought Leadership page titled: "What's going on with inflation?". 

This was a pretty general, high level article, so in this post, I wanted to add a few extra resources and details. 

Why doesn't the Fed target inflation at zero percent?

2% inflation provides a buffer against deflation (which is generally considered a bad thing).   In addition, a low level of inflation can lead provide some inherent flexibility for employers to adjust wage costs in slower economic times.  This is achieved by simply not increasing nominal wages, which results in a real wage cut for a worker.  See for example, this Cleveland Fed article for more details.  Also see https://www.federalreserve.gov/faqs/economy_14400.htm in which the Fed explains its 2% target.

In addition, there's evidence that a policy of complete price stability (0% inflation) could lead to a significant decline in GDP and employment.

What other factors might lead to inflation, aside from supply chain issues?

It's pretty clear that at the current time, inflation is being driven in large part by supply chain problems.   We can look at the price changes of new and used cars to see the impact the global chip shortage on car production.  But other factors might also lead to inflation.  

One possible factor might be stimulus money that was pumped into the economy during the pandemic.   This extra cash may result in fewer workers choosing to participate in the labor market.  Under classical economic theory, inflation is in part driven by labor market supply.

An interesting paper by the San Francisco Fed shows that the stimulus money (the American Rescue Plan) did indeed lead to a tightening of the market, but that the overall effect on inflation was fairly small.  A more general discussion can also be found in this NYT article (maybe paywalled).

 

Does everyone's wage increase when inflation increases?

The answer is clearly no.  There are many individuals who are perhaps on a fixed retirement income (technically not a wage), and also those in professions where wages are sticky.  A lot of government positions have fairly sticky wage structures.

There is some evidence the service/front line workers have seen wage increases, for example this Brookings Institute article shows wage changes at several retailers and restaurants chains.  

Inflation is coming and so is inflation illusion.

Inflation illusion is a favorite topic of mine, read prior posts here.   It's a topic that comes back time and time again, usually whenever there is a hint of inflation.   Case in point - this article in Barrons

https://www.barrons.com/articles/inflation-driven-stock-market-selloff-51622470534?mod=article_inline

The key line: "Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable. "

This is basically inflation illusion - the idea that when bond yields increase, the discount rate for stocks should also increase, thus lowering the value of the cash flows generated by the stocks.

Here's why this is flawed logic:

The value of a firm's equity can be given as: Value=FCFE(1+g)/(R-g)

Where R = the nominal discount rate, FCFE is the free cash flow to equity and g = the nominal growth rate.   

When inflation increases, R will increase.  This alone will result in a reduction in the value of the stock.  However, inflation will also act upon g, the growth rate.  Across the economy we would expect, on average for g to increase by the increase in the inflation rate.   The net effect of R-g is that the impact of inflation gets cancelled out.

Ironically, the article above contains the line:

"That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices."

Which basically says that the FCFE will increase - because prices are rising and therefore FCFE moves with inflation.

To be clear - I am not trying to beat up on a single, short, Barrons article.  Instead my point here is to show how common this mistake is.

Why stocks are good hedges for inflation.

I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.
Article is here: https://www.wsj.com/articles/which-is-the-better-inflation-hedge-stocks-or-gold-11560132361?mod=searchresults&page=1&pos=8

Quoting from the article:

The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.

To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.

Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.

Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."

What's the best way to protect against inflation?

I was recently interviewed by Mark Hulbert for this article in Barrons:
http://www.barrons.com/articles/whats-the-best-way-to-protect-against-inflation-1482943455

Inflation adjusted Dow

An interesting graphic from "The reformed broker" showing the Dow 30 adjusted for inflation.  

In real terms it appears that we haven't made much real progress in recent years - however I would point out that this chart only shows the level of the index (which is a price index only) and thus ignores the rather healthy dividend yield of about 2.5%.  So to say that the Dow has not made real gains against inflation would be a bit of a misstatement.

Social security should be indexed to Chained CPI.

The difference between different inflation measures didn't seem too important to most people, until the President unveiled his budget which proposes to link Social Security (among other things) to something called "Chained CPI".  This seems like some arcane adjustment, but in fact it is very important.

Background:   We frequently refer to the change in CPI (consumer price index) as being the rate of inflation - but in reality it is merely one way of estimating the rate of inflation.   The CPI-U (U refers to urban consumers) measures the price level of a representative basket of goods.   The problem with the CPI-U is that it doesn't account for substitutions of one item for another.  For example, this week apples are expensive, but bananas are not, so a consumer may switch between the two.   If the price index is measuring the cost of living, then it makes sense to include these substitutions.  This is what the Chained CPI does.

The President's proposal is to link increases in Social Security benefits to this Chained CPI measure.   Because the Chained CPI doesn't increase quite as fast as the non-chained CPI which is currently being used, the net result is that Social Security benefits won't increase as rapidly.

In the short run, there won't be much of a difference, but in the long run the difference will be far more noticeable.  Not surprisingly, many advocates for seniors are complaining that this amounts to a reduction in benefits.  While technically correct, the fundamental question is what are the benefits that Social Security recipients are entitled to?

As The Economist explains, by indexing Social Security to the ordinary CPI, retirees have, in effect, been getting a real increase in their benefits (note that the word "real" means an increase above the rate of inflation).  Even if we were to link Social Security to an index that tracks a basket of expenditures that are more typical of retirees, the rate of increase would still be less.

Given that we're facing an ever increasing federal debt, this seems like a reasonable and fair way of tackling at least part of the problem.  It is also worth noting that by not dealing with this problem, the children and grandchildren of today's retirees will most certainly be paying more in taxes and getting less in benefits.

Questions about TIPS

Marginal Revolution asks some interesting questions about TIPs and inflation.

People just don't understand inflation.

A recent article on Yahoo Finance talks about "Hedging 7 Big Retirement Risks"

The article is OK overall, but demonstrates a serious misunderstanding of the effect of inflation on stock prices (something that I am particularly interested in).  The offending paragraph states that:

To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich

 It is incorrect that growth stocks (low dividend paying high P/E stocks) will be a better inflation hedge than dividend paying stocks.   The value of both stocks derives from the present value of the cash flows generated by the underlying business.   Growth stocks reinvest this cash flow, income stocks tend to pay it out.  Either way, on average, the cash flow will grow at the rate inflation.  Thus the expected return on both types of stock is directly correlated to the expected inflation in the economy.  They are both "real" assets and should provide a hedge against inflation.

The "Fed Model"

The so called "Fed Model" (not endorsed or used by the Federal Reserve) postulates that there should be a relation between the earnings yield on a broad stock index and the yield on medium term Treasuries.  Proponents of the model claim that when the earnings yield on stocks exceeds that of Treasuries, then one should buy stocks.

The model has been widely discredited by academics because it mixes apples and oranges.  Treasuries are nominal assets whereas stocks are real assets (their returns are a function of inflation).   The fact that these two series seem to move together doesn't prove that they have predictive ability over the mispricing of stocks compared to bonds.  For a great discussion of the Fed Model, see Cliff Asness's article "Fight the Fed Model"  I've also discussed this issue in my 2002 JFQA paper with Jay Ritter.

So why bring all this up today?   Well, my favorite finance blogger, Felix Salmon appears to be making the Fed Model mistake all over again, long after I thought that the model was dead and buried.  Felix doesn't refer to it as the Fed Model directly, but his presumption is that Treasury yields and earnings yields should track each other.  After 2002 they don't.

While it looks like you'll earn a higher yield on stocks rather than bonds, this is very misleading.  First earnings are not cash flows - something that we hammer home at the beginning of any stock valuation class.   Second, whereas bond cash flows are pretty secure, the cash flows from stocks are much more uncertain - the risk premium is zero for bonds and who knows what stocks!   Finally, the bond cash flows are fixed in nominal terms, while the stock cash flows are real - they change with inflation.

Again: apples to oranges. 

Inflation linked bonds are back in the spotlight

With global concerns about inflation, the attention turns, predictably, to asset classes that are good inflation hedges.  The FT has a good article on the topic.   Mechanically, inflation linked bonds will provide inflation protection.  But they have a problem - only part of their nominal return comes from inflation - the other part is a real return.  Currently the real return on US inflation linked bonds is basically zero.  If demand for TIPs increases this could go negative (it has in the past).  

Alternatives to TIPs include any real asset.  For example, in the long run, stocks are excellent inflation hedges, although in the short run they often do poorly, in large part because investors don't understand that they are real and not nominal assets.  Commodities are good hedges - but very volatile.  

At the end of the day, trying to bet on inflation is a risky business.

The low real return on inflation linked bonds.

Jeremy Siegel discusses the near zero (and in some cases negative) real return on TIPs and what this means for investors. (source: Financial Times)

First, a bit of background:

• Siegel is a Wharton Professor who is famous (in the finance world) for his book "Stocks for the long run".  Siegel is a strong believer in stocks being excellent long run inflation hedges.  
• TIPs are inflation linked bonds that earn a real return plus the rate of inflation.  The inflation return is certain - the uncertain part is the real return that you earn.

OK, back to the article.  Siegel argues that the low real return on TIPs is due to the low level of economic growth.  This makes sense because it is broadly the case that the real rate of interest should roughly equate to the real growth rate.  He argues that as the economy improves, real growth will increase and so will the yield on TIPs.  Of course, as any student of bond math knows, an increase in rates will result in a drop in the price of the bond.   Siegel argues that the drop in the price of TIPs is all but inevitable as the economy improves.  His solution is to sell TIPs and buy stocks.

His argument has merits, but moving from TIPs to equities will substantially increase the risk of a portfolio.  So while you might dodge an as yet uncertain rate increase on TIPs, you'll expose yourself to much greater market risk.  Furthermore, other fixed income securities would come off worse than TIPs as they would be negatively impacted by both real rate increases and inflation rate increases.

Perceptions about inflation

Before you read any further - what do you think the current inflation rate is?

OK now continue...

The Pew Research Center for People and the Press periodically does surveys to test political and economic knowledge.  On a survey done last November, one result really surprised me.

Here are the responses on the inflation question.  The percentage chosen is in the left column.


PEW.18  Do you happen to know if the national inflation rate reported by the government is closer 
to…
   
 14    1% (Correct)
 15    5% 
 15   10%   
 7     20% 
 49   Don’t know/Refused (VOL.)



Basically 85% of those surveyed either had no remote idea of the inflation rate, or thought it was significantly higher.   That 35% thought it was 10% or higher is amazing.

Here's a graph of the annual inflation rate.  Inflation over 10% is very rare.

Is gold at a record high? Actually, no.

A nice take down in the NYT about the current gold frenzy.   Gold isn't at a record high after you adjust for inflation.   And as the author of the article says "you should always adjust for inflation".

Personally, I think there is a gold bubble forming.  I predict prices below $1000 in a year.

TIPs selling off negative yields

So the big news in the world of TIPS (inflation protected bonds) is that they are selling off a negative yield.  To be clear, this is the real return, not the nominal return on these instruments.  The view is that investors are willing to accept a negative real return in exchange for at least some inflation protection.
My colleague, Steve Allen expands upon this...



HT: Mike (one of my students)

More on the negative TIPs yield

The self evident blog argues that the negative TIPs yield is a rational response to the volatility in the "traditional" inflation hedge markets such as gold and real estate. In other words, investors are accepting no real return in return for stability, something which can't be found anywhere else.

The great one liner...

In short, the negative TIPS yield is a rational reaction to the lunatic casino that has infested essentially every market in the world.

Uh Oh. Negative real TIPs yields...

Felix Salmon talks today about negative real TIPs yields.

What does this mean? Well basically investors are happy to park money in TIPs just to keep pace with inflation. They are not actually earning a real return.
Why would investors do this? Perhaps there aren't any better places to put cash right now.

So overall this probably isn't the greatest news...

Inflation Illusion

People don't get inflation. Case in point - another blogger cites a recent communication from the AARP (the American Association for Retired Persons). Apparently, this year because inflation was zero, there will be no cost of living increase in Social Security. The AARP is very upset about this...

We’re already months into 2010, and seniors still haven’t seen any relief because of the lack of a cost-of-living adjustment to their Social Security. For the first time in 35 years, the regular payment update they’ve depended on did not occur.

Congress must act quickly. Will you help us flood their offices with letters, demanding that lawmakers make relief a priority?

.

Presumably, they'd be happier if we had high inflation and they got a larger cost of living increase.

What is a good hedge against inflation?

TIPs are good. But there is the uncertainty about the real rate.

Fama and French discuss the pros and cons.

Expected inflation

It is possible to estimate expected inflation by looking at the spread between TIPS and T Bonds. Here is a link that presents the data in a pretty clear way.

HT: Craig Newmark

Is high inflation around the corner?

Probably not. We talked about the spread between TIPS and Long Government bonds in class this week and in particular how this spread is only about 250 basis points. This spread represents the market's expectation of inflation embedded in bond prices.

Greg Mankiw makes the same point in his article tomorrow (Sunday) in the New York Times. You can read it here.