Thursday, March 26, 2015

Inflation and the end(?) of the Zero Lower Bound

Inflation came in low again.  It will be interesting to see how this plays out over the next several months.  In 2 years, there has been 1 single month with core inflation above 0.2% and no months with Core minus Shelter inflation above 0.2%.

In the past 8 months, core CPI has risen by about 1.0% and Core minus Shelter has risen by about 0.3%.  Much of the Year-Over-Year inflation came more than 8 months ago.  As we move to June, YOY core inflation and core minus shelter inflation will have strong headwinds to overcome as months 9 through 12 time out of the inflation measure.  YOY Core inflation is very likely to still be well under 2% and core minus shelter well under 1%.

Shelter inflation has stabilized. Possibly if we are seeing the slightest whiff of a continuation in a housing recovery, this might slowly begin to decline.  That will either pull core inflation down even more, or credit expansion in housing might lead to inflation in non-shelter core categories.

In any case, it seems as though the Fed will have to conjure up some pretty strong forward expectations in order to justify a rate hike in the coming summer.  I'm just watching for now.  I suspect that there will be a window where expected short term rate movements are at their lowest and where nascent recovery in mortgage markets haven't triggered bullish expectations yet.  Maybe that point is now.  Maybe it will be in June.  At some point, there will be a profit in short forward Eurodollar contracts.  I might very well sit on the sidelines too long and miss it.  This is a tricky one.


  1. Kevin,

    The basic problem with inflation measures is that they are always implicitly relative to zero, not in terms of what inflation would have been if money supply followed a productivity norm (what is now commonly referred to as a NGDP level target).

    It's entirely possible we "should have" seen deflation but because of mistaken monetary policy we end up with inflation. To my way of thinking, this is the single most important argument in favor of a productivity norm monetary rule - it follows as closely as possible what would actually happen absent a money monopoly.


    1. Yes, I think you're right. There is a cultural component and an expectations component there. A number of regimes are possible, but after a century of inflation expectations, there would be some dislocations associated with a less expansive regime. In general, I think monetary policy doesn't matter that much within a pretty broad range, as long as it avoids demand shocks like what we saw in the late 70s on the positive end and in 2008 on the negative end. I think some combination of Seglin/White free banking where the Federal Reserve happened to have a policy of creating a currency that it promised would grow at a rate to create a 5% NGDP growth rate. I think banks would prefer that to gold.

  2. TravisV here.

    Still hoping to hear from you re: what truly drove corporate profit margins down in the late 1960's, late 1980's and late 1990's. Your chart indicates that it wasn't actually increasing leverage and increasing interest payments.

    P.S.: Scott Grannis has an interesting post on corporate profits:

    And Joe Leider has an interesting post on stock valuations:

    1. I don't know. I've been digging into it. I don't know if I have much to say that I haven't said before. There are tons of things to think about - the growing portion of corporate income coming from abroad, leverage levels, real interest rate levels, inflation premiums, movement between corporate and non-corporate income, etc.

      I'm not sure what happened in the late 60s. It looks to me like equity premiums were low, but real growth expectations weren't particularly high. Of course, a lot of fiscal stuff was going on - Vietnam, the huge increase in federal govt. transfers, beginning of high inflation, etc. I don't have a particular coherent story to tell, though. I've tried. But, for once, I'm speechless.

      In general, though, I would say, when we account for all the corporate and non-corporate profit and interest income, the take-away from the chart in this post:

      is mostly about how stable it is. It dips by a couple percent in the late 60s, and I don't know exactly what to say about that. But, more generally, I would just say that returns to capital just don't move around that much. To the extent that there is somewhat higher profit and healthy multiples right now, I think we can point to low leverage, low interest rates, and growth potential in foreign markets. Equities will move around a narrow band of valuation over the next few years - 4-5% from nominal growth (plus a little more from foreign growth) + 2-3% capital gains from buybacks + 2% dividend income. Until the next demand shock hits.

      I don't know if I'm telling you anything you don't know.

    2. Maybe I can be a little more clear. I think I'm making this too complicated:

      The leverage issue is more of a secular shift. So, in that graph, the green line is total operating profits to corporations. Leverage determines how that is divvied up between debt owners and equity owners. Much of that was going to debt in the late 70s and early 80s. But, before the 70s it was almost all equity, and today equity is capturing more of the operating profit again. This is simply a product of the shape of corporate balance sheets. It's why profit is higher now than in 1985, but basically is the same as it was in 1965. Then, there is the added secular shift from noncorporate to corporate firms.
      The reason I say profit levels aren't unsustainable because they are coming from deleveraging is because (1) deleveraging has been happening for 30 years, so the green line is well below where it was in 1985, and the light blue line is basically the same level it has been in recoveries over that time. And (2) there is significant deleveraging happening right now, so the dark blue line is rising, but the green line is flat. All the gains to equity are coming from lower debt.

      The little cyclical squiggles in the late 60s, 80s, and 90s are not leverage related. I said leverage explains a lot about what makes the numbers today reasonable. I didn't say that it explains every squiggle in every business cycle.

      Those squiggles are hard to pin down. Sometimes, it is due to GDP shocks, which tend to hit equity earliest and hardest. But, I think sometimes, capital income can decrease when conditions lead to low risk premiums, so that capital expects more of the return to come from growth than from current profits. But, the mystery for me is that while the lower profit levels of the late 1960s do coincide with lower risk premiums, they don't seem to coincide with higher real growth expectations.

      It could be that the Keynesian and progressive policy shifts at the time were boosting consumption and confidence and reducing the risk of demand shocks, so that risk premiums were low but weren't being parlayed into investments in growth. I haven't pulled together an empirical defense of that theory, but it seems plausible.

      (One pedantic point. There does tend to be increasing leverage in a downturn because the NGDP shock leads firms to disequilibrium in their capital structures, since equity tends to take a hit. So, if the dark blue line and the green line are both falling with the same slope, there is a passive increase in leverage, because interest expense remains level while profits fall. In most cycles, debt remains fairly stable while profits rebuild. But, in this cycle, the green line is flat. Firms are actively deleveraging during the recovery.)

      Please let me know if I've failed to respond to any particular question, or if you think I am incorrect about something.