Inflation: Tiger by the Tail
Considering clarifications, objections, and responses from readers
Welcome to this week’s edition of the Mueller Report!
Minor Clarification
Two weeks ago, I defined “long” and “short” a little sloppily:
If you are “long” on crypto, that means you want to hold it for a long time and expect it to rise in value over time, even with a lot of volatility.
If you are “short” on crypto, you think the price will fall and you want to sell what you have.
Here are some helpful comments from a reader:
Technically though - “long” and “short” refer to being actually long or short on positions.
I think “bullish” and “bearish” would fit better in context.
Yes, technically “long” and “short” are financial terms that refer to whether you are holding an asset (long) or selling an asset (short / shorting) based on your expectations of its future value. Colloquially people will use “long” and “short” as I did to describe their expectations, not just their financial position - but bullish and bearish might be a cleaner way of describing one’s expectations.
Inflation: Considering Objections
If you follow financial news you are probably tired of hearing about inflation because so many people are talking about it. But we are in an important (and dangerous) moment and it is worth considering the issue at greater length.
Last week, a reader offered several interesting comments about inflation, whether buying a house now is a bad idea, and whether we are really in a housing bubble. Here are my summaries of some of his objections and arguments along with my response:
1) Don’t focus only on the monetary base because technically the monetary base (MB) cannot be “lent out” into the economy. The MB is primarily reserves that commercial banks hold at the Fed (just as you hold money in a checking account at a commercial bank). Although they can transfer money among those accounts at the Fed, the general public does not have access to that money.
This is correct and important. The monetary base is literally the liability side of the Federal Reserve’s balance sheet. Cash is part of the MB and does circulate among the general public, but we have not seen an explosion in how much cash is circulating through the economy. Almost all the expansion of the monetary base has been electronic and in the form of bank reserves held at the Fed.
However, growth in the monetary base goes hand in glove with artificial manipulation of interest rates which affect all kinds of investment decisions in the economy. One should focus more on the term structure of interest rates than the absolute size of the monetary base
2) Sure, several measures of money (M) beyond the monetary base have grown dramatically but velocity (V) is way down so M*V has not changed much.
This is also true (or at least has been over the last decade or so). This is largely why concerns about inflation after the massive growth in the monetary base after the 2008 financial crisis look like the boy who cried wolf. Velocity collapsed and more than offset increases in money.
However, velocity is not a fixed variable (as Milton Friedman found out post 1980). Many of us are concerned about inflation because velocity tends to increase with inflationary pressure. If the value of your cash is declining, then you should spend it before it becomes worth-less. As people rush to spend their money, their spending fuels rising price and increases velocity. Hayek regretted never writing a book about Keynesianism called “Tiger by the tail.” The gist of what he wanted to say is that once inflation arrives, it becomes very difficult to stop.
3) The U. S. economy is unlikely to see high enough rates of economic growth to sustain inflation.
This is mostly irrelevant. We found out in the 1970s that a country can have inflation with declining economic growth. They created a new term to describe it: stagflation.
4) Housing prices are high because of real factors in the economy. Demand is massive, supply is limited, it is becoming more costly to build houses [inflation?], Millennials are the largest generation ever, etc.
No doubt there is some truth to this. Demand is massive, supply is limited (often because of zoning restrictions and costly red tape), the cost of building is rising, etc.
Most of this was true in 2000, 2001, 2002, 2003, 2004, and 2005 until 2006 when it wasn’t so true. The question is why did the housing bubble in the early 2000s pop (or why was there a massive decline in housing prices if it wasn’t a bubble)? The answer is rising costs of financing home purchases - which is the next objection.
5) Houses are not overpriced because interest rates are really low. Even though prices are, say, 50% higher than a couple years ago, the monthly costs of a mortgage have not risen nearly that much. Remember that people’s monthly house payments involve more than principle and interest on the mortgage. They include property taxes, insurance, etc. So even if the size of the loan doubles, one’s monthly payment will not double - only the principle & interest portions will double. That means that wage growth can support larger loans and increasing home prices. If your income doubles and the price of your house doubles, your mortgage payment will not double (at least not exactly and not right away) - meaning that people can continue buying houses whose prices are growing more rapidly than people’s income grows.
There is a lot to unpack here. First, I basically agree with the financial points made (i. e. interest and principle are only part of one’s mortgage payment). The monthly payment on a $200k house with a $160k mortgage will likely be less than double the monthly payment on a $100k house with an $80k mortgage.
But the huge problem, which relates to whether we are looking at a housing bubble here, is what happens if interest rates on mortgages rise. If people are currently borrowing at 3% and the interest rates rise to 4%, the interest cost on their loans will increase by 33%. If rates rise to 5%, the interest costs on mortgages will increase by 66%. The massive demand for housing will dry up quickly if rates move a couple percentage points - at least that is what happened from 2005-2007. And inflation takes off, mortgage interest rates will rise.
6) Now is a good time to buy a house because 1) you are locking in a low interest/monthly payment; 2) if inflation occurs, the real value of your debt obligation declines; and 3) if inflation occurs, the price of your house will continue to rise with it.
I see the merits of these three points. Rates are really low which means debt is relatively “cheap.” I just refinanced my house myself simply to drop 100 basis points (1%) off of my mortgage rate.
It is true that, all else equal, having fixed debt during an inflationary period is a good thing. Presumably your wages and/or business income will rise with inflation while your debt remains fixed. This can be a powerful benefit to be sure and it is why so many people leverage their house or other real estate. It can also explain some of the frenzy in home buying right now - if inflation is coming, rates will certainly rise, which means borrowing now is a good move IF the borrowing makes sense. You wouldn’t want to borrow for the sake of borrowing to hold onto the cash because the cash itself will decline in value with inflation. You need some productive use for whatever money you borrow. It doesn’t matter how cheap something is if you don’t need it or can’t use it.
Regarding house prices rising with inflation, this may be the most important issue of all. I am not convinced that housing prices will continue to rise with inflation, at least over the short-term. I suspect that housing prices are on the leading edge of inflation - that is to say, much of the inflation we can expect to see in coming years has already been baked into current housing prices - they are not likely to rise more. In fact, I think there is a good chance they will fall (certainly relative to the price of other goods and perhaps in absolute terms) as increasing interest rates dampen effective demand.
Japan is an interesting case to consider. They did not see significant inflation in the 1990s or 2000s (quite the reverse actually) after a massive boom in real estate in the 1980s. Instead, they saw stagnation and their real estate prices plateaued for several decades. I don’t think we are headed into a Japan-style deflationary stagnation, but I bring it up to illustrate the possibility of real estate prices going nowhere for decades after having many years of rapid appreciation.
One final point regarding inflation: it’s already here.
I also offer this rhetorical question: If there were a checklist of public policies and/or market circumstances that could contribute to inflation and a housing bubble, how many of the boxes does the U. S. check?
Put another way, it’s hard to imagine more that could be done than has been done to get inflation going and to juice housing prices. It’s almost like they have been trying to do this for the past ten years…. Now after significant supply disruption from the past year and literally many trillions of dollars in additional stimulus spending on top of normal government spending - much of it in the form of direct payments to people’s bank accounts - policy makers have realized their goal.
And inflation concerns are not limited to free market, small government types either. Consider this excerpt from a recent article by Andy Haldane, the chief economist for the Bank of England:
During the Covid crisis, central banks have followed the same playbook as after the global financial crisis: a large and rapid crisis was met with a large and rapid monetary policy response. But after the global financial crisis, the economy recovered slowly so monetary policy was normalised slowly.
This time is very different. The economy is rebounding rapidly. Yet the guidance issued by central banks implies a path for policy normalisation every bit as sedate as after the global financial crisis. Having followed the global financial crisis playbook on the way in – rightly – there is a risk central banks also follow it on the way out. This would be a bad mistake. If realised, this risk would show up in monetary policy acting too late.
Friedrich Hayek once referred to inflation as the tiger whose tail central banks hold, usually with trepidation and ideally from a safe distance. If central bankers wait to see the whites of this tiger’s eyes before acting, they risk having to run like the wind to avoid being eaten. Waiting too long risks interest rate rises that are larger and faster than anyone would expect or want. It runs the risk of the brakes needing to be slammed on to an overheating economic engine.
No one wins in that situation. Not central banks, whose mandates will have been breached and which would need to perform an economic handbrake turn for which they would not be thanked. Not businesses, for whom a higher cost of borrowing and a slowing economy would, with debts high, be an unwelcome surprise. Not households facing the twin threat of a rising cost of living and a rising cost of borrowing. And not governments, whose debt servicing costs would rise, potentially casting doubt on their capacity to run big debts and deficits. Ouch.
The policy lesson is a clear one, and an old one. The inflation tiger is never dead. While nothing is assured, acting early as inflation risks grow is the best way of heading off future threat. This is monetary policy 101. As experience in the 1970s and 1980s taught us, an ounce of inflation prevention is worth a pound of cure.
While this time may be different and history never perfectly repeats itself, history does have a way of rhyming.
Talk to you next week!
Paul,
Thanks again for the time and effort in summarizing, following up with additional thoughts, and adding content.
Dean Fletcher,
Likewise, I also appreciate your follow up, thoughts and content. (BTW: I found the graphs particularly useful and enlightening.)
Some thoughts that resonated with me and a few takeaways...
Housing. I anticipate housing prices to continue to rise, albeit at a slower rate over the long-term (3-5 years). In fact, I believe they may even flatten out or stagnate for short periods of time. I doubt, based on current circumstances, housing prices will fall over the long-term. In addition, I don't believe inflation is "already baked into current housing prices" as postulated. Although, the housing prices rate of increase will wane as the supply and demand approaches an equilibrium.
I found the graphs suggested by Dean illuminating from a variety of perspectives. The composition of the borrowers and distribution across the first-time buyer, refinancers and second home buyers combined with the population demographics compelling. I did not realize millennials and Gen-X made up such a large segment of the U.S. population. This fact alone has significant weight in current and future housing prices. Of course, all bets are off if inflation gets out of hand.
Inflation. Friedrich Hayek comment about holding a tiger by the tail is spot on. Failure to address inflation pressures quickly will have a significant impact on the overall economy. It took the better part of a decade to get us into a sever inflation cycle due to a number of factors including the Keynesian policies of Johnson, Nixon, Ford, Carter, and Congress. I am seeing history repeat itself (again) under Bush, Obama, Trump, Biden and Congress. "Waiting too long risks interest rate rises that are larger and faster than anyone would expect or want." As mentioned, the "experience in the 1970s and 1980s taught us, an ounce of inflation prevention is worth a pound of cure." Paul Volcker started tightening the screws which was one of the main factors contributing to the 1979-1981 recession. Fortunately, he did what needed to be done even though it was unpopular and drastic. I have vivid memories of this time period. It was ugly. People lost homes, life savings, costs would rise on goods and services seemingly overnight, the market lost value, etc., etc. I don't know if something of that magnitude is going to happen now. If it does, and if you plan appropriately, you could avoid the more painful impacts of inflation and won't need to panic. (Just saying.)
Thanks again. Shalom.
-- Duane
Thanks for an open minded and excellent summary of my comments on your last article! I don't mean to be argumentative, but I'll repeat what I consider to be two key points you didn't directly address for why the housing market now vs 2006, "this time it's different."(famous last words!)
The first point is the shockingly high credit standards and quality of borrowers now vs 2002-2008. The first graph in this link is frankly mind-blowing: https://libertystreeteconomics.newyorkfed.org/2021/02/mortgage-rates-decline-and-prime-households-take-advantage.html
2021 isn't NINJA loans(No Income No Job=Approved!) to subprime borrowers. It is historically pristine credit conditions.
The second point was partially addressed, massive glut millennial population just entering peak home buying age(33), but I failed to mention the massive dearth of Gen Xers hitting peak home buying age in 2005-2008(rate of change in size is key). The first graph for this link is from 2016, so just shift everything to the right by 5 years.
https://www.cleveland.com/datacentral/2017/04/baby_boomers_slip_to_741_milli.html
In 2005-2008, just as home prices were starting to peak, we saw a simultaneous decline in the population of peak first time home buyers. Throw in my first point on credit worthiness, (plus Greenspan raising rates) and you get the perfect storm for a housing crash.
We have 100% opposite conditions today, thus my Bullish housing call for at least the duration of the peak in millennial home buyers (4-5 more years). And despite the 30 year high CPI data released last week, 10 year yields dropped (to my surprise). The long duration bond market, which is IMO the smartest and most indicative of the real economy, sees transitory inflation, so rates may stay the same or even drop (or go up, who knows what the Fed will do). I just don't think they will really take the punch bowl away just as the reflation party is getting started.
Cheers!