Tag Archives: inflation

The normal interest rate

22 Sunday Jan 2023

Posted by in Debt, Monetary Policy

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What determines interest rates and how lower private sector profitability, changes in the institutional infrastructure governing our economies, major geopolitical conflicts, and climate change, could usher in a ‘sea change’ of higher interest rates[i].

The simplest possible explanation of what drives interest rates is the demand and supply of capital and its mirror image debt. I find this to be also the most relevant one.

There are many other variables that matter, which fall under the broad umbrella of economic activity. These factors determine the ability to pay/probability of default and may impose a certain ‘hurdle rate’ (inflation), but it is important to understand that they are a consideration of mostly the supply side of capital.

So, what is a ‘normal’ interest rate? Obviously, when capital is ‘scarce’ (relative to the demand for debt), as indeed for the majority of time of human existence and ‘capital markets’, creditors are ‘in charge’, nominal interest are high and real interest rates are positive. So, that is the norm. But in times of peace and prosperity, as during the time of Pax Britannica (most of the 19th century), and Pax Americana (since the 1980s, and particularly since the end of the Cold war) surplus capital accumulates which gradually pushes interest rates lower as the debtors are ‘in charge’. The norm then could be zero and even negative nominal interest rates.

While indeed the norm is for interest rates to be positive, there is no denying that if one were to fit a trend line of global interest rates in the last 5,000 years[ii], the line would be downward sloping. That should be highly intuitive as human society evolution brings longer lasting periods of peace and prosperity (the spikes higher in interest rates throughout the ages are characterised with times of calamities, like wars or natural disasters, which destroy capital).

What is the function which determines that outcome? The surplus capital inevitably creates a huge amount of debt. This stock of debt eventually rises to a point which makes the addition of more debt an ‘impossibility’. It is important to understand that this happens on the demand side, not on the supply side – it is current debt holders who find it prohibitive to add to their current stock of debt, in some cases, at any positive interest rates.

Richard Koo called this phenomenon a balance sheet recession when he analysed the behaviour of the private corporate sector in Japan after the 1990s collapse. We further saw this after the mortgage crisis in the US in 2008 when US households started deleveraging. Not surprisingly interest rates during that time gravitated towards 0%.

The importance of 0% and particularly negative interest rates is not only that this is where the demand of debt and supply of capital clears, but, more importantly from a ‘fundamental’ point of view, this is the point where the current stock of debt either stops growing (0%) or even starts to decrease (negative interest rates). Positive interest rates, ceteris paribus, on the other hand, have an almost in-built automated function which increases the stock of debt (in the case of refinancing, which happens all the time – rarely is debt repaid).

Because our monetary system is credit based, i.e., money creation is a function of debt origination and intermediation, this balance sheet recession, when the demand for credit from the private sector is low or non-existent, naturally pushes down economic activity, which, ceteris paribus, results in a low, and sometimes negative, rate of inflation.

So, you see, it is low interest rates which, in this case, determine the inflation rate. This comes against all mainstream economic thinking. I am sure, a lot of people, would find this crazy, moreover, because this is also what Turkish President Erdogan has claimed, and it is plain to see that he is ‘wrong’.

However, there is a reason ‘wrong’ above is in quotation marks. You see, this theory of low interest rates determining the rate of inflation, and not the other way around, holds under two very important conditions. First, and I already mentioned this, the monetary mechanism must be credit-based. This ensures that money creation is not interfered by an arbitrary centrally governed institution, like … the government, and is market-based, i.e., there is no excess money creation over and above economic activity.

In light of a long history of money waste, this sounds like a very reasonable set-up, except in the extreme cases when the stock of debt eventually piles up, pushing down the demand for more credit, slowing down money creation and thus economic activity. In times like these, it is the rate of money creation which determines and guides economic activity rather than the other way around (as it should be). Unless there is an artificial mechanism of debt reduction, like a debt jubilee, the market finds its own solution of zero or negative interest rates to resolve the issue.

And the second condition for the above theory to hold is the supply side of the economy must be stable. Don’t forget that inflation is also independently determined by what happens on the supply side: a sudden negative supply shock would push inflation higher. That the balance sheet recessions in Japan, and later on in the rest of the developed world, coincided with a positive supply shock accentuated its disinflationary impact.

To go back to Turkey, Erdogan’s monetary experiment is not working because 1) Turkey’s economy is not in a balance sheet recession (private sector debt is not big, and there is plenty of demand for credit), and 2) Turkey’s economy was hit by a large negative supply shock in the aftermath of the breakdown of global supply chains on the back of Covid/China tariffs, and, more particularly for Turkey being a large energy importer, in the aftermath of the Russian sanctions on global oil prices. A related third reason why low interest rates in Turkey have failed to push inflation lower is the fact that institutional trust is low. In other words, the low interest rates are not market-based, but government-based (market-based interest rates are in fact much higher).

What has happened in the developed world, on the other hand, is, since Covid not only the economies have experienced a massive negative supply shock, but also monetary creation, for a while (well, most of 2020-21) became central-government-based (in the form of huge household transfers). In other words, even though private debt levels remain excessive, their negative effect on economic activity has been offset by other forms of money creation. This not only managed to reverse the disinflationary trend from before, but, when combined with the negative supply shock, it provoked a powerful inflationary trend.

Going forward, unless there is a repeat of the central-government-based money creation experiment under Covid, the demand for credit, and thus the growth of money creation, will remain low, as private sector debt levels remain too high. This does not bide well for economic growth and is disinflationary by default. At the same time, however, the effects of the negative supply shock are likely to be longer lasting given that the reorganization of the global supply chains is still an ongoing process. This is inflationary by default – if that means also lower private sector profits, thus lower capital surpluses, then interest rates should continue to be elevated.

When it comes to the developed world the black swan here is an eventual outright debt reduction (debt jubilee) – the will have a corresponding effect of an artificial capital surplus reduction as well. Maybe this is counterintuitive, but if you have followed my reasoning up to here, that would mean higher interest rates going forward.

An alternative black swan is a direct capital surplus reduction, caused by either lower corporate profitability, lower asset prices, or indeed an artificial or natural calamity, like war or a natural disaster, which have the unfortunate ability to destroy capital. In that sense, it is uncanny that our present circumstances are characterised by a war in Europe, a potential war in Asia and the looming threat of climate change[iii].

Howard Marks certainly did not mean literal ‘sea change’ in his latest missive, but this might ironically be one of the main determinants of higher interest rates in the future.

For more on this topic you might also find these posts interesting:

It would take a ‘revolution’ to wipe out negative rates

Negative interest rates may not be a temporary measure

Inflation in the 21st century is a supply-side phenomenon

‘State’ money creation – this ghost from the past is badly needed for the future

[i] This post was inspired by Howard Mark’s latest, Sea Change, and, more particularly, by his interview on the subject.

[ii] https://www.businessinsider.com/interest-rates-5000-year-history-2017-9?r=US&IR=T

[iii] We live by the sea, literally. When we bought the house in 2007, the sea was about 100 meters from the fence of our garden, in normal times. This has now been reduced at least by half. In the last three years, the sea has often come into our garden, which has prompted us to spend money on reinforcing the fence etc., which has naturally reduced our capital surplus.

The US labour market is slowing down

06 Tuesday Dec 2022

Posted by in Monetary Policy, Questions

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  • Is US employment data hot, ‘goldilocks’, or ‘cold’?
  • Have you been inundated by calls and messages with the question, “But have you seen the details of the Household Survey?”
  • Is the Fed right to keep aggressively hiking?

Summary: The US labour market is slowing down despite headline grabbing low unemployment rate and high wage growth rate. The recent details underlying this data show the total number of people employed growing below trend, fewer hours worked and lower quits rate. As a result, the growth rate of total earnings is also going down, the effect being a lower share of national income going to labour and total consumption as a share of GDP stagnating. All this should make the Fed further re-evaluate its aggressively hawkish interest rate policy.

The Household Employment Survey makes the headlines

After a couple of weeks of ‘SBF’ trending, I, for one, was happy to take my mind off to something much more prescient and important as far as my investments are concerned – the US employment situation. At first glance, the November NFP report came much hotter than expected but because the market did not really react the way one would have expected from such a strong report, we started looking for reasons why that was the case.

Which bought us to the US Household Employment Survey. ‘Us’ here does not mean us literally (for those of you who had followed my writings at 1859, there was plenty of discussion on this topic as soon as I spotted the divergence between the two employment reports in September). And this note is not on why the Household Survey is showing different things from the Establishment Survey.

If you want to, you can read zerohedge on this topic here (I know, think what you want but the folks there were one of the first to spot the issue way back in the summer). If you can’t bear some of the conspiracy language at zerohedge, you can read an inferior version (but still good!) of the same at the more balanced Macro Compass. Finally, there are quite a few respected people on Twitter who have talked about it (see here, here, here).

To give you the full  disclosure, there are some legitimate reasons why the Household Survey produces different results to the Establishment Survey – and they have to do with a methodology issue, see here. BLS is actually well aware of that issue and calculates a time series which reconciles the two surveys and which can be found here (also with a very, very extensive comparison analysis between the methodology of the two). This adjusted data does not look that bad as the stand-alone Household Survey data (the November data was actually very good). But over the last 6 months it still points to a weakening employment market, not a stable or even hot one as per the Establishment Survey.

OK, that’s more than I wanted to write regarding the Household Survey. The rest of the note will show why the US employment situation is actually weakening even taking the Establishment Survey as a base.

The three variables of employment

There are three aspects of employment in general as far as assuaging how hot the economy is doing: wages, people employed, and hours worked, i.e., we need to follow this sequence, purchasing power->consumption->GDP) Basically, one needs to know the full product of Wages X Total Employment X Hours Worked (assuming, of course, that wages are per hour worked; not all jobs pay per hour, but those that do have actually increased at the expense of the others – see some of the links above which discuss the prevalence of part-time jobs and multiple job holders).

The economy can be hot even when wages are flat, or even declining, but there are more people entering the workforce or there are more hours worked – there are multiple combinations among the three variables producing various results. The point is to consider all three variables.

Total number of employed is growing below trend

Let’s take the period in the last three years or so after the Covid crisis. Yes, wage growth has picked up, but more people have exited the labour force and there are fewer hours work.  

The labour force participation rate is still below the pre-Covid levels, and close to a 50-year low:

The total number of people employed has risen but, depending on whether one uses the Establishment Survey or the Household Survey, the number is either just above the pre-Covid levels or indeed below. In any case, regardless of which survey one uses, the number is still below trend (and has not been above trend since the 2008 financial crisis).

Higher wages but lower hours worked

Finally, here are wages and hours worked. I have included below a time series chart for only the last 3 years to be able to see better the divergence between the two: while wages continue to rise, hours worked peaked in January 2021 and have now reversed the spike in 2020.

Let’s focus more on the latest NFP report. Here are the relevant tables below.

  • Generally higher-wage industries, like goods producing, tend to exhibit a smaller increase in hourly wages than lower-wage ones, like services.
  • In some cases, like the Utilities sector, which has the second highest wage per hour but also the highest average weekly earnings (courtesy of more hours worked, more on this later), wages have actually declined.
  • Transportation and warehousing sector has an unusual jump in wages, about 5x the average rise in wages – is there something specific going on there?

The growth rate of total earnings is declining

It is important to look at the last columns in Table B-3 above, ‘Average weekly earnings’, which gives a much better picture of take-home pay as it combines wages with hours worked. So, while indeed the trend of declining 12m-growth rate of weekly wages was reversed with this latest report (back above 5%), which some commentators have warned the Fed should be worried about, the trend of declining total weekly earnings continues to be intact.

Note, average hourly earnings are still elevated, hovering at previous peaks but this is hardly a reason for the Fed to get more worried about, especially after already delivering the fastest interest rate hiking cycle in recent memory.

In fact, quite on the contrary. Despite all the excitement about the rise in wages, the share of national income going to workers has been on a decline, with the post-Covid spike now quickly reversed. We are back to the familiar territory of the low range post the 2008 financial crisis which is also the lows since the mid-1960s. If you were worried about a wage-price spiral issue, ala the late-1970s (I actually do not think there was one even back then as real wage growth even then was negative), you really shouldn’t be. It is a very different dynamic, at least for the moment.

Consumer demand as a share of GDP has been stagnant for more than a decade

And if you are really worried that consumer demand will push inflation higher, again, you shouldn’t be, necessarily: consumption as a share of GDP is elevated relative to historical records but it is not even above the highs reached more than a decade ago. In fact, it seems that consumption has not been an issue for inflation for at least the last two decades.

The quits rate is declining

One final observation, there is another labour data series which has been often cited as an example of a tight labour market: the quits rate.  I would though argue two things: 1) labour tightness explains only part of the elevated quits rate, and 2) the quits rate has already started declining.

A higher quits rate is quite consistent with an increasing share of lower paid jobs and with multiple job holders both of which have been trends seen post the 2008 financial crisis, and especially during and after the Covid crisis. It is possible to decompose the quits rates by industry and sector. For example, retail trade, accommodation, and food services, all of which are lower paid/temp jobs by multiple job holders, have much higher quits rates than the average across all industries. This is corroborated by a Pew Research report according to which most workers who quit their jobs cited low pay.

Finally, the quits rate actually peaked at the end of last year (notice the Household/ Establishment Employment Survey discrepancy started shortly after) at about 3%. This is the highest in the series, but the data officially goes back to only 2000. BLS has actually related quits rate data (but only for the manufacturing sector) prior to 2000 which shows that the quits rate has been above 3% in the past, and yes at above 3%, the quits rate is associated with the peak in economic expansion. You can see the full data set and BLS perspective on it here.

Bottom line: you do not need to believe in conspiracy theories about Household Survey vs Establishment Survey labour data inconsistency to conclude that the US labour market is far from tight. If anything, it has already started to slow down. Do not be confused by headline numbers of high wage growth rate and low unemployment rate, look at the overall employment picture taking into account trends in overall total compensation.  

Inflation in the 21st century is a supply-side phenomenon

01 Saturday Aug 2020

Posted by in Monetary Policy, Politics, UBI

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“For example, it is habitually assumed that whenever there is a greater amount of money in the country, or in existence, a rise of prices must necessarily follow. But this is by no means an inevitable consequence. In no commodity is it the quantity in existence, but the quantity offered for sale, that determines the value. Whatever may be the quantity of money in the country, only that part of it will affect prices, which goes into the market commodities, and is there actually exchanged against goods. Whatever increases the amount of this portion of the money in the country, tends to raise prices. But money hoarded does not act on prices. Money kept in reserve by individuals to meet contingencies which do not occur, does not act on prices. The money in the coffers of the Bank, or retained as a reserve by private bankers, does not act on prices until drawn out, nor even then unless drawn out to be expended in commodities.”

John Stuart Mill, Book III, Chapter VIII, Par.17, p.20

In his latest Global Strategy Weekly, Albert Edwards explains why he thinks the surge in the money supply is deflationary. As usual he is going against the consensus here even though he gives credit to people like Russell Napier who correctly identifies the changing nature of US money supply but concludes that this is highly inflationary. I think Albert is right for the wrong reasons, and Russell is wrong for the right reasons.

Albert Edwards is right when he says that ‘despite massive stimulus, deflation will nimble on for a while yet until capacity constraints become binding further down the road’ (emphasis mine). Yet in his view, deflation will persist because of keeping zombie companies alive by cheap credit. While, I have no doubt that this is invariably true, its effect on the deflation-inflation dynamics is weak because credit creation is now a much smaller part of the money supply than in the past.

Which is where Russell Napier comes in.  He is right in his view that ‘politicians have gained control of money supply’ but wrong to believe that this will inevitably cause a rapid rise in inflation unless, indeed, capacity does become binding.

Reality is that money supply is now turned around on its head. While in the past, pre-2008, the delta of money supply consisted mostly of loans, after 2008 and during QE 1,2,3, it moved to loans plus QE-generated deposits. During the Covid crisis, it shifted further away from loans by adding even Government-generated deposits to the QE-time mix.

It is ironic that we had to go through QE, when the power of loan creation on money supply started to wane, for us to truly acknowledge their significance in the process of money creation in the first place. Loans create deposits – yes. But under QE, if Fed buys from a non-bank, the proceeds go in a deposit at a bank without the corresponding increase in loans. If it buys from a bank, reserves at the Fed go up.

Source: FRB H.8

Things get more complicated when the government hands out free cash as it also goes on a deposit (Government-generated deposits) with no corresponding loan creation.

Source: FRED, FRB H.8

Of those bank credits, actually, only about half are loans, the other half are securities. So, in fact loans have created only about 1/6 of the money supply YTD (would be even less if measured after the Fed/Treasury initiated their programs in March).

Source: FRB H.8

What about inflation? Difficult to see how this massive rise of money supply can produce any meaningful push in inflation given that the majority of that cash is simply being saved/invested in the market rather than consumed.

Moreover, this crisis is hitting the service sector much more than any other crisis in the past. And unlike the manufacturing sector, which tends to be more cyclical, this decline in services may be structural as the virus changes our consumer preferences in general, but also in light of the new social distancing requirements. Some of these services are never coming back. This is deflationary, or at minimum it is dis-inflationary overall for the economy.

Services price inflation tends to be much higher than manufacturing price inflation. This paper from the ECB has documented that this is a feature for both EU and US economy and has been prevalent for the past 20 years.

However, as the paper demonstrates, the gap between the services and good price inflation has been narrowing recently, starting with the 2008 crisis. I believe that after the Covid crisis, the gap may even disappear completely.

For a sustained rise in inflation, we need a ‘permanent’ rise in free government handouts as that would increase the chance of some of it eventually hitting the real economy. Reality is that, even if this happens, the output gap is so big that inflation may take a lot longer to materialize than people expect. However, anything that shrinks the supply side of the economy (supply chains breakdown, regulations, natural disasters, social disorder, etc.) would have a much bigger and direct effect on inflation.

Bottom line is, as the speed of technological advances accelerates, and with no barriers to that, inflation in the 21st century becomes much more a supply-side than a demand-side (monetary) phenomenon.