Is there inflation? Government statistics say "NO," but it sure feels like there is.
John Mauldin provided an explanation in his May 4th "Outside the Box" letter. I had dinner with John this week and he's been a friend and colleague for several years. Here are his comments:
Where's the Beef? "Lies, Damned Lies, and Statistics"
I have long been a critic of government inflation statistics. Not so much with regard to the methodology they use, but because the measure of "average" inflation across the broad economy doesn't really describe the inflation that the majority of Americans experience. I've written about that at length in several letters.
Now my good friend Rob Arnott, along with his associate Lillian Wu, presents us with a research paper that lays out what inflation actually looks like for most Americans – and the picture is not pretty. The authors demonstrate that inflation in the main four categories – rent, food, energy, and medical care – has been running at roughly 3% since 1995, significantly more than the 2.2% the BLS data yields – especially when you think about the compounding effect. In the 20 years since '95, that 0.8% differential has compounded to over 20%, which has to be deflated against incomes. When you look at the stagnant income growth of the middle class and then reduce that income by 20%, rather than by the official inflation rate, it is not hard to grasp why significant majorities in both political parties are pissed off (to employ a technical economics term). Quoting from Rob and Lillian's paper:
Since 1995, households have expected inflation to be, on average, 3.0%, whereas realized inflation has been around 2.2%, leaving an inflation "gap" of almost 0.8%. What explains this gap? The following is our hypothesis. The four "biggies" for the average American are rent, food, energy, and medical care, in approximately that order. These "four horsemen" have been galloping along at a faster rate than headline CPI. According to the BLS definition, they compose about 60% of the aggregate population's consumption basket, but for struggling middle-class Americans, it's closer to 80%. For the working poor, spending on these four categories can stretch to as much as 90% of total spending. Families have definitely been feeling the inflation gap, that difference between headline CPI and inflation in the prices of goods they most frequently consume.
This paper is one of the most powerful indictments of central bank policy that I have read in a long time (even if the authors didn't intend it to be that). It reinforces my contention that the models central banks create and the data they base those models on are inherently flawed. And those flaws are compounded because the banks' manipulation of interest rates (the price of money) is perversely doing the opposite of what they think it should do. This is going to cause more mischief and economic pain during the next recession than any of us are prepared for or can even imagine. Seriously, we're going to have to restructure our expectations and strategies for our portfolios to deal with what I think is developing into a policy error of biblical proportions.
And on that happy note I think I will just go ahead and let you read Rob and Lillian's essay without further comment (you can read it in detail HERE).
I had a long talk yesterday with my friend Murat Koprulu, emerging-market strategist type hedgie for Mariner Capital in New York. He is writing a book called The Gig Economy, based on his research into young people and their approach to working. He echoed some of the same themes that Rob's paper does: younger and middle-class workers are getting squeezed. More and more young people are working multiple part-time gigs and are developing a very different lifestyle than their parents or grandparents were accustomed to. That dream job they hoped to get when they went to college is there; it just doesn't pay enough to let them live in, say, New York City. And when they leave New York, the pay drops.
As I peer into our economic future, I don't see it getting significantly better in the next 10 years. Oh, there are things a government could do to begin to turn things around, but I don't see anybody in government willing to do those things. They keep trying to micromanage the economy and run people's lives, and then when things don't improve much, they think we need more of what didn't work. The magic blue-pill "fix" for middle-class growth is not going to be manufactured by government. The world, and especially the US, doesn't need lower rates and quantitative easing, it doesn't need another government program. What we need is productivity and income, and those come from the marketplace. There is a role for government, but it is to be the referee that ensures a fair game, the sheriff that makes sure that everybody plays nice in the sandbox, the regulator that is there to make sure that crony capitalism and insiders don't drive the creators out of business with unfair practices.
I will get off my soapbox and go back to my inbox. You have a great week. I get to have lunch with Peggy Noonan and listen to her speak tomorrow, which I'm greatly looking forward to. I'm sure she will help us ponder what in the wild, wild world of sports politics this coming presidential election contretemps going to look like, given the participants. Oh my, I will have a few more things to say about that in this weekend's letter.
Your wondering how I got this busy analyst,
John Mauldin, Editor
Outside the Box
The gist of the argument is that there are serious flaws in how the government measures inflation. And people know it as shown in consumer inflation expectations. As you can see in the chart, there has been a measurable and ongoing difference between the inflation people feel and the reported inflation rate, especially since the financial crisis. The blue line represents the inflation that people perceive and the orange line shows the inflation the government reports. There has been a persistent 1-5% differential.
If you under report inflation, you over report growth. Thus, many people "feel" squeezed on both sides. They aren't experiencing growth and they are losing ground to inflation. This is killing the middle class (as explained by John Mauldin's friends Rob and Lillian):
The middle class is getting squeezed from every direction and is sadly disappearing. In 2008, according to Pew Research Center, 53% of adults considered themselves middle class. A scant 6 years later in 2014, that number had dropped precipitously to 44%. At this rate of decline, in 30 years there'll be no middle class left! For the class warriors, don't worry, be happy – the self-identified upper class has shrunk from 21% to 15% in that same 6-year span, so they'll be gone in just 15 years!
The aspiring have found the combination of increased regulation, an uncertain economy and a lack of access to capital to be devastating to their dreams of building a better future:
But this particular swing of the pendulum is profoundly disturbing and is doing a lot of damage to what was once called "American exceptionalism."
New business start-ups suffer too. Individual investors hesitate to fulfill their dreams of beginning their own businesses – home to the majority of our economy's jobs – because they don't know the cost of capital. Near-zero interest rates aren't available to them, and the future cost of capital is unknown but presumed to be higher. The prospective regulatory regime three to five years hence is shrouded in mystery too. Corporations, like investors, are deeply wary about long-horizon investments with uncertain prospects. Why plow funds into long-term risky business ventures when low-risk (but, of course, high-priced) stock is available for buybacks and can be funded with near-zero-rate financing?
The endgame is that the economy stagnates and the middle class slowly slips underwater. Is this speculation or fact? January 2016 was one of only a few months since the Great Depression with no IPOs.
The wealthy are likewise being squeezed. They just don't know it yet:
Former Fed Chairman Ben Bernanke was quite candid in saying that zero interest rates and quantitative easing were intended to create a "wealth effect." He wanted asset values to rise so the affluent would spend more, so the economy could boom. He achieved the first of these: asset values rose. But who owns assets? The wealthy. What this "stimulated" is a growing gap between the haves and the have-nots: the wealthy got wealthier. That's redistribution, backwards. Then, in a towering act of hubris and hypocrisy, the central bankers collectively deny they played any role in widening the income and wealth disparity, or in hollowing out the middle class. Ouch. But although the rich began to spend more, the impact on the economy was limited. If the rich mostly buy more assets (i.e., stocks, bonds, real estate, art, collectible cars, rather than "new stuff" that needs to be manufactured), doesn't that just fuel more bubbles?
And let's not forget the downside of bull markets. The benefits to the rich of accommodative monetary policy are short lived. The values of the assets they own soar, but the forward-looking returns on those assets crater. (Notice how hard it is to find a liquid mainstream market that offers real after-tax returns much above zero these days.) Then, net of spending and charitable giving, their wealth dissipates assuredly and rapidly, recycled into the economy with no assistance needed from the Pikettys of the world. The wealth of the richest is fleeting, typically dissipated by the third generation (Arnott, Bernstein, and Wu, 2015)…..
The fears surrounding the global economy and the calls for negative interest rates highlight the uncertainty surrounding the near future. When central banks finally step away from overt market interventions, however, capital market valuations will presumably revert to the levels that would prevail in the absence of intervention. Does anyone think that will mean higher price levels? Didn't think so. Accommodative monetary conditions inflate asset prices into asset bubbles that sooner or later will seek their fair value. If the interventions are artificially propping up asset prices, the average investor is justifiably wary. If fair values are lower, the good news is that, after the one-off adjustment, forward-looking returns will once again be sensible.
Those already wealthy have been feeling pretty good (at least on a relative basis) as their holdings have seemed to increase in value. The problem is that much of the asset price increase is artificial and evidence suggests it could evaporate without Fed stimulus.
All of this adds to the Inflation/Deflation debate. Is there inflation? YES. But economic growth has been terrible despite a massive increase in Fed activity. The Fed is now discussing the possibility of negative interest rates. And, there are reasons to believe that inflation could seriously worsen as we will discuss in a future installment. But there are also serious deflationary forces at work (built on a house of debt) that will have their impact as well. We will discuss those as well as our "tug-of-war" debate continues. We will conclude the debate with a discussion of how enemies of the United States are watching all of this and looking for points to disrupt and damage. Stay tuned.