Friday, January 6, 2023

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year coming soon.]

It's Not the Stimulus

Today’s inflation is frequently attributed primarily to the nearly $4.9 trillion economic stimulus packages provided by the US federal government in 2020 and 2021. As the story goes, the government printed a bunch of money and handed it out to people, who then went and spent it on things they normally wouldn't have, causing the economy to experience "unnatural" aggregate demand, thereby causing inflation.

First, this money wasn't "printed" but rather "keystroked" into existence. While this may seem pedantic, it's important to emphasize because of the connotation people have with "money printing" and historical examples of hyperinflation.

Second, there's no evidence of higher-than-normal spending by American consumers. US household spending is largely in-line with pre-COVID trends:

Mainstream economics posits that increasing fiscal deficits (i.e. the US federal government spends more than it collects in taxes) is a root cause of inflation. And yet, they provide no explanation as to why inflation hit multi-decade highs in 2022 despite a shrinking budget deficit. In fact, total US tax receipts in 2022 were $4.9 trillion, equal to the total COVID-19 related fiscal stimulus packages from 2020 and 2021. Said differently, the US government recouped its entire two years' worth of COVID-19 stimulus in the fiscal year 2022. It ran a budget deficit, and the new dollars created from its spending will be returned in future periods via taxes, just like the stimulus dollars. Unfortunately, this reality is never reported by the mainstream news media. 

It's also worth noting the US has lower rates of inflation than other parts of the developed world, including the EU and the UK, despite its much more aggressive fiscal spending programs.

In order to understand today's inflation, we have to go back to the Global Financial Crisis and the austere policies our elected officials chose to embrace.

Yesterday's Austerity is Today's Inflation

Following the Global Financial Crisis, President Obama emphasized austerity as a policy prescription. He wrote that the government should "tighten its belt" in solidarity with small businesses and families. He also decried how the US was "borrowing" from China in order to pay its bills, and that its long-term debt and deficits were unsustainable. The austere policies resulting from these fundamental misunderstandings were devastating to the US economy, resulting in the slowest job recovery on record, as millions of Americans lost their homes and saw their businesses collapse.

The ripple effects of these policy choices are still being felt today. In order to survive, businesses needed to lay off employees. When people are unemployed, they not only become disenfranchised, they also miss out on critical skills development, training, and experience. A quick anecdote: I am having work done on my basement/mudroom at the moment, and was recently chatting with my general contractor. He noted how difficult it is to find reliable, skilled workers to execute jobs that are up to the quality standards that is to be expected from a licensed contractor. There simply aren't enough people available with the skills needed. While they have a healthy backlog of jobs (especially for this time of year), they are struggling to convert that backlog into actual sales because of the limits on skilled labor. He also mentioned how his father, who owns their business, basically had to lay everyone off following 2008, and their family-owned operation never reached the same employment levels it had been prior to the GFC. Part of this reflects the weak economic recovery; part of it is exemplary of the psychological scarring that remains to this day. Simply put, business owners who went through that experience are much, much more reluctant to hire additional workers for fear that they would have go through a similar experience.

He also noted how how this effect can be seen with their suppliers, many of whom have hired inexperienced workers over the last couple years. This has created frictions in how they work together. For example, they have to be much more careful about purchasing 2x4's, because the less-experienced workers not catch a 2x4 that is warped to the point where it can't be safely used for construction. Little pain points such as these add up, and contribute to the additional labor costs and supply constraints. Everything is more difficult to secure. This is a real resource problem, not a monetary one, and contributes to rising costs. It shouldn't come as a surprise to anyone who's brain hasn't been poisoned by mainstream and Austrian economics that unemployment is sub-optimal. It causes permanently lost productivity, raises real costs, and lowers our general standard of living. We are bearing the brunt of these policy mistakes today, in the form of elevated inflation, worsening quality of services (e.g. hotels not offering as frequent turndown services because they can't afford to hire enough workers), and general anger and resentment towards one another.

Moving Forward

So, we know what the causes of today's inflation are. What about solutions? A federal job guarantee is one - we would effectively anchor the value of the dollar to employment. This would be an improvement from our current paradigm, which intentionally keeps people unemployed in order to "support" the value of the dollar. What's strange about this arrangement, though, is that we don't guarantee employment, but we DO guarantee payments to people who either can't find work. This seems sub-optimal and exposes us to potential inflation, because the newly created dollars aren't necessarily leading to enhancing productivity. They end up being spent on some essential good or service, then sit in a company or rich person's bank account, who doesn't spend it back into the economy.

On a more local level, I think there are compelling options. We should devote a portion of public dollars and real resources towards apprenticeships and vocational training. Our country is long workers doing things on computers and short workers doing things with their hands, whether that be plumbers or dental hygienists. I spoke with my plumber recently, and he has palpable anxiety about retirement: his body can only handle so much, and his skills are in plumbing, not working on a computer. I propose we find similar people and offer them money for either full or part-time apprenticeships, to ensure we have workers with the necessary skills to perform labor that is needed, and also compensate people who have great skills that they're no longer able to leverage into consistent income. A skeptic may argue this is unnecessary "government meddling in affairs," but I would argue that the government (i.e. the public) has had its thumb on the scale of certain types of work at the expense of others. I was required to pass Type to Learn to graduate from my public elementary school, and to write a sophomore research paper to graduate my public high school. This ostensibly favors certain skill development over others: woodshop was an elective, not mandatory for graduation. 

We are also facing a childcare shortage, for myriad reasons. My best idea to help in this regard is to create a pool of seniors who are living off income from social security, but want to make a little extra money and love taking care of children. Grandparents love spending time with grandkids; for seniors who don't have grandkids to take care of, or who just love children, they would get incredible joy and happiness helping take care of young children, so that younger moms and dads can do more productive work.

We should start having these conversations with local political leaders so we can galvanize resources and put this terrible inflation to bed.

Sunday, November 13, 2022

Rate Hike Disinformation is Getting Out of Hand

Before diving in to today’s post, let me first acknowledge that, when I began this blog in early 2022, I was very much still at the beginning of my MMT journey. Early posts, including obsessing over forward rates curves as a recession signal, were not really relevant to MMT and reflected a lack of understanding on my part. A lot of this writing is stream of conscious, so some of what ends up on these pages isn’t entirely thought out (that is part of the reason I started the blog, to help clarify my thinking!).

I also want to humbly acknowledge that the long Treasuries call was wrong. Upon reflection, and especially after the time spent this Summer at the Levy Institute, I’ve realized that I still had some “loanable funds” theory that had to shaken out of me. I assumed that Treasuries traded based on some sort of market-driven supply/demand dynamic. I was thinking in a framework of fixed money supply, so as recession risks rose, I anticipated investors and institutions to pile into Treasuries. That’s not how it works. The Fed sets the short-term funding rate, and the forward curve gets priced based on where the market thinks the Fed will set the price in the future. The government is the monopolist; it sets the price. Predicting where rates will go is pure speculation, because the price is arbitrary. It’s a political decision, not one based on any economic fundamentals. It creates its own economic fundamentals. I believe this is part of the reason why Warren Mosler says we should eliminate Treasury issuance beyond the 3-month t-bill - anything further out on the curve induces unnecessary speculation.

In the fund I manage, I recently closed a small position in the iShares 20-year+ US Treasury ETF (NASDAQ: TLT).

UPDATE: the following was originally written a week earlier, when mega cap tech stocks were rolling over. Following the better-than-expected CPI results this past week, stock markets staged a massive rally.

Moving on…

With that out of the way, time for a small victory lap about the call earlier this year to avoid mega-cap tech such as Alphabet (NADSAQ: GOOG, GOOGL) and Meta Platforms (NASDAQ: META). Both stocks have underperformed the already abysmal performance of the NASDAQ this year. At the time of writing, the NASDAQ has returned -34%, while GOOGL has returned -40% and META a whopping -73% YTD.

With the stimulus gravy train coming to an end, and record tax collections causing a huge fiscal tightening, funding for start-ups dried up, along with their huge budgets for marketing rents paid to Google and Meta. Tim Cook’s decision to limit data-sharing on Apple’s iPhone added fuel to the fire. And Mark Zuckerberg, who was trained by Peter Thiel in tyrannical corporate management, has decided to light his company’s owner’s money on fire with an incredibly stupid new science fair project dubbed “The Metaverse.” What I think people don’t realize Zuck is that at the end of the day, he’s a weird, socially awkward computer nerd who would rather live in a virtual world where he calls the shots. His “value creation” is more akin to “value extraction” - stealing people’s attention for ad dollars. Facebook was successful because the government allowed it to corner the photo-sharing network market when it blessed the Instagram acquisition in 2012. By killing competition, Facebook was able to thrive. Whenever it tried to create something on its own - such as a digital currency, or a dating function - it flopped. Big time. We wrote about this earlier this year, and warned people about the time bomb sitting in their portfolios. Unfortunately, we don’t have the reach so we couldn’t make our case to the masses.

By the way - it’s entirely plausible that META and GOOGL are good buys here, at least in terms of forward economic returns. That doesn’t mean we can’t celebrate getting the call right at the beginning of the year ;).

Finally, a note on rate hike disinformation. This past week, the Fed’s GDPNow indicator showed yet another uptick in growth for the fourth quarter, currently running at 4%:

Why such a huge discrepancy between “Blue Chip consensus” and the Fed’s GDPNow? I believe it is due to misinformation about rate hikes. Rate hikes are widely accepted to represent a form of monetary “tightening.” This is a complete mischaracterization, as we’ve written about before. The government pays interest on debt, INCLUDING interest on the Fed’s reserve liabilities, by crediting bank accounts. This increases reserve balances, and expands the federal deficit. Increasing federal deficits means increasing income for the non-government sector. It is ostensibly expansionary, despite being referred to as “tightening.” Not only that, but due to the effect of compounding interest, each incremental dollar added to reserve balances itself creates more dollars because the government pays interest on reserves. It wouldn’t surprise me to see interest paid on by the government to approach $1 trillion by 2024 at this rate, which would represent about 4-5% of GDP. That is a LOT of free money going to people who already have it. Don’t expect a slowdown in luxury sales anytime soon.

Understandably, people are freaked out by the rapid rise in rates in terms of financing costs for things like auto loans and mortgages. Two things need to happen in order to make houses and cars more affordable in the short-term: prices come down (or at least stop going up), and people get raises. With unemployment at 3.7%, workers should be able to demand big raises at the end of this year. This is particularly true in industries with tight labor markets, such as real industry like mining, quarrying and oil & gas extraction:

Currently sitting at 0.9%! Workers in these industries need cars, and will have substantial bargaining power to increase wages. Higher incomes will be able to support higher cost of financing for vehicles. And domestic auto production is still below pre-COVID levels; as the chips shortage eases, I expect production to ramp to get back to historical averages, enabling dealers to build their inventories back up. The flood of supply should bring used car prices down, further easing the auto inflation experienced over the last couple years. So, higher incomes for workers + production ramp could lead to an auto credit boom in 2023/2024. I’m keeping a close eye on this, and have several names in my portfolio that I believe stand to benefit, including Cleveland Cliffs (NYSE: CLF), Ally Financial (NYSE: ALLY), and Open Lending Corp (NASDAQ: LPRO).

While recent layoffs in the tech sector grabs a lot of headlines, as pointed out in the FT’s Lex column (  the people fired from these tech companies are likely to take their software engineering talents to other major corporations who need to beef up their technology departments. A redistribution of talent, if you will.

Getting back to the point though, the Fed raised rates which is making the cost of financing homes and vehicles to go higher. Workers have to demand higher wages in order to be able to afford purchases of those items. So the Fed is fueling the inflation it claims to be fighting! It is raising the term structure of prices, and providing the income to support higher prices.

Monday, October 17, 2022

A Thought Experiment

Finance 101 introduces the concept of the "time value of money." The idea is that there is an opportunity cost in having money today vs. an uncertain future, and a premium should be placed on having spendable money today vs. the future ("a bird in the hand is worth more than two in the bush"). The cash in your pocket pays no interest, and the money in your checking account pays little to no interest relative to where the current Federal Funds Rate is.

When evaluating financial assets, analysts look at the projected cash flows of the asset and "discounts" them to the present using a rate. This is referred to as a "discount rate," and reflects the opportunity cost of having cash today vs. in the future, the term premium demanded by investors, and the certainty those cash flows are secure.

A discount rate is exactly as it sounds - the higher it is, the bigger the discount to a buyer of that asset, similar to discounts offered by retailers selling goods. Larger discounts are a benefit to the buyer, at the cost of the seller. This concept can be observed when considering the market price of interest-bearing, zero-coupon securities: they trade at a discount to par value.

Any purchase of a financial asset involves a security interest or claim on a future pile of cash. In the case of equities, the size of that pile is highly variable, depending on the performance of the economy as well as idiosyncratic factors related to the underlying operational performance of the business and its capitalization structure. Fixed income securities by contrast are (as the name would suggest) fixed - you have a contractual claim on a future pile of cash which is nominally fixed in size.

When someone buys a US Treasury bill, note, or bond, they are purchasing a fixed-size pile of future cash. The rate paid by the government to the holder of the security is functionally the instrument's discount rate, and is used to come up with the "fair value" of the security. The discount rate is the price paid by the government to the UST holder for deferring spending power to the future. When the Fed raises rates, the Treasury offers a higher discount rate for its debt securities. Said differently, the government is offering bigger discounts to UST buyers. And yet, despite this truism, we refer to bigger discounts to buyers as "tightening."

The real tightening occurred when the interest rate was lowered. This represents the government forcing UST buyers to pay a premium in the form of accepting a lower discount rate. Forcing institutions and people to pay a premium for financial assets they want or have to purchase is a form of financial tightening, just like paying higher prices at the gas pump is a form of tightening.

When credit spreads go lower (i.e. the difference between yields on corporate bonds vs. UST securities goes down), financial professionals and the media refer to this as "tightening." And yet, when yields paid on UST securities go down, approaching the 0% rate for cash, the same people refer to it as "loose." This inconsistency makes zero sense.

Someone who purchased US 2-yr T-bills a year ago at a 0.5% rate will receive 100c on the dollar of their principal + 0.5% interest, compounded annually, at the security's maturity date. This will happen regardless of where rates go in the interim. The nominal size of the cash pile owed to the buyer is fixed. They will receive the pre-agreed upon contracted amount of dollars.

However, that piece of paper today trades at around 96c on the dollar. That 4c mark-to-market loss is what makes people think that the Fed is "tightening" credit. But that 4c hasn't been canceled or lost: if the holder sells at a 4c loss, that same 4c accrues to buyer as the security's maturity date approaches. It isn't lost so much as it is transferred from seller to buyer in a zero-sum fashion. Said differently, the net change in "money supply" is zero.

The Fed hasn't lowered the money supply or credit by raising rates. It's actually the opposite: the mark-to-market loss on the T-bill is a reflection of the Fed's policy to expand the money supply through the interest income channel, and therefore effectuates a decline in the relative value of that security. The holder of the T-bill will receive the same nominal amount if rates are at 0.5% or 4%. The reason its cheaper today is that the government is offering larger discounts for the same future cash piles.

This should be the very definition of inflation. In fact, economists in the 19th century used to use the term "depreciation" instead of inflation in reference to a general, sustained rise in prices/reduction in a currency's purchasing power. When the Fed raises interest rates, it is ostensibly depreciating the current value of future cash piles. Why we don't refer to this as "loosening" or inflationary is truly bizarre.

The implications for this are enormous. Purchasers of both equities and fixed income securities today are getting a bargain relative to a year ago. And in the case of equities, the government is promising to increase the nominal amount of dollars it will spend into the economy via the interest income channel, thus expanding the pool of potential dollars the business can accumulate through its operations. This is perhaps the best buying opportunity of my career. I have been increasing equities exposure lately, with a particular focus on pro-cyclical stocks that will be direct and indirect beneficiaries of recent policies enacted by the federal government, including the Inflation Reduction Act and student loan forgiveness.

Another way to think about this is what Warren Mosler calls the "term structure of prices." Higher discount rates for future cash piles are incorporated into market prices for real economic activity. A gold producer who sells on the spot market chooses to deliver gold in exchange for cash at the current price. If they decide to instead enter into a forward contract to deliver the gold in exchange for cash a year from today, the agreed upon price has to reflect the level of interest rates. If the producer can sell the same amount of gold for the same price on the spot market (i.e. today) and the forward market (i.e. a year from now), and 1yr UST bills were paying 5%, then the producer could sell it on the spot market, pocket the cash, and invest that cash to generate a free 5% return. The buyer therefore has to discount the price offered for delivery in one year vs. delivery today to reflect this reality and not hand a free lunch to the seller. Plus, there are storage costs associated with holding gold for a year, and the 5% discount rate will be baked into funding costs for that storage. The discount that the seller/producer must pay for delivery a year from now vs. delivery today reflects a discount in purchasing power of future dollars, which should be what we call inflation.

Friday, October 14, 2022

Rate Hikes Are Loose, Not Tight, Monetary Policy

Public (and private) discourse about inflation and rates is truly bizarre. Consider the following scenarios:

Scenario A:

Savings account beginning balance = $10,000

Savings account ending balance = $10,000

No contributions or withdrawals over the period

Time lapse = 1 year

Scenario B:

Savings account beginning balance = $10,000

Savings account ending balance = $10,300

No contributions or withdrawals over the period

Time lapse = 1 year

The only difference between Scenarios A and B is the ending balance, for which B is $300 more than A. It is self evident that Scenario B is more expansionary than scenario A - there are literally more dollars at the end of a year in Scenario B, whereas Scenario A's balance is flat. And yet, according to the economists at the Fed, the media, Wall Street, elected officials, most of academia, and basically everyone with an "informed" opinion on the subject, Scenario B is considered a form of monetary tightening. The finance and economics professions are some of the highest paid industries in the country, and generally employ our nation's "best and brightest" or "Masters of the Universe." And yet despite this incredible brain trust, people continue to accept the axiom that rate hikes = monetary tightening, generally without thinking twice about it. The Fed has never released any research supporting the assertion that rate hikes "tighten" credit, limiting the availability of credit and subsequently tightening the money supply. Over the past year, the Federal Funds Rate (i.e. the rate that banks lend reserves to each other overnight) has gone from nearly 0% to around 2.5%:

This has resulted in the 10-year US Treasury, the risk-free rate for which all securities are priced off of, to rise from around 1.5% a year ago to nearly 4% today:

And yet, despite this "tightening," credit growth has remained strong:

And the employment to population ratio has ticked higher:

With US debt to GDP at around 120%, the impact of rate hikes on US federal spending is amplified. Total interest paid on Treasury debt is up nearly 30% year-on-year:

This increase in federal spending is a form of fiscal stimulus for people with savings. Similar to the checks sent out to Americans in 2020 and 2021, this increase in government spending stimulates aggregate demand (albeit to a wealthier cohort than the COVID stimulus programs).

And yet, the vast majority of the population calls this "tightening."

While we have been fairly negative in our outlook for the economy, it appears these rate hikes are having the unintended effect of stimulating aggregate demand, keeping us out of recession. In addition, federal programs such as the CHIPS Act, the Inflation Reduction Act, and President Biden's executive order to cancel a portion of student loans are further sources of stimulus that are coming down the pike. The student loan cancellation is especially important: Penn Wharton has modeled the program will "cost" over $500 billion in 2022 (in reality, it's not a cost but rather savings for households who qualify). Functionally, this is a tax cut: it reduces households' payment obligations to the federal government. And it is progressive, as it targets lower-income households. This is a very positive development for the US economy, as it creates capacity for these households to borrow and spend money on things like a house, a car, or other productive goods.

I'm not ready to go all-in on US avoiding a recession, but these developments are noteworthy and the Atlanta Fed GDPNow predictor indicates 2.9% growth for the third quarter:

Remember: savings don't drive investment, it's the other way around - investment creates savings. When consumers and businesses borrow and spend, that spending creates income. Rate hikes ostensibly are a form of increased government spending, which increases income for those with savings. Recall the scenario comparison above: in Scenario A, rates were at 0% and there was no change in the savings balance over the course of a year. In Scenario B, the interest rate was 3% which resulted in a higher savings balance at the end of the year. People make economic decisions based on real supply/demand factors. If a family decides it needs to buy a house to accommodate the birth of a child, they will pay the rate that's offered - assuming they can afford it. Whether they can or can't is a matter of a host of other economic factors. Rate hikes impact the distribution of income - people with savings get paid more at the expense of people who are net borrowers. That can have very negative economic effects. But to call that "tightening" is a stretch.

Saturday, August 6, 2022

Inflation, Markets, and Macro

Two straight quarters of neg GDP (we predicted coming recession)…

At the beginning of this year, we predicted a recession and risk-off period in markets based on the extreme fiscal tightening by the US federal government. While in the US the NBER is the ultimate authority on when recessions start and end, the “rule of thumb” is that two consecutive quarters of negative GDP indicate recession. Some even refer to this as a “technical recession.” While the NBER may very well not categorize the last two quarters as a recession, the fact that we are even having this debate shows the incredible predictive power of the MMT macroeconomic framework: literally no one in the mainstream press or Wall St was predicting recession at the beginning of this year.

Hot jobs report…

That being said, yesterday’s jobs report was undeniably, unmistakably strong, as total non-farm payrolls rose by 528k and unemployment fell to 3.5%, officially matching the pre-COVID era low  (although the labor force participation rate ticked lower to 62.1% in July from 62.2% in June).

We are not in a recession yet, but will likely be in the coming months/quarters.

Inflation rolling over…

We’ve experienced relief on the inflation front recently, following the red-hot 9.1% CPI increase in June. Commodities have largely rolled over, and crude oil finished below $90/barrel for the first time since February:


5yr/5yr breakevens have come down substantially:

This is not a surprise, because this period was not a “real” inflation. There are essentially two types of inflation: a “real” inflation is when our economy is at true full employment, and additional spending/money creation does not yield enhancements in productivity. We are far from that state of affairs (more on that topic below). The second type of inflation is one related to bottlenecks: we may not be at full employment, but supply side constraints, hoarding, and other bottlenecks are causing prices of goods and services to go up. Once those bottlenecks clear, prices will come down. There is no “secular” change in inflation expectations as many are arguing, and the market largely agrees based on breakevens and an inverted yield curve (which we predicted would happen).

I don’t have data to support, but I suspect there is some merit to the argument that financial markets stress (both in traditional stocks and bonds as well as a frauds like cryptos and NFTs) is forcing people who thought they could make a living off day-trading back into the job market. If true, then this is more of a one-off jobs boost.

Why is consumer sentiment so bad? Taxes remove dollars out of circulation causes fiscal tightening, rate increases force companies to raise prices without expanding output…

Consumer sentiment surveys are at or near historic lows:

Why is it so bad, despite the favorable jobs backdrop? Because consumers are being squeezed: on the one hand, fiscal tightening has caused money to be tight, forcing consumers to go into debt to meet their obligations. Revolving consumer credit balances (e.g. credit card debt) have exploded as of late, after falling substantially during COVID recovery period. This is entirely consistent with the framework of MMT, as federal surpluses are creating household deficits.

Meanwhile, there is no evidence of a “wage price spiral,” as real wages are negative year-on-year. The explanation for this is simple: the Fed’s rate hikes are causing companies to raise prices without expanding output. Think about it: if a large corporation issues commercial paper to meet its short-term funding obligations, and the cost of that debt has gone up thanks to the Fed’s rate hikes, then those companies must raise prices to maintain their margins. Fed rate hikes cause prices to go higher.

Big relief rally in July…

Stocks returned +9%, while HY spreads came in:

YC inversion trade worked…

Our yield curve inversion trade idea has worked:

TLT has outperformed SHY since we posted our idea on May 18, although the spread compressed a fair amount yesterday following the strong jobs report (note, the below shows price comparisons, and doesn’t include dividends reinvested, which would put TLT even further ahead of SHY).

Prediction: crude oil prices to go higher…

Making a call here that oil prices are set to go higher. OPEC recently announced they are raising production. While most people think the increased supply should be negative for oil prices, I believe the opposite: if the Saudis are increasing production, they are doing so to meet higher demand. The Saudis are quasi-monopolists, as the are the swing producer of oil. When non-Saudi producers are at full capacity, refiners are forced to place orders with the Saudis, who can name their price. The only reason for the Saudis to agree to increase production is in reaction to increased demand. Barrels of oil are “made to order” instead of “made to stock,” because there are physical limits to oil storage; if they can’t find a place to store the oil, the price for that barrel collapses, which is what happened when crude prices went negative in April 2020. This is why, despite announcements they will increase supply, the Saudis simultaneously announced record high price hikes set for September.

I also view the White House’s recent proposal that the US Department of Energy create a market for fixed-price forward purchase contracts of crude oil as extremely positive for domestic oil producers. The White House’s stated goal is to flatten curve for spot oil futures. By promising to purchase crude in the future to replenish the Strategic Petroleum Reserve, the US Federal Government is enticing domestic producers to increase production, and locking in prices to do so at levels that enable more sustained, consistent profitability. The E&P’s I like are Occidental Petroleum (OXY) and Civitas Resources (CIVI).

I recognize that many people, particularly those of the MMT persuasion, are generally against fossil fuels and loath investment in the industry. I have mixed feelings on this topic. While I believe transitioning away from fossil fuels is essential for human survival in the future, I also recognize that they are essential for the survival of civilization today. I think the move by the WH creates more sustainable and predictable cash flows for E&P’s.

Thursday, June 30, 2022

Levy Economics Institute MMT Seminar Post-Mortem (Part II)

Last week, I wrote part I of a post-mortem from a fantastic MMT seminar at the Levy Institute earlier this month. There is a TON of material to cover, so I am sharing what I consider to be the most important takeaways. Last week I wrote about the Fed; below are notes on inflation. Without further ado:


Inflation has been all over the news for the past 6-9 months, and the public's discourse around it has intensified. Inflation is an incredibly emotional/moral/political topic, which I suspect is because it effectively serves as a tax on rich and powerful people. As we have written about in the past, modest inflation and low rates helps low-income people who are net debtors: they generally experience higher incomes while their debt obligations remain fixed. Rising rates and unemployment are devastating for this cohort, which is why it is so shameful that people in positions of power and privilege are demanding the Fed to hasten its rate hikes in order to put people out of work. It's astonishingly cruel and out of touch with the American people to be spewing this rhetoric. I will never understand how intentionally putting people out of work can possibly give us a collective better quality of life in real terms. But that is a discussion for another day.

Anyway, the most important fundamental takeaway from our roundtable on inflation came from Randy Wray, who put it concisely, "money is a stock; spending is a flow." This is critically important. Most of us think of inflation as a general rise in prices due to an increase in the supply of money (i.e. all things being equal, increasing the supply of money makes it less valuable and depreciates its purchasing power). However, Wray's point is an important distinction. Prices going up (or down) reflect transactions. Transactions reflect spending, where money flows from one party to another. We use transacted prices (and some imputed ones, based on surveys) in order to come up with a reasonable guess of the rate of inflation (e.g. CPI, PCE). So using concepts like the "money supply" (as most mainstream economists and analysts do) is nonsensical for the purposes of predicting and analyzing inflation. The water in a bathtub does not magically become "faster" when one has increased its supply; however once the drain pipe is pulled, the increased mass would cause the flow rate of the water moving through the drain pipe faster. Gravity forces the water through the drain pipe, and the additional force from the added water mass causes it to move through the pipe faster. Arguing that increasing the stock of money causes inflation is like arguing that increasing the quantity of water in a tub makes it faster. It's a ridiculous assertion, because if the drain hasn't been pulled, then the velocity of that water is still zero, just as it was before!

Two additional points on the money supply myth. First, the panel confirmed my proposal that, to the extent there may be periods when both inflation and increases in the money supply are high (which is questionable at best), analysts and economists have the cause and effect backwards: increasing the supply of money doesn't by itself make prices go up, but an increase in the real costs of goods and services may be the cause, rather than the effect, of new money creation. The example I used is if a retailer normally buys a product from a wholesaler with a four-week lead time, and supply chain disruptions suddenly causes that same product to have a four-month lead time, then the retailer can't realize a sale of the product until it is actually delivered, and will need additional credit to make up for the shortfall in cash flows it would normally generate. The real shortage of that product, combined with the additional money/credit required to finance it may be reflected in a higher price.

This example provides a bridge to the second point, which is that the demand for money is equal to the supply. Because modern money is simultaneously one party's asset and another's liability, the demand for money must equal supply. There must be a party willing to have a money deficit in order for another to have a money surplus. This is why the "increased money supply causes inflation" trope is so ridiculous. Increasing the money supply requires a party to simultaneously be in deficit, so the aggregate change in financial assets and liabilities is zero! What matters is how that money is spent. Looking at things like M2 as a measure of the money supply is misleading, because it assumes money exists on its own. The Fed defines M2 as:

 "A measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds."

It ignores the fact that currency and coins held by the non-bank public, checkable deposits, travelers' checks, savings deposits, small time deposits, and shares in retail MMMFs are assets for their owners but liabilities for their issuers! It's this dual-entry accounting, "two sides of the same coin" reality that most people fail to understand. Increasing one person's supply of money requires an increase in someone else's deficit. So unless the government, as the monopoly supplier of money, is willing to run a deficit, then the only way for a person to have a surplus of money is for someone else to be willing to take on debt. Therefore, treating money as if it were a fixed, scarce commodity that follows simple supply/demand curves is incorrect. Money supply is equal to demand.

Some may argue that the American Rescue Plan may not have caused inflation but it increased the "potential" for inflation. Going back to our bathtub water analogy, the money printing is akin to doubling the supply of water, causing an increase in potential energy that, once the drain was pulled, created conditions for higher kinetic energy output. The problem with this argument is that the US federal government already has an unlimited amount of money it can create. Thus, there is already infinite "potential" monetary energy in our modern money system. Actually converting that potential energy into kinetic energy requires a political process. If the votes are there, the checks will clear. If the new money is used productively, we all experience a raise in living standard. If not, we don't.

Turning to MMT's view of inflation: MMT makes a distinction between true inflation (i.e. fiscal spending beyond real capacity) and bottleneck or supply-side inflation. The current bout of inflation is very clearly the latter. There is ample evidence that we are nowhere near our full productive capacity, the current inflation is supply/bottleneck-driven, and that it's real resources that matter. As Keynes wrote in How to Pay for the War, by thinking about real resources, the government can increase its spending by a large degree without causing excessive inflation. See selected slides below:

Source: Y. Nersisyan (Levy Economics Institute)

The last slide is illustrative here: between 1942 and 1944, federal government spending as a % of GDP went from 30% to 45%, while the rate of inflation collapsed from 11% to 2%. By executing a successful "war bonds" program, the US government was able to convince consumers to tighten their belts and hold off on spending until after the war. If it hadn't, and consumers kept regular spending patterns on goods, inflation would have exploded, because the supply of consumer goods was limited thanks to the government requiring producers to shift from goods to supporting the war. Indeed, I visited the Sagamore Rye distillery in Baltimore, MD a few years ago and they explained how rye distilleries were common in the area pre-WWII, but they were all forced by the government to switch to producing ethanol to help fuel aircrafts for the war. By encouraging thrift, the US government was able to free up real resources  that helped it win the war, and the savings that Americans had accumulated were spent after the war was over, leading to an economic boom. This was a far better outcome than prior instances, such as post-WWI, when an inflationary war period was followed by a huge bust as people's savings were depleted.

To further drive the point home that increased money supply does not cause inflation, consider the following, which compares the year-on-year change in M2 (blue) with the year-on-year change in CPI (red):

The change in M2 appears to be inversely correlated with the change in inflation, which runs completely contrary to the neoliberal/monetarist view. Even Fed Chair Powell admitted recently that an increase in M2 has little correlation with inflation.

Looking at the latest CPI data, it becomes overwhelmingly clear that the cause of the recent inflation is predominantly supply-driven. Most of the inflation is directly related to higher energy prices, which feed directly into food prices:

Source: M. Nikiforos, Levy Economics Institute

Energy prices are high for a variety of reasons, including declining production in the US, which is still below pre-COVID levels:

And two substantial oil refineries have been closed since December 2020:

Which has led to crack spreads (i.e. what oil refineries charge for refined product vs. the price of crude) at all-time highs:

Meanwhile, the Saudis (who are a quasi-monopolist as they are the swing producer for oil) continue to raise their prices.

The other big items are shelter and things related to transportation: new and used vehicles as well as transportation services, which have been supply-constrained thanks to a chip shortage.

Importantly, the inflation is NOT driven by higher wages, as real wages have on average declined year-on-year, so the idea of a wage-price spiral is taking place is total nonsense:

Source: M. Nikiforos, Levy Economics Institute

Meanwhile, the 10-year breakeven rate for inflation is around 2.3%, and trending lower:

Finally, Randy Wray recommended an inflation measure I had not heard of before: the Trimmed Mean PCE Inflation Rate, published by the Dallas Fed. The definition of this measure is as follows:

The Trimmed Mean PCE inflation rate produced by the Federal Reserve Bank of Dallas is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). The data series is calculated by the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are thrown out or trimmed. The inflation rate is then calculated as a weighted average of the remaining components. The trimmed mean inflation rate is a proxy for true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.

The result is a smoothed measure of inflation that is arguably a better measure of the change in the "general price level." The latest reading for this measure is roughly 3.5% - high for recent history, but by no means extraordinary relative to the 1970s and 1980s:

As we can see, too, this is arguably a more useful measure than PCE and CPI, which are much more volatile:

Bottom line: this is a supply/bottleneck driven inflation that will prove to be a temporary setback. Unfortunately, the Federal Reserve is buckling under the political pressure to "do something" about inflation, and is hiking rates as the economy slows down. This is likely to exacerbate the slowdown and cause a recession, and unless Congress passes a new spending package, we are risk of a financial crisis. More on that in Part III.

UPDATE 7/5/22

I wanted to include this on the original post but couldn't find a source for it. Federal Reserve Chairman Jerome Powell spoke recently at the European Central Forum and said the following:

"I think we now understand better how little we understand about inflation"

This is an absolutely remarkable admission. The Fed employs over 400 Ph.D. economists, and yet here is the person in charge acknowledging that they don't even understand one of the most important topics in economics! The problem here is that these Ph.D. economists have all been taught a fraudulent form of economics, known in the MMT community as "neoclassical," "neoliberal," or "market fundamentalism" which became the standard in US universities in the 1970s thanks in large part to the influential University of Chicago economics department. They use Dynamic Stochastic General Equilibrium (DSGE) econometric modelling to make forecasts that ostensibly have a terrible track record. As one young Ph.D. economist explained to me during the week at Levy, and I am paraphrasing here, but basically these models "work very well 95% of the time...but the 5% of the time they don't work, they blow up spectacularly." I don't think it is a stretch to say that sounds like a terrible framework to use for an institution that is supposedly in charge of overseeing the economy.

A recent paper released by Jeremy Rudd of the Richmond Fed found the following (emphasis added):

"Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors."

This highlights how broken the economics institutions in this country are. The Neoclassicals are the gatekeepers to power, prestige, and influence in the economics field, and some insiders are starting to realize their profession is profoundly uncritical and lacking in analytical or empirical rigor. Debunking their ridiculous myths, and offering better, more coherent, more accurate economic models and frameworks is critical for the future prosperity of the people in this great nation. Jay Powell is admitting the quiet part out loud, acknowledging that they don't know what they're doing. This is an opportunity for the MMT community to step up and right the ship!

Thursday, June 23, 2022

Levy Economics Institute MMT Seminar Post-Mortem (Part I)

Last week, I travelled up to Annandale-on-Hudson, NY to visit the Mecca of MMT: the Levy Economics Institute at Bard College. Indeed, the term Modern Monetary Theory was coined there when Warren Mosler first visited Randy Wray and crew in 1997.

The program ran Saturday-to-Saturday, each day with lectures beginning at 9am and ending at 6pm (we had one afternoon off to visit FDR’s home). One attendant calculated we had 41 lectures from 32 speakers. Needless to say, it was one of the most intense, and enjoyable, academic experiences of my life. I kept describing it as a “firehose” of information to the other attendees and they seemed to agree.

The official agenda was “Minsky, Godley, and Modern Money Theory” but the topics covered a broad range, including the history of money (with a focus on US colonies), the Job Guarantee, FinTech, strategies for developing nations, and current outlook/projections for the next few years. In preview, things are not looking particularly rosy for the US economy. Needless to say, there is a LOT to cover, and I won’t be able to fit it all in one post. Plus, I want to keep this relevant for financial markets. Without further ado, let’s dive in:

The Fed

A core tenet of MMT is that the Fed sets the price for money; it doesn’t affect the actual supply. Money is created and destroyed by commercial banks and/or the federal government. The Fed sits between the two, acting as an agent of the federal government and ensuring payments clear. It also conducts monetary policy (i.e. setting interest rates) through its open market operations. But it does NOT affect the aggregate stock of money in the economy. It can impact the composition of bank balance sheets by adding or removing reserves, but doing so necessarily involves swapping those reserves with US Treasury securities. As we have argued in the past, Treasuries are not loans made to the US federal government. Rather, they function as a “reserve drain” for banks. Banks tend to play “hot potato” with reserves because they offer meager yields and occupy space on their balance sheets, so they are incentivized to hold as few as possible. They purchase US Treasury securities with excess reserves in order to maximize their profitability. As an aside - I recently asked Warren Mosler on Twitter whether the Fed’s RRP (which has attracted much attention in the press and recently surpassed $2T) whether that program was functionally the same as US Treasuries, in that they served as a reserve drain, which he agreed.

Another important point about the Fed is that it’s power is limited. It can raise or lower interest rates, but these are blunt, ineffective tools for achieving its goals, which include maximum employment and price stability. There is a perception that the Fed is in the “driver’s seat” for the US economy, but we have seen repeatedly over the decades since WWII that that is a farce.

For example, consider the Global Financial Crisis of 2007-2008. A few days after the failure of Lehman Brothers (September 15, 2008), Fed Chair Ben Bernanke realized that credit markets were freezing up, meaning banks were at risk of failing. Capitalism and the entire economy was at risk of disappearing. Recognizing the gravity of the situation, he urged US Treasury Secretary Hank Paulson to lobby Congress to pass a $700 billion spending bill so the Fed could purchase toxic mortgage assets. Think about that for a moment - the Fed needed money. It needed Congress to pass a bill because only Congress has the legal authority to create new money. After the Emergency Economic Stabilization Act of 2008 failed to pass, financial markets were in full meltdown mode, with the DJIA recording its largest ever daily point decline.  The panic forced Congress’ hand and they eventually passed the bill. While financial markets continued to sell off, the country momentarily avoided a complete extinguishment of the financial system. It’s worth noting that Warren Buffett’s famous “Buy American” Op-Ed came after Congress approved this bill. Clearly, he understands that it’s Congress, NOT the Fed, who has the power of the purse in the US. In February 2009, President Obama signed the American Recovery and Reinvestment act, which authorized nearly $800 billion economic stimulus package. The stock market would eventually bottom out a few weeks later in March before an incredible 12-year bull run.

This episode is illustrative, because the Fed clearly lacked the power and/or legal authority to authorize new money creation to save the financial system from a complete meltdown. Only Congress has that power. And it also shows the impact that spending from the US federal government has on financial markets. People on Wall St love to talk about how the Fed “injects liquidity,” but the reality is that Congress is the only entity that can actually add new dollars into the economy. And financial flows into and out of the US Treasury impacts financial markets - when the Treasury spends, it adds to the net financial assets of the economy, and likewise removes them when it collects taxes. This dynamic played out again in the COVID crisis of 2020 - financial markets bottomed out following Congress’ passing of the CARES Act in March 2020, and financial markets continued to roar all through the end of 2021. Many of the programs passed in that period were not renewed in 2022, and the progressive nature of our tax policies has meant that spending by the US federal government has dropped by over $1T year-on-year so far in 2022, financial markets have been in a tailspin all year. The takeaway for investors is that fiscal flows can at times be used for opportunistic buying (and selling) of financial assets.

That’s not to say that Fed policy is completely irrelevant. Raising and lowering interest rates do have impacts on financial markets and the economy; raising rates makes it more expensive for people who need to borrow money to subsist, raises the cost of capital for companies to expand production, and stimulates demand through the income channel. It is also argued by some MMTers that it raises the general price level, as it raises the term structure of the rates curve. I am also of the belief that raising rates when margin levels in the stock market is high forces leveraged traders (i.e. HFs) to de-gross their portfolios. And it makes it more expensive to take out a mortgage or an auto loan. It is a blunt tool that is intended to slow credit growth and therefore demand, although they ignore the impact that slowing growth has on the supply-side of the economy. One thing that was pointed out last week was Keynes’ idea that money demand = money supply; money is created when it gets voted into existence by Congress or when a bank makes a new loan, so there has to be both supply and demand for the “creditworthiness” of what that money is going to be used for.

One final point on this topic is that the Fed is supposed to be counter-cyclical, i.e. raising rates when the economy heats up and lowering them to stimulate when things slow. However, history has shown that for whatever reason, be it flawed economic models or institutional/political structure, they have proven to be pro-cyclical: lowering rates when the economy heats up and raising them into a slowdown. The Fed recently announced a surprise 75bp rate hike, and Chairman Powell anticipates more in the near future. If history is any guide, that is a bad sign for the US economy (more on that later).

To be continued...

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...