Simple monetary arithmetic - P-star suggests higher inflation

Few money managers are monetarists. Many lost money and in some cases their jobs for believing that the expansive QE of the post-GFC period would lead to higher inflation. Follow money at your own risk, but some analysts say this time is different given the magnitude of money growth and the large decline in money velocity. See, for example, Lars Christensen "The Market Monetarist" blog and his simple use of the P-star model. 

P-star is a simple toy model. Take the classic quantity theory of money equation, MV=PT and include money growth, long-term trend in velocity, and long-term NGDP growth to solve for inflation potential. P-star = M(V*)/NGDP*. 

P-star is the price inflation that would exist given current money growth and if velocity and GDP were at their long-term trend. It is then easy to compute the gap between P-star and P. This gap would be the expected inflation given trend velocity and GDP versus actual inflation. This inflation gap can be closed a number of ways; however, if money growth stays high and velocity and growth normalize to trend, the only solution is an increase in actual inflation.  

There will be a delay effect between a money shock and economic trend, but the logic is straightforward. If excess money balances are drawn down, velocity which has been excessive low will increase and move back to long-term trend velocity. GDP may rise above trend, but if it reaches potential GDP, prices will have to rise. If GDP growth is constrained by its potential, then higher money will need to be held as higher balances which will lower velocity or prices will have to rise to equilibrate our classic equation. 

There are a number of simplifying assumptions with this toy model, but it provides a point of departure for discussion using a simple monetary framework. If growth is below potential, there is less likelihood that prices will rise. If money balances are high (velocity is low), there is less inflation, but if balances are reduced and spent, prices will rise especially if GDP is constrained. Output gaps which are closed will also close inflation gaps. 

Of course, this does not account for leakages into the financial system which have been high and have served as an alternative to purchases of goods and services. Money balances may decline not to buy good but to purchase financial assets. The financial leakages have driven financial prices not real assets. It is assumed that as the economy normalizes, financial leakages will switch to real purchases.   

Working with this simple equation leads to the uncomfortable conclusion that inflation may rise significantly in the next year as economic growth returns to potential and velocity normalizes. This inflation will only be transitory to the extent that money growth slows going forward. This is not a prediction but a point of departure with the classic monetary identity. 

Investors forming bets around transitory inflation arguments

There is heightened discussions on inflation especially with the higher than expected April CPI print, but the real focus is on the issue of transitory inflation. The Fed has fostered this discussion with their argument that there is no need for any preemptive early action even if there is an inflation spike because it will not last. Any inflation fears today should be tempered. This is consistent with market consensus inflation forecasts and inflation breakeven term structures. Overall inflation expectations are higher, but the inflation term structure is inverted. In a year to eighteen months inflation should decline albeit be slightly above 2 percent. 

We have listed a set of arguments for transitory inflation in the table below. Many of the transitory inflation arguments make sense and have good foundations. For example, supply chain bottlenecks can lead to higher prices now which should be offset over time. Some labor shortages will be eliminated as pandemic rules are further relaxed. Base effects and inflation dispersion will be moderated over time as we return to pre-pandemic economic behavior. 

However, a focus on short-term transitory inflation is a smokescreen versus the core issue of whether current monetary and fiscal policy provides a foundation for a higher inflationary environment. Recent history suggests that any link between money and inflation is weak, and any Phillips curve trade-offs is illusionary, yet these are the questions which have to be addressed for higher long-term inflation. A bet on higher inflation and a monetary policy mistake is against the consensus yet betting on or hedging against extremes is a time honored approach to higher performance. The cost of following the consensus may be very high in this case. 

 

SPACs and changing optimism - A possible sign of changing sentiment

IPO and SPAC issuance provides a measure of market optimism and potential speculative excess. An increase in issuance tells us something about demand, but price performance against benchmarks provides a measure of market optimism in the face of uncertainty. IPOs provide a measure of optimism on potential growth of small new firms that are driven by new ideas and technology. Investors look at the filings and recent past performance and extrapolate this growth into future to form a valuation. 

SPACs have the process backwards. Rather than bet on the known past, investors buy into a management team that will find a future opportunity within a fixed time period. The SPAC investor forgoes known behavior for an unknown future. You are buying pure optimism on unknown opportunities. 

There are ways to track the SPAC market, the CNBC SPAC 50 index and the SPAK ETF. Both show strong optimism in early 2021 only to see a quick reversal. The SPAC ETF can be compared with an IPO ETF (IPO). Both show the same behavior with a slight upward bias toward the IPO portfolio. These moves may represent an early change in overall market sentiment. 

Bond yields move around FOMC dates - Policy centric clues drive markets

If you are a bond trader, go to sleep except for the periods around FOMC meetings. The other days are often just noise. That is the conclusion from a recent research piece focused on the bond yield changes and the Fed albeit Fed information and learning may be more disperse over the last decade. See "The Secular Decline in Long-term Yields Around FOMC Meetings". 

Let's start with some graphics. The following graph shows the cumulative change during the three days prior and after a FOMC meeting. The yield declines are all centered around these days. The other days are noise. The authors looked at all scheduled and unscheduled FOMC meetings from 1980-2017. 

A similar pattern can be seen with 10-year TIPS yields and with 10-year breakeven inflation.  

A close relationship with dividend and equity yields can also be seen. 

The impact of FOMC meetings on cumulative excess returns has declined in recent years, but the long-term power of the Fed is clear. There are reasons for the decline and the authors find a clear break after 1994 when the Fed became more transparent with operating procedures. The stable post-GFC period coupled with forward guidance may have made FOMC dates less impactful, but that can change as expectations for shifts in policy increase. 

For better or worse, all investment managers have to be close Fed watchers regardless of the Fed's policy of transparency and forward guidance. It is not often the economic data but the perceived policy response to data that drives markets.