September 01, 2012

Give me my fix, Doc

"One more round of QE please. The world economy needs it. I am feeling the withdrawal." That is the market's plea to our MIT-trained monetary Dictator. The market's starvation for the much-needed next QE fix seems to be creating a never-ending game. "The market needs more accommodating monetary policy. We can't allow deflation to set in", the rational goes. The terror of deflation drives Central Bankers around the world into competitive devaluations, pushing everybody else into a self-accelerating monetary easing race that precipitates a monetary flood of epic proportions. USD $2.3 trillion in the United States. GBP £375 billion in Great Britain. EUR €1.0 trillion in Europe via the ECB's LTRO, just to name a few significant examples. Central Banks around the world are forcibly participating in a game of one-upmanship, the likes of which we have never seen.

Central Banks Balance Sheet size has almost tripled in 6 years.
Graph by James Bianco
All of this in the hopes of preventing the collapse. Quite a noble goal, indeed. And everything is a-OK so far --until it is not, of course. All it takes is a trigger for all that money floating around to turn into a massive stampede running for safety. Investors start looking for the one currency that does not make them lose value, or the one that has the least inflation. But how do you avoid inflation when every major Central Bank in the planet is churning out bills at the speed of light? Well, that is easy if there is no inflation to run from (if you believe what we are being told, that is).

Is there really no inflation as our monetary Dictators around the world tell us? Are expectations so "well anchored" that savers don't have to fret nor take cover in safe-heaven currencies or precious metals? Well, first of all, to believe this we'd have to assume that Central Banks are credible institutions with good reputations. Reputations are gained via good track records --good "batting average" keeping inflation within their own stated targets. Actual inflation hitting target inflation. We all know target inflation in advance (that is clearly stipulated publicly by Central Bankers). Measuring actual inflation, however, is the tricky part. The Central Bank has every incentive to make "actual" inflation fit into target inflation. The problem is that there is no "fail safe" mechanism built in the system to keep the Central Bank from tampering with actual inflation. Actually, it is the very Central Bank who measures and reports actual inflation. There is no need to bribe, corrupt or influence any third party into producing an actual inflation figure that conveniently hits your own target. Beautiful. That's like an Airline claiming to have an outrageously high punctuality rate, when in reality they are the ones who measure their own flight times (Hello Ryanair!). How do they do it? Through pompous, hard-to-understand gimmicks:

The first one is the concept of "core inflation" (which is the most widely known). This concept strips food and fuel (the "bread and butter" of daily expenses of the average consumer --pun intended) out of the CPI basket. Those exponential crude oil price increases or $4 per gallon of gasoline? Gone. Global grain shortages? No problem. None of that is accounted. The second one is substitution effect, which states that when an item in the CPI basket increases in price, a rational consumer behavior is assumed and the basket automatically switches to a close, cheaper substitute product. Thus, the basket is always guaranteed to hold the cheapest products. This gimmick implicitly condemns this imaginary average consumer (the one that consumes the CPI basket) to continuously downgrading its standard of living and to use lower quality, cheaper products. Then you have geometric weighing, which reduces the weight in the CPI of a category that is rising faster than all the other categories. Finally, you have hedonics baked into the actual inflation statistic. This one states that when technology improvements make products better --regardless of price-- a downward adjustment in the price of the improved product in question is made for CPI calculations (like an iPad that sells in year 1 and in year 2 for $350, but in year 2 it enjoys better definition technology, then the CPI in year 2 will consider the price of this iPad at $250 instead of $350). Experts state that 46% of the CPI is adjusted for hedonics.

What would happen to actual inflation if we reversed all these gimmicks? The answer is obvious. In fact you don't even have to undo all these gimmicks to know what the actual level of inflation is. You already know it from you daily life. Your last trip to the grocery store will tell you what is your level of inflation. Or, if you are one of those who don't do the groceries at your household, you might be surprised --or not-- to learn what is happening with all those stratospheric amounts of money floating around in the world economy. They push real estate prices to stratospheric levels in some very exclusive market segments. Of course, you don't have to worry about those price increases affecting the CPI. One57 does not make it into the CPI basket these days, so don't expect any pull from its $100,000,000 condos.

Collapsing currencies behave in quirky ways. When they are in the first stages of their demise, luxury items see outrageous price inflation. Iran, hit by sanctions and isolation, is seeing record sales of Porsches. In the times of the Weymar Republic, the currency flight began with the frenzied buying of diamonds, gold and country houses. It turns out wealthy people --usually shrewd people in terms of financial matters-- run for cover and buy what they know other wealthy folks will buy too. Jewelry, art, exotic cars. This is why I feel unease when people rationalize insane U.S. real estate prices by redefining real estate as "art" (some other times, however, I just laugh).

Inflation is a psychological phenomenon as much as it is a monetary phenomenon. If inflation expectations depend on the reputation of the Central Bank, the Central Bank's reputation depends on its track record, and its track record depends on a baked statistic, we should be concerned about the fact that the world's money supply in the most important, biggest Central Banks has grown 177% in the last 6 years while the world's nominal GDP has grown 41%. Especially if the stability of your status quo --people trusting Central Banks' reputations-- rests on a cooked statistic. Deflation is not the only thing monetary Dictators should be afraid of. By trying too hard to the get away from the evil of deflation, they are dangerously getting closer to another, equally hurtful, calamitous outcome.  So, in evaluating if administering the next heroin dose to our patient, monetary Dictators should be careful not to induce a monetary OD.

Update 9-19-12
In the 18 days following the writing of this piece the World Monetary Dictators (WMD's) have gone "all-in" on their monetization efforts. Europe has committed unlimited amounts of Euros to buy Sovereign paper; the U.S. has written its blank check and pledged Zero-rates until 2015; and Japan doubled its Asset-Buying program. Heavy heroin doses, indeed.