As inflation moves beyond (or below) 1-2%, P/Es drop.
Bull markets are born on pessimism, grow on skepticism, and die on euphoria.
-Sir John Templeton
The Federal Reserve’s inflation target is 2% and an important indicator the board uses for measuring inflation is the Personal Expenditures Consumption (PCE) index.
Last Friday the government reported that both core PCE (excluding food and energy) and regular PCE was running at 1.5% on a year over year basis.
Dragged down by technology stocks, global stocks turn bearish.
Below are the latest estimates for stocks, bonds, and various asset mixes. The return estimates are based on a CAPE in the 96th percentile (stocks) and the 20 year Treasury bond. The risk estimates are based on historical standard deviations.
As the central bank creates or distributes more money, people don’t suddenly go out and consume goods and services.
Falling or rising interest rates play out where they are the primary cost of doing business: financial transactions.
The chart below shows the relationship between monetary velocity (nominal GDP per dollar of monetary base) and Treasury bill yields, in Federal Reserve data since 1929.
Further increases in the monetary base simply push us further and further to the left, and velocity simply declines in direct proportion to base money.
Further monetary easing or a larger money supply does nothing for nominal GDP.
Inflation emerges primarily from supply constraints or an exogenous shock that reduces supply.
In that environment, the marginal value of goods surges relative to the marginal value of a currency.
Hyperinflation results when there is a complete loss in the confidence of currency to hold its value, leading to frantic attempts to spend it before that value is wiped out.
I don’t think we’re there yet.
For the third time in the last 12 months, the wave price pattern of US tech stocks turns negative.
“My idea of the modern stoic sage is someone who transforms fear into prudence, pain into information, mistakes into initiation, and desire into undertaking. “
– Nassim Taleb, The Black Swan
The problem with what is commonly thought of as inflation is that consumer prices move up and down for many different reasons and, at any one time, there will be prices rising somewhere and falling elsewhere.
So, what prices should be checked by the compilers of the statistics?
The answer, inevitably, contains much subjectivity because the prices of every good and service in an economy cannot be monitored all the time.
This begs the question of what use measurements of consumer price movements are in the first place.
Mark Mobius, the emerging markets investment pioneer, has recently published a book titled “The Inflation Myth and the Wonderful World of Deflation.”
In it, he argues that consumer price inflation measurements are severely flawed, a central reason being that no account is taken of changes to the quality of the good or service, or innovation generally.
In the past – nominal prices might have stabilized for personal computers and TVs, for example, but the product has been so much better year-after-year.
Despite these inherent flaws, consumer price inflation is arguably the most important economic statistic on the planet because it directly influences the level of central bank interest rates which, conventional thinking would have us believe, affects the overall economy.
However the broad economic path is driven by trends in mood. Mood can influence consumer prices, but it mainly drives asset prices and debt.
Yet the money and debt-inflation of the past decade is far more important than consumer price measurements.
Today we see monetary policy causing market participants to bid up asset prices such as debt, equities, and real estate.
What comes after this artificial asset price inflation?
Asset price deflation.
Powell’s approach to inflation has been described as “fuzzy” compared to his predecessors. Maybe it’s because of his background in law.
Asked at the FOMC press conference what the Fed means by “moderate,” Powell said, with perhaps a hint of frustration, “It means not large. It means not very high above 2%. It means moderate. I think that’s a fairly well-understood word.” He then added, “You know, we’re resisting the urge to try to create some sort of a rule or a formula here.”
The approach policymakers settled on involves more discretion than the Fed has exercised since the Greenspan era. Powell and others have refused to say how long or how much they will allow inflation to overshoot 2%. Consider this: Inflation would have to average 3% from now until April 2026 for the price level to reach where it would have been if inflation had been 2% since 2012. It’s unlikely the Fed would let that happen because it doesn’t want shoppers to start thinking of 3% inflation as the new normal. On the other hand, just a month or two of, say, 2.1% inflation wouldn’t be much of a makeup.
Market participants may have to read between the lines until the end of Powell’s testimony tomorrow.