Inflation and Price Stability in the 3D Universe

JengaBarry Ritholtz wrote a hilarious, mock summary headline yesterday to explain the recent stock dumpage.
At first, I laughed because I have written the same sort of stuff in the past. Then it got me thinking. Yes, soundbites are necessary because people have short attention spans. With enough repetition, a person learns to “explain” the day’s moves in the form of some simple equations whether they are true or not:

  • Market down, no reason = Profit taking
  • Market down, rates up = Inflation scare
  • Gold up = Dollar is going to zero due to twin deficits
  • Market up, rates up = Economy growing faster than expected
  • Market up, no reason = Bull market
  • Market dumps in June = Sell in May and Go Away

Mark Tinker, a portfolio manager at AXA Framlington, is one of my all-time favorites. He explains:

The insatiable demands from the 24-hour financial media mean that every event needs a fundamental explanation. In effect, markets are trading “noise” rather than fundamentals. A noise trader, of course, doesn’t much care if the facts are correct, so long as the person the other side of the trade does. In such markets the facts become “true” regardless. So far, so harmless. It becomes dangerous, however, when the fundamentals invented to suit the noise become accepted as facts, and people try to invest on this basis. This is where bubbles build.
This happens when the noise traders stimulate trend traders, who need to move prices further than noise traders and so shout louder in the bid to find the bigger fool. The more people hear the fact, the less they feel able to challenge it. The game ends when the fact changes. Despite not being the real reason the market went up, it becomes the reason it goes down. — October 31, 2004, The Sunday Independent

The trouble is, of course, that there are virtually no linear cause and effect relationships in the stock market. The market does not predictably react to Event A with a rise and Event B with a decline. It is not even a web where Event A and Event B will converge to Reaction C. It is a three dimensional structure full of black holes and internal shadows, a diabolical game of Jenga where we can never be sure which block can be safely removed.
Being the tinker toy that it is, the market does feature one interesting property: things do not happen in a vacuum. It was only three weeks ago that everyone was freaking out about new lows in the Dollar. All things being equal, rates rise as buyers of U.S. Treasuries demand higher yield to compensate. As rates rise, the Dollar goes up in response. That is exactly what has happened over the past few days, but because capital flow is not something lodged firmly in the public consciousness, it never makes the list of usual suspects.
Let’s go back to the inflation example. On one hand, Barry is correct to say that an inflation gauge ought to factor in food and energy. If these were included, then inflation would be much higher, and price stability seems threatened. It is a very old argument that makes sense on the surface. And it has been repeated long enough for the man on the street to accept as gospel. So why would Fed officials and economists be so moronic as to continue using ex-food and ex-energy indices?
Because what lurks on the other hand is a new, and not obvious menace. These things take at least two minutes to contemplate. They cannot be compacted quickly — yet. Mark Tinker again explains:

Which leads us to the other issue: the difference between the official rate of inflation and the cost of living. This is not semantics; the CPI is what the Bank of England should focus on in judging whether the economy is growing too fast, while the cost of living reflects people’s disposable incomes – how well off they feel.
And here they are right to feel aggrieved. For many people, their mortgage is their biggest single cost of living and this was up almost 20 per cent before the latest rate rise. This is the Achilles’ heel of the UK economy: in order to slow demand at the margin, everybody gets hit. In almost every other economy, once you take out a long-term loan, you know what your monthly payments are going to be. Not here. For most of his term, Gordon Brown has benefited from rates falling, boosting consumption. Now it is going the other way. At the same time, fuel and lighting is up almost 30 per cent, council tax is apparently up 5 per cent and rail fares 4 per cent – though most people would argue that the last two are up far more.
None of these price rises have anything to do with a runaway economy; people have no choice but to pay them. They are, in effect, taxes. And actual taxes are also going up: the latest figures show disposable income growing at a mere 0.4 per cent in the third quarter, and that is in nominal terms.
The economists at the Bank fear a wage-price spiral. And this is the real problem. Prices are not rising in the private sector, or anywhere where there is competition. But they are rising rapidly in the public sector and it is here where there is risk of a wage-price spiral since the public sector imposes its higher costs on the rest of us. And the only policy being applied is higher interest rates, which destroy disposable income and create deflation in the competitive sector to offset the inflation in the non-competitive sector. In effect, the Bank is trying to run an incomes policy. — January 21, 2007, The Independent

I urge you to read the article carefully. He distinguishes the difference between the cost of living vs. the official rate of inflation, and notes that with floating rate mortgages, rising rates act like an immense tax burden which is deflationary, yet there is enough inflationary pressure in the form of the public sector wage-price spiral that could make increases in food and energy prices look trivial.
Perhaps the mass exodus from 30-year mortgages to ARMs and credit lines is doing the same in the United States, and therefore, raising rates in response to increases in the cost of living is not something that the FOMC considers appropriate to their long-term goals.
More reading: Mark’s take on “Sell in May and Go Away