Matthew Klein is the author of The Overshoot, a newsletter that helps readers make sense of the global economy. Matt is also a returning guest to the podcast, and rejoins Macro Musings to talk about the hot topic of inflation and its outlook. Specifically, David and Matt discuss what is driving trend inflation, Matt’s decomposition of the CPI, whether or not we should be worried about inflationary trends, and more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]
David Beckworth: Matt, welcome back to the show.
Matthew Klein: Thank you very much, David. Thanks for having me.
Beckworth: Great to have you on, and I mentioned you are the author, the producer, the creator of content at The Overshoot, and you've had quite an interesting career. I remember you worked for Sebastian Mallaby on the big Alan Greenspan book. You worked at The Economist, Bloomberg, Financial Times. Barron's, I believe, was your last stop, and now here you are. You're an entrepreneur. You're putting forth your own little shop, and producing really great content. I mean, I subscribe to it, and in fact, this is one of the reasons I have you on, because your last newsletter was really good on the inflation issue. But just tell us a little bit about your journey into entrepreneurialism.
Klein: Oh man, well I think the theme that ties it all together is that I am really interested in understanding what is going on in the global economy, and how everything fits together, and how the links between what businesses are doing and households are experiencing and financial markets and all these things that, a lot of times because it's just hard to put it all together in one giant picture, people focus on one piece of it or something. The idea of trying to see it as a whole and as a system is something that really appeals to me and has appealed to me for a while, and understanding it and then explaining it to people in a way that's useful.
Klein: That's really been the through line here, and basically I've really enjoyed what I was doing at Barron's, where I was the economics commentator there, and that was my role for them. There were some people who I would have liked to have read my stuff that weren't necessarily able to read it, or willing to because Barron's, it's a big product and has a lot of stuff that not everyone else... Readers who might be interested in my kind of work might not necessarily want to pay for the rest of it, so there was an opportunity there to kind of branch out and do something a little bit by myself. So, that's what I've been doing so far, and I started in July, so it's only been a few months, but so far it's gone pretty well and I'm pretty excited about it. So, thank you for being a subscriber. I appreciate that.
Beckworth: Oh, absolutely, and I encourage our listeners, if you aren't already subscribing, to do so. It's been fun to watch several of you. I mean, you're one. There's some other friends we have that are doing this as well, but I mean look, you guys are emerging young capitalists on the intellectual scene here, sharing your ideas with us and stuff. So, this is exciting to watch this development in this space. Okay, so I've called you on the show today to discuss inflation. As you know, last month's numbers came out, October. 6.2%, and man, this just fueled the fire. There's almost a fever pitch of inflation commentary right now.
Beckworth: The end is near, the inflation is about to turn permanent, we're going to have a trend acceleration. People will also turn to five year breakevens, which also are running really high. And they are understandably high. And then you get people like Larry Summers, and Mohamed El-Erian saying, "See, I told you so. I warned you earlier this year." So, there is this fever pitch, almost a bubble. A bubble of inflation angst, and is it about to pop? Or is it going to continue to grow larger? So, should we be worried, Matt? And I want you to draw upon this article you recently published, *The Case for Patience On Inflation.*
Should We Be Worried About Inflation?
Klein: Well, I mean the headline kind of gives it away. I mean, I think that obviously, we have seen prices rising at a relatively rapid pace. I mean, if you look at sort of the long swath of history and across countries, 6.2% is not that much in this space. Relative to the past several decades, though, it is a big deal, and especially the rapidity of the acceleration and the extent to which it's concentrated in a few items. If you are looking to buy an appliance, or a car, or gas, or meat or whatever, those prices have gone up quite dramatically. That is a big deal. But the question is, is this a macroeconomically induced phenomenon that policy makers caused, and therefore should reverse, which is really the question here? And I think the answer is no.
But the question is, is this a macroeconomically induced phenomenon that policy makers caused, and therefore should reverse...And I think the answer is no.
Klein: I mean, we can basically attribute almost all of this to the pandemic itself. Which is understandable, because the pandemic was incredibly disruptive and destructive. Aside from all the people who've died, which in and of itself a tremendous consequence of it, and the people who've gotten very sick, some with permanent damage, it also led to really massive changes in what people wanted to buy and what people were able to produce. And understandably, that flows through the economy in a lot of different ways, and you can kind of look at what are the actual components that are really driving a lot of the outsized inflation.
Klein: If you just focus on the ones where we can clearly tell stories about how the pandemic has affected them, the motor vehicle complex whether it's rental cars, used cars, new cars, that's a big thing. Energy's a big thing. Meat is a thing, because of the way the pandemic affected butchering and meat processing last spring, and how farmers reacted to that by culling their herds, which means there's less pork and beef now. You can point to all these things, and it turns out if you do that disaggregation, which I did and it's not that hard to do. I mean, the government publishes all the data, then other people don't bother to count it up. That's why I charge. And then, you can see most of the inflation that we've seen that is excessive, relative to what we think is sort of a normal, desirable amount, is due to these factors.
Klein: So, what that tells me is that if the pandemic and its impact on our ability to produce, and on the things we're trying to buy, but particularly our ability to produce recedes, which hopefully that will happen. I mean if not, then we have bigger problems, quite frankly, but if that happens, then the inflation that we're seeing should recede along with it, and we should get back to where we are in general. That should be sort of our base case, and I think the question then becomes, well, is that going to happen? And before that happens, might people start changing their behaviors in ways that make this logic not work? But I think right now, everything we're seeing is consistent with this idea that it's the pandemic that's to blame basically. That the inflation is obviously not good, but relative to the alternatives we could have expected, given what the pandemic did, this is sort of the cost that we're paying. Now the question is, how do we get past that?
Beckworth: Yeah, those are great points, and I want to go back to this one you just made about doing the right counterfactual. So, inflation is harming people in America, and I think both of us agree, we think it's going to pass and all the commentary is focusing on this harm caused by inflation, but the point you just made is, well, what was the alternative? How would things have turned out if we had tried to address this inflation if we hadn't responded with the policies that we did? So, can you flesh that out a little bit for us?
I think right now, everything we're seeing is consistent with this idea that it's the pandemic that's to blame basically. That the inflation is obviously not good, but relative to the alternatives we could have expected, given what the pandemic did, this is sort of the cost that we're paying.
The Inflation Counterfactual
Klein: I think there are a couple of interesting things here that are a little... Could be counterintuitive. A lot of the inflation I mentioned comes from cars and trucks, and I think in that case, actually, looking back the problem was that there wasn't enough of an aggressive early commitment by the government to say that we're going to protect the economy, and then that led to basically cuts in supply that are now being felt. So, just to break that down a little bit, you go to last spring. All the auto makers shut down their plants completely, and there are good reasons for this because they don't want to get their workers sick. So, production literally... The Federal Reserve tracks motor vehicle assemblies. It goes to zero in April.
Klein: So, that was a big deal, and your demand also fell off a cliff, because people are like, "I'm not going to go inside… Why would I want to be inside a car to do a test drive with someone?" That makes sense. And car rental companies meanwhile, their business is a mixture of business travel and tourism, both of which are dead, and a lot of them... I mean, most notably Hertz, but not only Hertz, they borrow by issuing debt that's explicitly collateralized by the cars in their fleets. So, to raise cash they were like, "Well, we need to sell the cars. After all, we don't have customers coming back." And one more thing, after the April shutdown of the auto plants, they then restarted production but at a lower rate than before the pandemic, like 10-15% lower, and basically stayed there, even though consumer demand actually snapped back very quickly.
Klein: Business demand did not because the business demand is basic rental cars and rental car companies were selling, but consumer demand was very strong. You put these things together, and what ends up happening is something surprising, which is that by the summer, actually, you see that demand for cars is very strong by consumers and demand for rental cars ends up coming back pretty quickly. It takes a little bit longer, but it ends up coming back pretty strongly. But then you end up in a situation where the car makers didn't produce enough, so the dealers basically had to sell what was on their lots and the rental car companies temporarily helped alleviate the shortage by selling their fleets into the used car market, so that helped with consumer demand, but then when consumers wanted to rent a car, there weren't any available. So, then the rental car companies did two things. One, they raised their own prices by an enormous amount. I mean, I think rental car prices, as tracked in the consumer price index by the government, it's like 50% higher now than before the pandemic.
Klein: That's enormous, and at the same time they said, "We need to rebuild our fleets as quickly as possible." So, they went after the used car market, and they basically call people up to go to auctions, and those prices are also up 50%. These are very small components of a typical consumer's basket. I think combined, you add in used cars and car rental, you're talking something on the order of four percent or something of the total. Four percent, with each one going up 50% has a big impact.
Klein: And then, it started to filter through to new cars, and part of the problem is that when the car makers decided to cut back on their production and not restart fully, one of the things they did was they canceled a bunch of orders for various microprocessors and stuff they use in the cars, and the companies that make those chips, the car makers, are not really valuable customers to them. They make a lot more money selling chips for laptops and phones and gaming consoles and stuff like that. Those are much more high margin and much more technically sophisticated and higher priced. If the car makers say, "We don't want this," and they say, "Okay, fine. Back of the line."
Klein: You get to the end of 2020. Car makers are belatedly realizing they should be producing more to catch up, that their dealers are struggling with low inventories, and then the chip makers say, "Well, okay. You're at the back of the line, sorry. You either have to pay up a lot," which the car makers are starting to do, or you need to cut back on your production, or some mix. And so, that's then, as a result, flowed through to inflation in new car prices, which is now starting to be pretty dramatic. I mean, we're talking 10% a year, which is the fastest inflation by far we've seen in new cars since basically the '80s. The early 1980s, basically pre-Volcker.
Klein: That's a big deal, but these are all very specific things we can trace to, again ironically, a lack of government support for the economy, not too much demand. It was basically insufficient demand early on that then cascaded those decisions through. And so, that's a big chunk of what we've seen. You can also look at oil in kind of the same way, in the sense that going on in the pandemic, you also had this volume price war kind of thing where Saudi Arabia and Russia were trying to get back market share from other producers, particularly American shale producers, and so they flooded the market in the spring of 2020. That led to, remember when West Texas Intermediate was at negative, right?
Klein: This was sort of an extreme case, but even if you forget that, a normal price was $20 a barrel. That drove a lot of shale producers into bankruptcy. They'd already been into bankruptcy in like 2015, 2016, so second time in less than five years. Investors say, "Okay, we will finance you out of bankruptcy again, but unlike last time, as soon as your oil price breaks your break even cost of extraction, you can't just start pumping as much as possible," which had been their approach. So, what that's meant is that now, even though oil prices are substantially higher than they were, above the breakeven point for these shale producers, and they're actually doing very well, instead of financing more drilling and more investment, more production, they're paying down debt, making dividends.
Klein: All that stuff which, capital discipline is the term. Effectively, again, you can think of that and that's more complicated in terms of what could have been done to prevent that outcome, whether it should have been prevented… You're getting into environmental policy question, but again, that points into because there was this big collapse in demand early on, it means less supply now, which is very different from the story you hear from people like Summers and El-Erian saying there's too much demand now, and that's I think missing a lot of what's actually happened here.
Beckworth: Yeah, I want to come back to the composition of these products. They're all durables or commodities that's driving this high inflation, but just going back to the counterfactual point... So, to the extent that fiscal policy did play a role, so all the stimulus checks, all the added unemployment insurance, for me at least, when I look at that and I think of the counterfactual, I think of, well, that could have been removed. It could have been avoided. But then what would have happened? One thing we didn't see was another great financial crisis, and one reason is because nominal incomes, dollar incomes were stabilized. So, it could have been a lot worse, and if the price we're paying today is a temporary bout of inflation... Again, I think this is a very small part of the story but to the extent you buy that story, I don't see it as being, in terms of tradeoffs, cost benefit, not such a high price to pay if the alternative was really high and sustained unemployment and other problems in the economy.
Beckworth: But let's go to the composition of goods that are driving this. In fact, the key thing you've been describing are mostly tangible things. Cars, meat, oil, completely separate from the service side. The service side of the economy, and you've seen this graph, I've seen it, too. I've tweeted it several times recently, but if you look at the decomposition of the inflation rate by services and goods, all the inflation is coming from the goods side. I should take that back. There's a little bit of inflation now on the service side, but most of it is coming from the goods side, the consumer durables, and I was really struck when I looked at this data that consumer durables all the way back to 1995 have actually had a deflationary trend.
Beckworth: The rates have been going down for 25 years, so to suddenly have an explosion in price, to have consumer durable inflation and to believe that it won't reverse really is a leap of faith in my mind. It's hard to understand why we wouldn't return to that once things get normal on the other side. But speak to this, because you take this fact that these are durables, these are pandemic related, and you create your own decomposition of this CPI, and you show certain things. So, walk us through your decomposition.
Matt’s Decomposition of CPI Inflation
Klein: Sure. So, I think the first thing to note is that the durable story is very interesting, and I agree. You can look at this, for example, the washing machine tariffs that were put in during the Trump administration. If you look at the long-term trend of appliance prices, it's down pretty steeply. You can see the bump up when the tariffs are imposed, and then it goes back down again. Even with that, it was only 25% or whatever, it didn't actually have that much of a sustained impact. Yeah, I think that the general trend... I mean, who knows? The world can change or whatever. So, the decomposition that I do, to be clear, is not just durables versus services, because I think it would be misleading to just say, "Everything that's a durable good is supply constrained," or whatever.
Klein: I don't do it that way. I basically, as I said, what are the sort of things we can point to as being idiosyncrasies of the pandemic? I said used cars, new cars, car rental, energy I think relates to this. Then, there's services where, basically, and this is when people talk about base effects. Basically, if the price went down a lot in the beginning of the pandemic, hotels, live events, schools, air fares, and then they start going back up, even if they're lower than they were before, if they're going back up pretty quickly because all of a sudden you have people getting vaccinated and feeling more comfortable going back into doing things, that's going to show up on the month over month basis as very inflationary.
What are the sort of things we can point to as being idiosyncrasies of the pandemic? I said used cars, new cars, car rental, energy I think relates to this. Then, there's services where...Basically, if the price went down a lot in the beginning of the pandemic, hotels, live events, schools, air fares, and then they start going back up, even if they're lower than they were before, if they're going back up pretty quickly because all of a sudden you have people getting vaccinated and feeling more comfortable going back into doing things, that's going to show up on the month over month basis as very inflationary.
Klein: So, that's basically what I did, and then everything else is everything else. I include a lot of things that have gone up a lot. Appliances is in the everything else category. When I started doing this, I actually didn't put meats in the pandemic category. I later said, "Oh, I should have done that." But anyhow, it's actually in the everything else category, and even so, you still see that pattern that we're talking about where the everything else has been pretty stable. Exercise equipment, you've seen big inflation there, actually, but it's normal. There's someone else I saw using this, I thought it was a good way of putting it. It's like a terms of trade shock, but basically people literally couldn't or didn't feel safe buying a lot of services, but they still had money because government as you said did the right thing and made sure they still could buy something.
Klein: So, they bought goods and they bought housing. That means that the relative prices of those things moved a lot, but at the macro level, understandably it offsets. The fact that healthcare inflation and rent inflation and other kind of services inflation basically slowed a lot, it was offset by inflation in things like appliances and exercise equipment and stuff like that. And that's fine, because if you add that all up, it basically gets to where you want it to be. What's interesting is that the excess on top of that is due to categories that's explicitly, as I said, this is sort of supply constrained due to the pandemic, which is...
Klein: That's where I think this is the interesting story here because the under the hood stuff of durables versus services, you probably would expect that to rebalance. I mean, I think rent inflation is going to come back mechanically. The way CPI calculates health insurance cost is very strange and also, it was a big deflationary force, and it's already turned around, so that's going to come back. But I mean, at the same time, I don't think appliance prices are going to go up another 20%. Maybe they will. Maybe I'll look silly saying it, but it's probably not going to do that.
Beckworth: It's hard to see that happening.
Klein: Right. I think these are going to be off setting forces. Yeah, I think that's basically how I try to look at it. I mean, someone else could do other decompositions. They publish the data of all the categories and how much they contribute to each monthly gain, so people can feel free to play around with it in their own way. This is what I did and I think it made sense. That's how I've been doing it since March or April or whatever, but it seems to work for me.
Beckworth: No, it's very interesting, and again, it really illustrates that most of this inflation is related to the pandemic. As you mentioned earlier, that there were big changes in consumption patterns, so people didn't go out in the service sector. They cut out eating out, hotels, travel, and shifted into durables, working from home and such. That's a real change in the economy, and we think it's probably going to go back the other directions once things improve, and so let me speak about things that could improve. One thing, of course, is the labor supply. A lot of people still haven't return to the labor force, and there's different stories that are being told.
Beckworth: I think one of them is just the Delta variant, and people are still careful. I saw one tweet of a picture from Mark Zandi, where he showed that the percent of people staying home was related to the age of their kids. Kids don't have daycare or school, so you think once things improve in terms of public health, those people will be back in the labor force. We'll see things improve there, more supply side. But another critique that comes out, back to the fiscal stimulus side, is all these people are sitting on excess savings and such, and I know you've written on this, but how do we make sense of that? Is the excess savings a story here or not?
The Excess Savings Story and the Retirement Argument
Klein: I think it's sort of a perverse critique, because the implication is people need to be at threat of imminent starvation or they won't work, and therefore, if they have any kind of financial security whatsoever, it's going to be bad for the economy. I think that's just bizarre on a lot of levels, so I don't think that. I mean, the other thing, too, is we can also look at who holds the excess savings as best as we can tell through things like Fed surveys, the enhanced financial accounts. Mostly it's people at the upper end of the income distribution, which is not where we've been seeing supposed labor shortages. I mean, maybe it's playing a role, but I don't think it's a negative role on the whole. I mean, you're also seeing a huge increase in entrepreneurship. We talked about this at the beginning.
Klein: The government publishes every single week the numbers of people who are applying to the IRS for business tax IDs. I must be in there somewhere, and you can see in 2021, you have this enormous increase relative to previous years. 2020 actually was bigger than previous years. There's a huge dip in the beginning of the pandemic, and I remember writing a piece in April 2020 saying, "This is going to be a disaster like it was after the financial crisis, where this big decline in business dynamism and stuff." It turned out, thankfully, that was wrong. By the time you get to the summer of 2020, it turned around pretty quickly, and by the end of the year, the cumulative amount of business applications was substantially higher than in previous years.
Klein: Then, this year, I think the total number, including self-employed individuals like me, is 50% higher, even if you're including people who are the more narrower category of they're planning to actually hire people under them and actually have a real job creating... That's 30% higher, so that is a consequence, in part, of the so-called excess saving. I think maybe it's affecting labor supply, but I think it affects it in a lot of different ways, and I think it's not really negative. I think the child care thing, I suspect, is probably a much bigger factor, and overall health concerns are going to be a much bigger factor. But there's probably a lot of things going on.
Klein: I mean, the short version is we know that total employment is down about five million or so from what it was during the pandemic. That population's grown somewhat, and that arguably, we weren't at full employment before the pandemic anyway, so we're talking about millions and millions of people who could be working who are not, and the idea that it's because of the government gave them money is, I don't think is the main explanation or really much of an explanation.
We're talking about millions and millions of people who could be working who are not, and the idea that it's because of the government gave them money is, I don't think is the main explanation or really much of an explanation.
Beckworth: What about the argument about an increase in the level of people retiring? So, I think it's part of the great resignation. People are leaving just because they were old and they were going to retire anyway, so they did that. I saw some good pushback on that, but I'd like to hear your take on that argument.
Klein: Yeah, I mean, the pushback… We've probably read the same thing, but the Kansas City Fed had some economists look at it. It's always good to look at exactly what's driving these numbers. There are people who go into retirement, and then there are people who come out of retirement, and it turns out most of the time, the numbers of people doing each of those things are pretty stable. More people go in than out generally, that's why retirement goes up over time. But people do come out of retirement, especially if we're looking at people who go into retirement when they're under the age of 65, which is actually a lot of people, especially recently.
Klein: What the Kansas City Fed found was that the big change in the pandemic was that the people coming out of retirement went down a lot. People going into retirement stayed pretty constant, but coming out went down. That's since normalized a bit, but cumulatively that could go up more. Again, it's consistent with the idea that if someone lost a job or they had to stay home to take care of a child, or something like that, they're just going to say they're retired for the moment because it's just temporarily that situation. But if a good job comes along, they'll come and get it.
Klein: I mean, that's basically what we saw after the financial crisis. There were a lot of people saying, "Oh, well of course we're not going to get back to employment because the population aged a lot after 2008," which turned out to be kind of horse hooey. I mean, for one thing, the participation rate among the over 65s specifically kept going up, which tells you that was not a good story. But also, it turns out a good job market brings people in, because it's more rewarding to be employed under the right circumstances. Maybe there's a recalibration that needs to go on in terms of what jobs are offering workers, but it doesn't mean that these people are gone forever. Unlike a lot of people who did die, these people are not dead, they're just not working temporarily and that can be fixed. That's not an actual decline in labor supply, so I think we shouldn't treat it as this permanent thing, because I feel like every time people say that it turns out to be wrong.
Beckworth: Yeah, it reminds me of the development we saw in people on disability rolls actually dropped over the decade after the great financial crash. As the economy continued to grow, more jobs... A category you would normally think, "Oh, they're on disability. They're never going to get back to the labor force." It actually changed, which is amazing, and Nick Bunker, our friend, he had a great few tweets recently where he showed that the rate of unretiring, I guess is the term he used. So, people who were retired going back in is actually picking back up. Since that, as you mentioned, was the key category, the big change, that's a very promising development.
Beckworth: Now, there's a lot of room to cover, a lot of ground to catch up on, but it's promising to see them do this. Again, I think as we get to the other side of this pandemic, a good, healthy, vibrant economy is going to do a lot of good for the labor market. One other thing you mentioned is that business dynamism is up, which is amazing, fascinating. It makes me happy as a capitalist at heart. You make me happy doing your own business. But what makes me sad is that many of my fellow capitalist-loving friends, I feel like they lost their religion in interpreting the inflation numbers and the potential for recovery. Part of the story I like to tell is that global capitalism still works, markets still work, and if oil gets high enough, eventually those frackers will go in.
Beckworth: Maybe it's a little bit higher now because investors are picky. Eventually, shipping companies will figure out ways to get goods to the port. Eventually, auto makers will respond. If you believe markets work the way we're taught and the way I believe, then there's a solution to this. We're not talking about a trend change in inflation, we're talking about this spike that you mentioned in these physical goods and commodities. I don't know if you've noticed that too, that a lot of market-friendly people suddenly lost their market friendliness.
Klein: I agree, and in fact we're actually... If you want this stuff closely, we're seeing some of the developments. I think I saw, it was today actually, a forecast for US oil drilling saying that production's going to hit a new high by sometime in 2022, which would be a big growth relative to where we are now. Yeah, there's that old line, "The cure for high prices is high prices," and it's supposed to work two ways. One is that people say, "This is expensive. I don't want to buy it." Which we're seeing some of that, by the way. I mean, the durable goods that have gone up the most in price, I wrote about this in the piece... Inflation-adjusted real consumer demand has gone down a lot for those things, and so we're already seeing a shift and a rebalancing, even though total consumer spending is still going up, that demand for the things that are in the shortest supply and the biggest price hikes like cars and certain furniture, whatever has gone down.
Klein: So, that's one side of things, which I think is what we hopefully expect. You see that for housing, too, by the way. Houses went up a lot, partly because there was this one off migration accelerated from people who wanted to get a house, move away, get more space or whatever. Then, it began to recede as prices jumped, so that's what you'd expect. And then the other side is more investment, which again, I mentioned we've seen in oil, you're seeing it in residential construction. I mean, I think we're probably going to see it in a lot of things. That's how it should work, and the idea that it can't happen that way… Do we not have confidence that businesses are going to respond to a situation where their demand is going up, where they're making a lot of money and where they have access to financing to capital investment? That would be weird. That's what they're supposed to do. And they've been announcing CapEx plans/ Yeah, so I agree with you is the short version.
Beckworth: Yeah, and to be clear I'm not saying we shouldn't be mindful in thinking about public finance, the health of the Treasury, what the Fed's doing. All those things are important, but I just don't see, from that side at least, anything that's troubling me in terms of a change in the trend inflation rate. Maybe we'll come back to that in a minute when we talk about our theories for inflation, but I want to go to the indicators. So, we look at headline CPI or headline PCE inflation, we look at these five year breakevens, and one thing this experience has taught me is to really think about the difference between short run movements in inflation and long run trend line. The long run, medium trend movements are more, in my view, about macroeconomic policy.
Beckworth: Again, we'll come back to that in a minute, but it's striking if you look at, for example, commodity prices plotted against the headline inflation rate. There's some tracking going on there. It's also true if you plot the five year breakeven against commodity prices. So, one of the takeaways I had, and I want to see what your take is, that maybe markets, and people see this in terms of high gas prices, they're basing their near-term expectations on these commodity prices, these durable goods prices that they see, but over the longer term it's based more on the fundamentals. What is your take away from that?
Viewing Inflation in Terms of Commodity Prices
Klein: Yeah, I think that makes a lot of sense. I mean, the commodity prices are the most volatile and they will flow through to shorter term inflation, so that makes a lot of sense. The other thing too, which again, following up what we were saying, a lot of these commodity prices have come down a lot. People were talking about lumber. Lumber is now has crashed to the point where the price... I mean [maybe not] crashed, but it's now basically where it was pre-pandemic. It went up, tripled or something. Now it's back to where it was. Iron ore is down by half, I think. There was this big spike in natural gas prices in Europe a couple months ago. That's down by 30% or something.
Klein: So, consistent with this idea, I mean that line, "The cure for high prices is high prices," is a commodity thing. Yeah, we're already seeing these kinds of developments. This is why, in the piece I wrote, I like to look at term structures of things and there's a five-year breakeven. There's also a 30 year breakeven, and what you can do with relatively simple math is you can say, "What is the implied 25 year breakeven that starts five years from now?" Whatever stuff the pandemic is will hopefully have washed out, or at least that's what people are betting. It turns out that breakeven inflation is basically the same as it's been for the past five, six, seven years.
Klein: It's lower than it was in 2010, 2011, not higher than it was in 2018. That makes me think that there are multiple explanations for why that could be. One explanation could be traders are expecting that the Fed and the Treasury will do this big retrenchment and that's a... I don't know. There are a lot of explanations for why, but regardless, people are acting... Sophisticated people betting on this stuff are betting that it's not going to be a problem after the first few years, which I think makes a lot of sense and is consistent with the other data.
It turns out that breakeven inflation is basically the same as it's been for the past five, six, seven years...There are a lot of explanations for why, but regardless...Sophisticated people betting on this stuff are betting that it's not going to be a problem after the first few years, which I think makes a lot of sense and is consistent with the other data.
Beckworth: Yeah, completely, and again, it's great to look to the market because these are folks who have skin in the game. They're making a living... they're investing people's retirement funds and they have to be very thoughtful. And it's a market. There's give and take, so the fact that the 10 year Treasury today when we're recording this is about 1.6%. 30 years around two percent. That tells me at least that the market at this point still believes that the inflation target is credible, they still believe that fiscal policy will be manageable, public finance will be manageable over the medium to long run. So, let's switch gears to that horizon then, Matt, and talk about theories for inflation and why markets don't see it, and why maybe you don't see it. I don't see it, I'll explain my side, but I'd like to hear what you think about what is ultimately going to drive trend inflation?
What is Driving Trend Inflation?
Klein: The argument that I've heard that's compelling is basically... Actually, Martin Wolf had a column in the FT today basically making this point, but there other people are making this point too, which is that, contrary to everything we've just been talking about, but the actual problem is that there's too much spending. Too much consumer demand in particular, and that there's only so much supply and that people like you and I, we are supply-side optimists and that optimism is unjustified, and that sooner or later, the immovable object will hit the unstoppable force and we're going to get inflation with higher prices. Again, I'm not seeing that yet. Maybe that could happen. I think the big question, though, is… Let's say that I think I'm right about what's going on, and what's driving the excess, and that should fade. People seem to be acting as if that's right for now, but if they don't keep thinking that way, and then they adjust their behavior to protect against the possibility that inflation will get worse, then you can end up in a very interesting situation.
Klein: People talk about inflation expectations and what that means, and I think a lot of that argument, in terms of causing inflation, I think that argument often is not helpful. I remember there were people in the early 2010s being like, "Ah, we just need Bernanke to come out with a Hawaiian shirt and say 'I want to go Weimar.’" I think there are a lot of steps between that and actually inflation to make it work, but there can be circumstances where it takes fewer steps. This is where it gets interesting, where if you have, actually, a situation where people have a lot of money, businesses have a lot of money, wages are growing relatively quickly, that is an environment where a change in expectations about inflation would be much more potent in terms of actual inflation than other economic environments. So, that's where I think you potentially could have a cause for concern. At the moment, I don't think we've seen that yet, but it could be a concern.
Klein: Basically, if people are like, "I have a lot of money in my bank account, I'm getting really big pay raises. I'm seeing prices of cars go up a lot, I'm going to make sure I go out and buy a car now and I'm going to pay whatever, because I think it's going to get worse later." That sort of thing. Or, if businesses are like, "Well, I'm really worried about the cost of this input that I want to have for future production, or the cost of this building, or the cost of these workers. I'm going to pay up as much as possible now to lock that in." That could become a self-reinforcing problem, and I don't think we're seeing this yet. I think that so far, in fact, people are acting as if they're pretty confident that the current disruption is pandemic-related, and as the pandemic recedes, hopefully the price pressure will recede. But that, I think, is a legitimate thing to be worried about. The trick is how you manage that. Part of it is just what we're doing now and actually explaining a lot of what you're seeing now is temporary, but that is a risk.
Beckworth: So, you're saying there is the potential for a wage price spiral if household expectations become unanchored. Is that right?
Klein: Yeah, that's the standard jargon. I'm not sure I would quite phrase it that way. The idea is that, "Oh, I get a pay raise, therefore that makes it more expensive for businesses and I have more money to buy stuff." The phrasing I like to think of, this is not original to me, but you basically go from trying to live your life and buying things, what you want right now, to instead being like, "I am worried about inflation as a problem. I'm going to try to hedge that risk, I'm going to alter my behavior away from what would be my normal economic behavior to do that.”
Klein: That's true at the individual level if or when this becomes a problem, and it's true at the level of businesses. Once all these different economic actors start thinking about inflation as a problem they're trying to hedge, and that's a big concern of mine, as opposed to, "I just want to make money and not worry too much about inflation." That's when you have, I think, bigger problems. That's the big downside risk. I don't see that being something that's actually showing up right now in the US or the other advanced economies, but that's where I would see the risk.
Once all these different economic actors start thinking about inflation as a problem they're trying to hedge...That's when you have, I think, bigger problems. That's the big downside risk. I don't see that being something that's actually showing up right now in the US or the other advanced economies, but that's where I would see the risk.
Beckworth: Let me lay my theory out as to why that's the case now, why you don't see that. I'll begin with this: I think for households, and you mentioned businesses as well, to get into that mindset, it has to have support from fiscal policy, from government finances. I don't think on their own they could fall into that kind of equilibrium. Maybe they could in some unique model, but in my mind for them to get caught up and get this inflationary spiral going because their expectations are becoming unanchored, there has to be some support from excessive fiscal stimulus, money printing if you want to call if that. As an extreme example, we look at countries that actually have had hyperinflation. They didn't have hyperinflation because people woke up one day, "Oh my goodness. My inflation expectations are unanchored."
Beckworth: They did so because the government was turning to the printing presses literally, in some cases, but an environment of fiscal dominance, where their financing costs were being born by issuing excessive amount of liabilities. In my mind, if we wanted to see this process unfold, we need to look at what is the projected path of US public finances? The US Treasury, what are they going to encounter? One could say, "Well David, that looks pretty scary, actually." The debt-to-GDP ratio now is about 100%, the CBO is projected persistent deficits, primary deficits as far as the eye can see. My retort to that is two. Number one, the deficits we see going forward are much smaller than the last two years. They're still deficits but they're smaller, therefore more manageable number one.
Beckworth: So, even President Biden's new Build Back Better proposal, all of those recent... the infrastructure bill, they're spread over 10 years, so you got to kind of keep that in perspective, too. It's a small part of the GDP over that period. But the other thing, and I think this is where your previous work probably comes into this consideration, is that we look at debt to GDP, and the projected primary deficits and we get really worried, but what we're doing is we're looking at just the supply of those securities, and there's another side of that. There's the demand for them, and so I foresee the same forces that kept interest rates low before the pandemic, that kept the demand up for those securities before the pandemic, as continuing afterwards.
Beckworth: The whole safe asset shortage story, there's also some dollar dominance, a lock in effect. People don't have many other alternatives to turn to, but essentially, the real demand for US Treasury, US public debt is still going to be strong going forward, and that should be enough to offset the primary deficits we're going to run. That's why I think Treasury markets today aren't panicking. They aren't freaking out. They maybe implicitly understand that. I don't know, what are your thoughts? Am I being too optimistic here, or is there some merit to it?
The Optimistic Take on Inflation and the Debt
Klein: I guess I basically share your case for optimism. I think one way of looking at this is the yields on inflation-protected Treasury debt are as negative as they've ever been, I believe. You're talking about the two percent yield on a 30 year Treasury. That's nominal, which does reflect a degree of confidence or unconcern about inflation, but the flip side of this is that it implies a great degree of pessimism about growth and what is the appropriate industry to avoid putting the economy in a depression, which is consistent broadly with the idea that the pre-pandemic world will eventually reassert itself with all of its issues. That might not work out that way. There is an interesting question, I don't think to the extent that the changes in the pandemic actually did, to a degree, change household and corporate balance sheets, particularly household balance sheets... It did lead to big wage gains people at the lower end of the income distribution.
I don't think to the extent that the changes in the pandemic actually did, to a degree, change household and corporate balance sheets, particularly household balance sheets... It did lead to big wage gains people at the lower end of the income distribution.
Klein: That might have had some of an impact. I don't know how long lasting that's going to be, but something. I mean, it's not anywhere near the scale of what we saw, say in the 1940s, where I think is the closest analogy we can think of, but it was something. But yeah, I think that it's reasonable to be confident, or at least not unduly concerned. You mentioned the deficit shrinking. I think this is another way of looking at it. There was a huge fiscal impulse in 2020 and 2021, which I think was appropriate. We talked about this earlier, but it's also, that was it. It was basically a one off, and it led to a big one time bump in household savings, corporate savings.
Klein: Those are going to get... Either they're going to get liquidated or they won't, but either way it's not going to keep happening, as you said. Unless we're in a world where every year, the government sends people $2000 per person, which I don't think is going to happen. In fact, I think for better or worse, what we've experienced over the past six months is going to make that less likely in the future. I think that's probably for the worse, actually. So, those are the kinds of things I think we should be thinking about, in terms of the longer-term outlook.
Klein: And, this gets back to the counterfactual of the pandemic. You had a situation where people stopped producing a lot of stuff, because they literally couldn't, and the government stepped in and gave people a lot of money. We can argue about whether they could have done it more efficiently and more effectively. I think that in the US it was unfortunate that a lot of ties between workers and businesses were broken because businesses were basically allowed to shut down or lay people off, which is different from what you saw in Europe or Canada, but you did give people a lot of money. So, on the whole, household income was preserved very well. In fact, arguably better than it would have been had there been no pandemic. But it makes sense that at some point, unless people spent literally none of that money, it would be strange if there were no kind of offsetting increase in prices of stuff eventually, because if you have all that extra spending power, it goes somewhere. Some of it's going to go into higher production of stuff, which is the optimistic case. Some of that is happening. I thought we had some spare capacity before the pandemic, but then some of it's going to prices. But then, that's a one time shift. That's a level shift, that's not a change in the rate.
Beckworth: Exactly, yep.
Klein: And so yeah, to your point, it takes a lot more catalysts, and again, it's possible, but it's not something we're seeing yet. It takes a big leap of faith to argue that we're going to actually see this kind of inflationary self-reinforcing spiral.
It takes a lot more catalysts, and again, it's possible, but it's not something we're seeing yet. It takes a big leap of faith to argue that we're going to actually see this kind of inflationary self-reinforcing spiral.
Beckworth: Yeah, in some ways I think it takes more faith than the position that we hold. But to your point, yes, there will be price level effect. There's no doubt about that. I mean, maybe on some commodities it'll come back down, but I think overall, you're right. The fiscal impulse, the higher prices on some goods and maybe some services, that will be permanent. But the question is, will there be a permanently higher inflation rate? And to generate that takes a lot more work, a lot more faith as we just said. I just don't see that in the cards. As you mentioned, the past six months, if anything's going to impose more fiscal discipline, the concerns...
Beckworth: Here's another thought I'd had, Matt, about the past six months. About this high inflation run, if we do get to the other side, and the Fed comes out looking like oh, you actually worked, you did a good job, this could actually be a blessing in disguise. The silver lining here might be the Fed can say, "Look, we navigated you guys through this crisis, we came out the other side. Inflation did return back close to our target, so in the future chill. Don't panic. We've learned a lot ourselves, you've watched us grow, we've grown together. Relax." Do you think there will be some learning about the average inflation targeting framework because of this experience?
Klein: I hope so. I feel like... It was Bernanke who wrote the paper years ago, I think, about how oil shocks, central banks should basically ignore the impact on inflation, right? That makes sense. If you're going to adhere very rigidly to a given inflation target, and then the price of a particular item or set of items skyrockets for reasons that have nothing to do with macro policy, the only way to maintain that inflation target is if the prices of everything else go down, and imposing that on an economy that is not used to prices going down a lot is going to be extremely painful. Therefore, the standard argument is you shouldn't do that. You should let overall inflation go up by having the prices of everything else go at sort of their normal rate, and then the one thing goes up a lot, which is essentially what we're seeing now. It's kind of interesting to me that there's an argument about whether that...
Klein: Now, people are saying, "Maybe we didn't mean that." That's essentially what we're seeing now, so I think yeah, you're right. If it works out well, hopefully it will lead to some kind of long-term lessons. You mentioned this before, but I think there's also a big lesson for fiscal policy, too, which is that if there hadn't been the fiscal response, repeated fiscal response... There was the initial CARES Act, then there was the reupping stuff over the summer, then there was the end of 2020, then there was the American Rescue Plan Act. The cumulative amount was massive, and of course, it was offsetting a really massive shock, so it makes sense. But the Fed's actions were extremely helpful, but would not have been very helpful without that.
Klein: So, I think that the pairing of those two things worked really well, and I think it would be very encouraging if we do learn the lessons from that. I hope that we do, and that we don't end up saying, "Oh well, that was a mistake. We'll never do it again," or, "We only do that during global pandemics, that hopefully won't happen again like that.” Maybe they will, but that's a different story. I don't know. I do like to be optimistic and say we'll learn valuable lessons from this, but I can also see it going the exact opposite way. So, we should be careful.
I do like to be optimistic and say we'll learn valuable lessons from this, but I can also see it going the exact opposite way. So, we should be careful.
Beckworth: Well, that's one reason we do this show, Matt, is to get the message out there. But absolutely, and again, going back to this point I mentioned earlier, the fact that we did keep dollar incomes in the aggregate relatively stable, it spared us a much worse outcome, right? We could have had another financial crash, banks could have done really poorly. There was this whole debate surrounding the Vice Chair of the Federal Reserve for Financial Stability, Randy Quarles, and he had a speech where he goes, "Look, banks did really well." And then a bunch of the critics were like, "Oh, that's because you guys threw all this money at them." I replied, "You know what? That shows, though, stable nominal incomes might be a sufficient condition for financial stability." They didn't like that point, but I think it is an important lesson to learn.
Klein: It's funny, because I did write a piece about this, and I would say I'm somewhere in the middle, which is yes, obviously if you prevent all downturns and loan losses then you won't have loan losses and banks will look like they're doing well, but the flip side is if you create that expectation going in, then that will lead to greater risk-taking behavior by banks and borrowers. So, it becomes increasingly expensive to sustain that. My take was that you basically, the reason we have bank regulations isn't because banks will blow up without them necessarily, because we can always prevent that, but rather that it's sort of like an excess profit tax. The real problem with too big to fail is essentially a distributional argument, and the behaviors that it encourages rather than that they will literally blow up. But that's a different... That's a whole other... We can go on that for another 20, 30 minutes.
Beckworth: We could have a whole show on that discussion for sure. Well, in the time we have left, I want to move to another article you wrote recently, and this deals with interest rates. You've been talking about interest rates, they're still low here, but let's move down to the short end of the yield curve, and let's talk about any lessons we've learned about central banks managing interest rates. I want to go to Australia, where they actually implemented yield curve control, and they're trying to pull out of it. Maybe remind our listeners, what is yield curve control, and what is the Reserve Bank of Australia learning about how to function with it?
Yield Curve Control and the Reserve Bank of Australia
Klein: First of all, they don't call it yeld curve control. They call it a yield target on a specific yield, and in fact, they say that it's not equivalent to the yield curve control as practiced by Bank of Japan or the Fed of the past. But. So, yield curve control as it was done in the US in basically, during WWII was the Fed said, "This is the interest rate on three month bills. This is the interest rate on 10 year notes. Don't fight us on it." And that actually worked. What was interesting was that first of all, there's two different rates, and then the other thing that was interesting was that the Fed basically had to do nothing to guarantee the 10 year rate. It was at 2.5%, I think. The thing that they actually had to intervene on quite a bit was on the short end, later on in the 1940s.
Klein: Bank of Japan more recently established a yield curve control, the target for the 10 year rate, and basically trying to make sure there was a spread between the short rates and long rates so that banks wouldn't systematically lose money. Europe's sort of done this implicitly, but not with an explicit target. In Australia, they did something a little different, which is that in the course of their response to the pandemic, they said, "We're going to target the interest rate," on what they call the three year government bond. One thing I learned that was interesting is that they don't actually issue bonds very frequently, so once or twice a year at the most. So, it's just a particular bond, once a three year bond changes...
Klein: Anyhow, the big reason for that is in Australia, basically everyone borrows either floating rate debt, or fixed rate debt means three years. It just happens to be an important industry for mortgages and business loans and stuff. There are only two main interest rate futures in Australia, three years and 10 years, so again, three years is a thing to target. They said, "We want it to be this," and then they lowered it, and it worked actually very well. Basically, at the very beginning they bought a few bonds, but that was it. They later started their own bond buying program back about a year ago, because they were worried about the Australian dollar appreciating too much against things like the US dollar because everyone else was buying bonds and they weren't. That's different from this. You get to the spring and they're already sort of thinking about rolling off this program.
Klein: They basically were telegraphing it to people that, basically, there only are so many bonds, every meeting they can say, "Do we want to keep this bond or go to the next three year bond?" It's like April, November, that kind of thing. They said, "We're going to think about it," which, back this March I think they said they were going to start thinking about it which was a clue... Because if they did switch, once it stops being the three year bond, then it becomes much less important. It's not tied to the futures markets and it's not tied to the rates on mortgages and stuff.
Klein: So, that was already a warning signal, but they did their own version of what the Europeans do with the TLTROs. You let banks borrow for three years, that is a crucial thing. Three years, and subsidized rates if they make loans to businesses or whatever. They said in June that they were going to stop doing that. Again, that was a three year thing, they introduced that with the three years being a key thing, that was already done, then in July they said, "We're going to stick with the April 2024 bond," which was going to stop being counted as three year bonds soon.
Klein: You get to September, that bond wasn't even in the basket of three year bond futures at that point. And then what's interesting is, even though that bond yield didn't go up, you already were seeing other bond yields in Australia start to move, in particular the November 2024, which is the three year bond, was going up a lot. Basically the implied one year rate, two years forward, as it were, was going up quite dramatically. Swap rates, which the RBA, Reserve Bank of Australia, had not been targeting. Those started to move up in advance, and that's actually what the pricing of mortgages and business loans... I mean, normally the swap rates and the bond rates move together, but there was a divergence already.
Klein: So, there was already a lot of signals that this was kind of done, and the RBA at this point was like, "Well, this particular bond is not doing anything for us. We own most of what is outstanding. It's not tied to any economically relevant rate anymore. The economically relevant rates are doing their own things. It doesn't really matter." So, when someone decided to challenge it, they were like, "Fine. Whatever. We'll give up." I think they kind of knew. At some point, there's no way to get out of this policy without it being, okay we give up, and it's going to be a snap move, which is what happened.
Klein: There wasn't actually a lot of trading... I mean, someone lost a bunch of money, but it wasn't really a big deal. One thing that's kind of interesting is that because both households and businesses borrow so much alternating between variable and fixed-rate debt, because of the variable rate debt is tied to what they call the cash rate, or things very close to that, which is still zero. It's very easy to refinance into something, and if you look at the weighted average mortgage rate right now in Australia, which they published, it's been going down throughout this entire period because people just are, “Okay, I'm not going to get a fixed, I'm going to get a floating."
Klein: Their experience was, this was fine for what we wanted to do. The market in the US is so different in terms of how people borrow in the term. I'm not sure what lessons they immediately would draw. I mean, maybe just relevance for the UK or Canada, but they have a lot of shorter term borrowing, too. It's interesting to see how it played out, and I guess it was balance sheet efficient for awhile, in terms of not having to actually do a lot of transactions.
Beckworth: Quick question on Australia's mortgage market. You got me interested now. We have the 30 year kind of standard, they've got the three year. Do most people finance if they want a fixed rate, with a three year? And what do they do, roll it over once it matures? How does it work there?
Klein: Yeah. Either they roll it over, or they have variable rate. Actually, the US situation is extremely unusual. 30 year fixed rate mortgages basically do not exist outside of the United States, and the reason they exist is because the government created them and created an elaborate subsidy system for them in the '30s, and that's because we used to be like other countries, where you had two to five year mortgages. But then during the Depression, people couldn't roll over them, and then they all had foreclosures, and then the banks went bust. So, they said, "Let's not do that." But other countries that didn't have those degrees of bank failures and foreclosures... If you look at Canada, you look at the UK, you look at Australia, you don't see... I think in the UK, a long term mortgage is five years, which I guess is a little longer than Australia, two is pretty common, I think. So yeah, a lot of people will just roll it over. Which I think, if we're really getting into the weedier stuff, but it means that short rate policy in these countries, I think, has much more of a direct flow through to economic conditions.
Klein: I mean, in the US we're always talking about like, "Well, what really matters is long rates, and the relationship between long rates and short rates is very unpredictable, so how does Fed policy work anyway?" It's fun to twiddle our brains over this, but if everyone is borrowing and floating rate debt, or close to it, then actually you can very clearly draw a link, and it's not rocket science or anything.
Beckworth: That's fascinating. Yeah, so the structure of the mortgage market can have a big bearing on how direct monetary policy touches the economy. Circling back to the... I want to say yield curve control, but they don't, but Australia's version of it, was there any major disruptions to the financial markets? Or any kind of spillover effects? And the reason I ask is because one of the critiques of yield curve control, at least in theory, is that it's easy to get in, but it's hard to get out.
Klein: Yeah, I guess it depends on your point of view. There are clearly some funds that were betting on the continuation of the yield target that lost a bunch of money, and that I think as a consequence of that, you can see on the same day a big spike in two year yields in countries that did not have these policies, particularly Canada and New Zealand. Probably someone was betting on all of these things, and they had to close out of their positions. But in the grand scheme of things, I don't want to say it completely reversed. The funny thing, too, is that if you look at what the RBA is actually saying about where they think the economy is going to be, they are actually much more... dovish isn't the word I would use, but you look at what's going on in the US versus Australia, there's a speech about this Philip Lowe did yesterday.
Klein: They're not looking to do their first interest rate increase from zero until 2024 at least, which is very different from what's in the US. So, the idea that a two year interest rate in Australia is much higher than what it was in the US, and is still high, it's kind of funny to me. But that's a separate point. You can see why the people who lost money would be annoyed, because irrespective... Yeah, I don't think in terms of major spillovers... Like I said, you can see it in a chart and it's interesting, but it's not like it led to some major financial crisis.
Beckworth: Very fascinating. Well, with that our time is up. Our guest today has been Matthew Klein. Matthew, thank you for coming on the show.
Klein: Thank you very much for having me.
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