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Good morning The retail price of beef has hit a record high in the U.S., driven by droughts across America’s cattle-producing regions. We’ve tried to stay calm about inflation over the past few years, but if the steak becomes unaffordable, the Unhedged team will succumb to economic panic (see below for even more rational thinking about the connection between inflation and sentiment). Email us at [email protected] and [email protected].
The poor consumer sentiment is not surprising
A common complaint among Democratic supporters is that Joe Biden and his party don’t get credit for a strong economy with employment and real growth levels above those of the rest of the developed world. And sentiment is not improving, even as inflation falls and markets recover. The preliminary November reading for the University of Michigan Consumer Sentiment Survey was 60.4, the lowest level since May and in line with a miserable sideways trend dating back nearly two years:
At Unhedged we don’t find this surprising at all. Prices have increased by almost 20 percent since the start of the pandemic; Food prices have risen by 24 percent and energy prices by 37 percent. It is only natural that the world becomes vicious and unpredictable as a result. It doesn’t matter that wages, on average, have kept pace. If I get a raise, I’ve earned it; it is not just a symptom of strong national production. When food prices skyrocket, it’s a bad economy or the government’s fault. It also doesn’t matter that the inflation rate has fallen. People don’t see how quickly the amount in a gallon of milk changes. You see a price that is significantly different from what it once was.
Still, one might ask why sentiment hasn’t improved even though arguably the most important price of all – gasoline – has fallen over the past six weeks. This can be explained by the fact that although consumer sentiment can fall quickly, it is slow to recover. It’s like a personal reputation: built up slowly, gone in an instant. Note that sentiment (the blue line in the graph below) fell very quickly in the recessions of 1991, 2001 and 2008, but then took some time to return to consistently high levels.
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The current moment may seem a bit strange, as consumer sentiment and changes in real spending (the pink line) appear to follow each other historically, but are now falling apart. How can people feel like times are bad and still happily spend money? Well, if you accept that people believe that changes in nominal prices are inherently bad, no matter what nominal incomes do, then this conundrum goes away. Mood and spending don’t have to go hand in hand.
Yield curve control: a lesson (or warning) from Japan
Last week in Unhedged, Jenn Hughes asked whether yield curve control could come to the US. That would be an extreme outcome, but it only takes a little imagination to see how we would get there. A historically high budget deficit in peacetime is suddenly accompanied by significantly positive real interest rates; Politicians remain hostile to tax increases or spending cuts; Bond investors get nervous and an external shock sends yields soaring. The central bank concludes that debt monetization is the least bad option.
Does this make you feel anxious? Fiscal doves have a reassuring answer: Japan. Government debt there is more than three times GDP, and the Bank of Japan has bought most of the government bonds for a decade without causing a catastrophe. And now Japan’s economy is finally experiencing inflation and nominal wage growth as companies slowly reform. Real GDP is expected to grow by 2 percent this year, predicts Marcel Thieliant of Capital Economics. Extraordinary fiscal and monetary policy interventions appear to have bought Japan the time it needed.
But a new paper by YiLi Chien of the St. Louis Fed, Harold Cole of the University of Pennsylvania and Hanno Lustig of Stanford suggests that Japan’s example is not as encouraging as it seems. Chien, Cole, and Lustig argue that Japan averted a financial crisis by, in effect, engaging in massive self-financing carry trades over the past three decades.
In a standard yen carry trade, investors take advantage of low Japanese interest rates by borrowing yen, exchanging it for dollars, and investing the dollars at higher U.S. interest rates. This is risky as any currency can move against you. But it can be lucrative.
The Japanese authorities have done something similar, financing risky investments with artificially cheap financing from Japanese households, using the banking sector as an intermediary. The authors (hereinafter abbreviated CCL) see two problems. Japan’s financial and monetary system acts as a giant transfer from the young, poor and financially uninformed to the older retirees, the financially sophisticated and the state; and the trade could ultimately fail.
CCL presents a composite balance sheet for Japan’s public sector, including the central government, the BoJ and the state pension fund. It has changed a lot since the 1990s (all numbers are shares of GDP):
On the liabilities side, note the increase in bank reserves by around 100 percentage points and on the assets side, the increase in stocks and foreign securities.
CCL offers the following theory of the case:
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The Japanese public sector borrows at shorter maturities through bonds and notes (average maturity is seven years). Most importantly, the central bank issues bank reserves in exchange for bonds, keeping interest rates low under quantitative easing. This is debt monetization.
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Through the state pension fund, the public sector invests in longer-term risky assets such as stocks and foreign securities (average maturity 23 years). These positions are not hedged against interest rate or exchange rate risks, so the government “carries trade risk premiums for the crop.”
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The BoJ’s QE pushes down Treasury yields and keeps the cost of Treasury borrowing low. This allows the government to issue overpriced bonds to raise new debt, since retail investors know they can easily turn them around and sell them to the BoJ.
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The public sector is in long-term debt; it wins when interest rates fall. This trade brings in a lot: up to 3 percent of GDP per year. This roughly corresponds to the gap between taxes and government spending promises (excluding interest payments) of around 3.5 percent of GDP.
It is a carry trade in which the investor sets his own financing costs. The additional fiscal capacity created by cheap financing – and the fiscal penalty when financing costs rise – gives the public sector a strong incentive to keep real interest rates low.
But while the public sector wins, many Japanese lose. Most households, especially younger ones, have few financial assets. Wealth is disproportionately held in bank deposits, which amount to 200 percent of GDP, have no maturity and provide virtually no return. Some Japanese invest in stocks (38 percent of GDP) or have private pensions or insurance (98 percent of GDP). But overall, surpluses are being shifted from deposit-holding Japanese to the state and pensioners.
Is this setup stable in the long term? We put this question to Stanford’s Lustig, who argues that this is not the case. He draws an analogy to underfunded U.S. pension systems that are taking more risk on the asset side of the balance sheet to improve funding ratios in the hope of better returns. The danger is that mandatory liabilities are pitted against assets that may lose value. “The Japanese government made all these risk-free promises to retirees and issued bonds that were supposedly risk-free. But on the asset side, they are increasing equity exposure quite dramatically,” he says. “It doesn’t end well unless you’re very lucky. They could have poor stock returns and end up with an even larger deficit.”
Asked what lessons he learned from Japan for a U.S. context, Lustig added: “Central banks can be pretty flattering to your estimates of fiscal capacity.” But as they step back, you realize it’s a lot smaller than you thought. ” (Ethan Wu)
A good read
“Far from being a stock game, private equity is a debt game where the economics are driven by the cost of money.”
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