Monday, November 15, 2010

QE2 is about rates, not prices

A big thank you to Fernando for stepping up and playing the Monetarist. If there's a better source for why Monetarists have no understanding of money, and therefore the economy, I cannot think of it. And if any of your are wondering, Fernando is not a plant! He's the real deal. I could not make him up if I tried.

In the last couple of posts I outline why QE2 is a non-event. I assert that 1) you cannot move consumption forward, and 2) inflation expectation has no channel that leads to CPI. Fernando makes two claims:
[If there was a positive inflation expectations shock]... I would buy commodities and demand a rise in my salary.

When people expect more inflation they tend to spend more today, velocity rises.
The scenario was a sober minded Brazilian rich in Cruzeiros circa 1979.

Fernando has not responded yet, but I think it's fair to assume that, in the face of inflation, the commodities he would buy would be commodity futures, not actual sheafs of wheat. So Fernando is swapping one financial asset (nominal savings) for another financial asset (commodity futures). This would increase the price of commodity futures, but as far as I know, futures are not part of CPI. Going long futures only makes sense if the anticipated inflation comes to be, and Fernando continues to come up goose egg for any actual mechanism for this inflation. If everyone anticipating inflation goes long futures, it will have no impact on actual inflation and that positioning will come to naught.

Real life actual third world countries take a different approach to expected inflation.

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Blogger Fernando said...

Frankly the reason I didnt respond is because you are making such an absurd claim I dont even feel like waisting my time, but I will. Like, seriously, you are claiming inflation expectations dont affect actual inflation?lol

I lived under brazilian hyperfinflation, it wasn't a money printing problem, it was a problem of everyone trying to get rid of cash, it didnt matter that people were in poverty, as soon as you got cash you tried to get rid of it because you knew the value was going to collapse. I sent you the NPR link that explained how they controlled expectations and ended hyperinflation

This was a clear cut example of expectations creating actual inflation

Furthermore I showed you link with the chart showing a tight correlation between actual inflation and iexpectations in the US, you complained some nonsense about Mishkin and refused to address the fact that your claims aren't supported by the data

ps:"This would increase the price of commodity futures, but as far as I know, futures are not part of CPI."
Actually futures buying do affect the CPI(at least for a number of commodities), given that the spot market is arbitraged with the futures delivery system
If oil was $100 in a near term futures contract but $80 in the spot, sellers would short contracts and deliver the oil instead of selling in the spot market(which would push spot prices up and futures down). Of course these discrepancies dont happen because of the arb'ing that goes on. Even futures buying at 2020 expirations can affect spot prices today IF the discrepancy is large enough to offset cost of capital among other things
That fact that you are not aware of this is amazing

2:21 AM  
Blogger winterspeak said...


Welcome back. And yes, this is exactly my point. When people expect inflation they switch from the financial asset they expect to depreciate to another financial asset that they hope will not depreciate.

This is *not* consumption.

The (garbage) macro models tie inflation expectations to velocity via the consumption channel (ie. households will move consumption forward). This mechanism simply does not exist in real life, because it is extremely difficult to move consumption forward. It is even more difficult with an overleveraged household sector.

Your oil example illustrates this perfectly. Lots of financial speculation, and no real impact. The cost of actually arbing futures by leasing oil tankers is very high. Is this now your new mechanism for how expectations actually impacts CPI: people speculate on futures markets, so arbers fill up warehouses of wheat, the shortage of which drives by prices? Really?

10:31 AM  
Blogger scharfy said...

This post/concept, on the difficulties of pulling demand forward - has been haunting me for a good week now.

When you sculpt away all the fluff and speculation, which cause volatility but isn't actual demand, stimulating *actual* consumption is rather tricky...

Can't gas your car up more, can eat more food, can't buy more christmas presents, prepay 3 years of rent, or pre-purchase braces for your 14 year old...

So, forgive my ignorance, but what was the answer to the question - "what did they do in brazil circa 1979?"

I hope they didn't save more, did they?

I think this is a mind-bending topic... Bravo

11:59 AM  
Blogger Fernando said...

" The cost of actually arbing futures by leasing oil tankers is very high. Is this now your new mechanism for how expectations actually impacts CPI: people speculate on futures markets, so arbers fill up warehouses of wheat, the shortage of which drives by prices? Really?"

1st, it has nothing to do with leasing oil tankers, people with oil stored in Cushing have always the choice of either sending the oil through pipeline to a refinery(the spot market) or delivering against a future contract in Cushing. This keeps the 2 market prices IN LINE(more or less, there are some small technical differences)
This also applies to a NUMBER of commodities, the producers have the choice to selling in the spot or delivering against futures. You should study the futures market a bit more with your friends

In 2008 your 'futures speculation that has no impact' lead to a 5% yoy print in the headline CPI. That was a clear case of a commodity futures speculation period that lead to an actual price impact. Furthermore I recall my mother storing several months worth of beans and rice during hyperinflation, this is not necessary these days with a stable currency

Maybe the word 'Velocity' is confusing you, think of it as money demand, if that goes down, people will try to get rid of cash, it doesnt matter that its a swap one of asset for another, prices will rise(and the 'price' of the currency fall), this means no Japan, thats what matter. Balance sheet constraints wont make people behave like morons and not get rid of a collapsing asset

3:23 AM  
Blogger Игры рынка said...

In 2008 your 'futures speculation that has no impact' lead to a 5% yoy print in the headline CPI. That was a clear case of a commodity futures speculation period that lead to an actual price impact

I love this argument. But what about inflation expectations? Where are they two years later?

You mother stored beans not because she expected the price to rise but because she expected not to be able to buy. This fact has to do with capacity to produce. It is a bit different twist to your story, isn't it? And by the way, I lived through a hyperinflation so I know what I am talking about first-hand.

The oil effect works both ways. When consumers agree to cooperate you can push futures to 160 and dump this increase on consumers. But when they stop cooperating then no price of any futures can make them drive. And then futures market gets inline with the spot. No magic here. Spot market is the dog, futures market is the tail.

7:39 AM  
Blogger Greg said...


Part of the flaw in your story is that in aggregate we cannot all get rid of any asset. Every dollar holder will not be able to unload it if they are all trying at once. This is part of the fallacy of composition that way too many neoliberal macro models ignore.

And the beauty, if you will, of flexible exchange rates is that moves to unload will have a yo yo effect and put more upward pressure on the value of the currency. It becomes self correcting to a degree. Now, for sure there are different currency regimes operating today, many have pegs to something (China) or are not truly sovereign (all Euro users) so the picture is muddied and fraught with potential stress points. True sovereign currencies like Japan, Canada, the US, Australia and Britain have will behave in the manner previously described, but the world is more complex than that I know.

7:52 AM  
Blogger winterspeak said...

Игры рынка & Greg:

It is even worse for Fernando, because now he isn't distinguishing between cost-push and demand-pull inflation.

Remember, the problem we're trying to solve for here is unemployment caused by lack of aggregate demand. The idiotic economist model has a dumb discount function that sees consumption as something that can be deferred or moved forward symmetrically. "If you expect deflation, you defer consumption, and if you expect inflation, you move consumption forward."

This is nonsense because consumption is not symmetric -- you can defer it but it is incredibly hard to move forward in any meaningful way.

Nevertheless, Fernando soldiers on, repeating the nonsense in the textbook, and ends up with arbitrageurs hoarding warehouses of commodities, leading to $5 gasoline which... turns savers into consumers again.

Remember when gas was actually at $5? It was not a boost to the economy.

So we leave Fernando in his Sao Paolo apartment, pondering his stack of Cruzeiros. He's going to drawn the balance down -- how is unclear, but it involves commodities. However his apartment is small. Think Fernando, think!

9:44 PM  
OpenID pebird said...

Come on, unless you are a producer or consumer of the commodity you NEVER take delivery. And there is a big difference between hedging due to supply/demand uncertainty and speculating (or shifting asset composition).

Most of what we hear in the media of "inflation expectations" are market actors playing their book.

As speculators realize that real demand will not meet expectations prior to expiration, there is a squeeze, assets get reallocated across shorts/longs and the game starts again.

Unless the stuff actually gets consumed, there is no inflation pressure (other than what we hear on CNBC).

Inflation = demand outstrips economic capacity to produce goods & services.

9:11 AM  
Blogger winterspeak said...

Pebird: yeah, the futures market just doesn't work the way people think it does.

Inflation can be driven as you suggest but it can also be cost push and it can also come from large negative real shocks. In mixed currency regime it could also come from portfolio shifting

11:13 AM  
OpenID pebird said...

I guess in my view, a negative real shock is a diminution of economic capacity (less real resources available).

I think cost-push "inflation" is more of an income reallocation story between market participants, rather than a generalized rise in cost due to demand/capacity mismatch.

The last 70s oil shock was a combination of both - a short-term engineered supply constraint combined with a desire to break established income patterns for labor (union contracts, escalators).

Coincidentally this period was also when US home prices began their initial jump from a period of relative stability. Funny that a commodity price "shock" would wend it's way through the system at the same time as higher home prices - had not occurred in prior post-WWII inflationary periods.

2:19 PM  
Blogger winterspeak said...

pebird: Yes, a negative real shock is a diminution of economic capacity. Salting all your farm land, for example.

But I think cost-push is real as well, particularly in energy. If oil goes up, yes income is reallocated between participants, but this isn't a neutral reallocation.

Good observation re: the 70s. Something else very special happened around this time, related to house prices. Can you guess what it was?

3:17 PM  
Blogger Bill said...

Hey winterspeak,

I've been checking for your posts in my RSS for months, assuming you just weren't posting anything. I just subscribed again, gonna have to go back and read everything I missed. You're the main reason I began to understand ideas of PK/MMT. Gonna have to read your back posts.

Did you change the blog somehow which made my old subscription useless?


6:53 PM  
Blogger winterspeak said...


Yeah -- Google changed how they supported the service, so I had to move a bunch of stuff around. It might have killed RSS. Hope it works now!

Welcome back!

7:12 AM  
OpenID vimothy said...


Why are you assuming that agents only shift out of "money" into another financial asset? If we make this assumption, then I agree that rising inflation expectations are unlikely to lead to consumer inflation, but it is not obvious to me that this assumption is wholly realistic.

For instance, if consumers expect prices in the next period to be higher and the real value of their savings to be lower, the may chose to dissave and increase their consumption now.

Similarly, if producers expect input prices to increase in the next period, they may raise prices to cover expected costs.

Why do you find these outcomes so implausible?

12:27 PM  
OpenID vimothy said...


Imagine an economy with a fixed stock of "money" assets. In a situation where agents want to get rid of money, it is precisely because this is not possible on aggregate that the price of it must fall (i.e. cause price inflation in whatever it is trading against). This is of course analogous to the fed funds market and the way that the Fed controls interest rates.

12:37 PM  
OpenID pebird said...

Well, lets see ... I remember property taxes being reduced drastically in California in the late 70s.

The Prop 13 phenomena was in response to the homeowners protest at rising taxes - at that time tax rates were based on annual government assessment of property value.

I might be missing something else around that time - my perspective is US only.

9:01 AM  
OpenID pebird said...

BTW, with regard to the cost-push of oil - from a consumer perspective, as long as there is sufficient oil to meet the real demands of the economy, then it functions to reallocate income, as opposed to being a generalized inflation factor. The jury is out (IMHO) that the oil shocks we have experienced over the past decades are true supply constraints vs. market plays by cartels and competing economic interests.

Of course, income reallocation is not neutral (by definition). Inflation is different in that, by being generalized across the economy it impacts everyone from a consumption perspective. As we know, from a financial perspective, it tends to favor debtors over creditors.

9:10 AM  
Blogger The Arthurian said...

pebird says BTW, with regard to the cost-push of oil - from a consumer perspective, as long as there is sufficient oil to meet the real demands of the economy, then it functions to reallocate income, as opposed to being a generalized inflation factor.

My notion, for what it's worth: Suppose there's an oil-price shock that wants to create a recession. The Federal Reserve may respond by "printing" some extra money (excuse the metaphor) to avoid recession. One of the Fed's mandates is to promote growth, right?

So the Fed's response to the cost-push shock is to provide money enough that prices in general go up. That said, the question is: Is this demand-pull inflation, or cost-push? I say cost-push, because it started with a cost problem.

On this model, the single most significant cost-push force since World War II is the rising factor-cost of interest due to our increasing reliance on credit. Not oil.

10:41 AM  
Blogger winterspeak said...

vimothy: I'm not sure I'm assuming anything. I'm just finding it difficult to see how anyone can shift consumption forward. The economic models assume consumption can be moved forward and backward symetrically--I'm just struggling to see this in practise.

Certainly, if you look at third world countries with histories of inflation, you don't see aggressive consumption. You see alternate forms of savings.

I asked Fernando to consider a Sao Paolo resident with many cruzeiros in 1979 -- what should he do? Fernando suggested going long futures. This may be a good investment strategy, but I don't see how it's going to feed into CPI.

If you have a better response on how to move consumption forward, I'd be interested to hear it.

pebird: Yes, California passed prop13 in the 70s, but this was in response to rising prices, not what caused them. The big change was mortgage securitization. Securitization loosens credit, so you get higher prices, and more bad loans.

As for "cost-push", I just want to differentiate between a scenario where rising input prices drive costs up, and one where you have too many dollars chasing too few goods. Other things can increase CPI too.

Arthur: In your scenario, it is cost push. you're going to get higher prices no matter what. You do get to pick how much unemployment you want with that inflation though.

your focus on credit is astute

1:32 PM  
OpenID vimothy said...


That is because you are framing the issue in terms of "moving consumption forward"--of course it doesn't make sense to "move consumption forward".

Nevertheless, if you think the value of an asset will fall, you may want to move out of this asset into another. This then will affect the price of said asset "self-fulfilling prophecy" style (or as in the Salant/Krugman currency crisis model).

I may not be able to move consumption forward, but I can choose to save more out of income, or choose to save less and consume more.

There is a direct link between nominal spending and nominal income. Anything that increases nominal spending will increase nominal income. Expectations about the future path of nominal income obviously form part of the basis for agents' current spending patterns. The link between expected and actual inflation therefore seems straightforward.

4:18 PM  
Blogger winterspeak said...

vimothy: You're begging the question. I don't deny a direct link between nominal income and spending. I question the connection between inflation expectations and anything! And it's not me framing the issue as "moving consumption forward" -- this is the standard framing for how agents decide how much to spend or save out of income. Standard economics always frames this as a choice between present and future consumption, and always has an inflation adjust discount rate. I'm saying that when you look at the actual mechanisms available, the equation does not seem pertinent to real life.

This is worth posting on again.

10:51 AM  
Blogger Will said...

@winterspeak, interesting that you mention hoarding wheat. I just, a few minutes ago, read about Pauwels van Dale, an Antwerp merchant who bought wheat and kept it off the market to drive the price higher. In September 1565, the warehouse collapsed from the weight of his hoard.

/The Great Wave: Price Revolutions and the Rhythm of History/, David Hackett Fischer (Oxford University Press, 1996), p. 88

9:59 AM  

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