Fed can't keep the rates low

[wabuffo]

Can you expand on this? "Common sense" would seem to say that higher taxes would decrease inflation since it reduces the money supply. I'm out of my element here so your insight is much appreciated (as always).  

 

There is a difference between tax RATES and tax REVENUES.   Economists (and the Fed) always seem to assume that a higher tax rate will lead mechanically to higher tax revenues - thereby reducing the deficit and vice versa.  It just ain't so.   Here's a chart of US Federal Receipts as a % of GDP (since we measure deficits on the same basis as a % of GDP).

 

 

In the 1950s and early 60's the top US tax rate was 91% (!!)  During the late 80's the top rate was down to 28%.  Other than recessions which always reduce tax revenues, Federal tax revenues always seem to bob around 16-17% of US GDP - whether rates are high (90%) or low (20%).  

 

However, I believe that the high rates of the 1950s-1960s created inflation.  It was masked at first by the US peg to gold but inflation exploded out into the open after the peg was severed in August 1971.   The great inflation of the 1970s was tamed, not by Volcker (I am in a minority in this as I believe Volcker was ineffective as a Fed Chairman as well as I’m a big skeptic on how much power the Fed actually exerts on inflation) but by the huge tax cuts of the Reagan administration.   The top rate was 70% when Reagan began his Presidency in 1980 and was down to 28% when he left in 1988. 

 

After Clinton cut the capital gains tax rate too in 1997 to 20% (and significantly relaxed the tax on gains from selling one's house) - these additional tax cuts actually led to deflation as the budget deficit slipped into surplus from 1998-2001.   This one-two of 1) increasing the after-tax equity value of the nation's housing stock - plus 2) causing deflation -- sowed some of the seeds for the housing crisis to come.  But that's another story.....

 

wabuffo

Edited June 25, 2021 by wabuffo

[spartansaver]

4 hours ago, wabuffo said:

Can you expand on this? "Common sense" would seem to say that higher taxes would decrease inflation since it reduces the money supply. I'm out of my element here so your insight is much appreciated (as always).  

 

There is a difference between tax RATES and tax REVENUES.   Economists (and the Fed) always seem to assume that a higher tax rate will lead mechanically to higher tax revenues - thereby reducing the deficit and vice versa.  It just ain't so.   Here's a chart of US Federal Receipts as a % of GDP (since we measure deficits on the same basis as a % of GDP).

 

 

In the 1950s and early 60's the top US tax rate was 91% (!!)  During the late 80's the top rate was down to 28%.  Other than recessions which always reduce tax revenues, Federal tax revenues always seem to bob around 16-17% of US GDP - whether rates are high (90%) or low (20%).  

 

However, I believe that the high rates of the 1950s-1960s created inflation.  It was masked at first by the US peg to gold but inflation exploded out into the open after the peg was severed in August 1971.   The great inflation of the 1970s was tamed, not by Volcker (I am in a minority in this as I believe Volcker was ineffective as a Fed Chairman as well as a skeptic on how much power the Fed actually exerts on inflation) but by the huge tax cuts of the Reagan administration.   The top rate was 70% when Reagan began his Presidency in 1980 and was down to 28% when he left in 1988. 

 

After Clinton cut the capital gains tax rate too in 1997 to 20% (and significantly relaxed the tax on gains from selling one's house) - these additional tax cuts actually led to deflation as the budget deficit slipped into surplus from 1998-2001.   This one-two of 1) increasing the after-tax equity value of the nation's housing stock - plus 2) causing deflation -- sowed some of the seeds for the housing crisis to come.  But that's another story.....

 

wabuffo

Thank you for explaining. It will take time to digest. Whenever I read your posts it's a good reminder of how little I know, and how far outside my circle the macro world is. 

[TwoCitiesCapital]

On 6/14/2021 at 2:35 PM, TwoCitiesCapital said:

But I'm not currently convinced ANY of that will happen into 2022 which means after the one-time transitory impacts of higher prices in 2021, nominal prices will begin to revert to the sub-2% inflation mark we were seeing pre-pandemic.  

 

On 6/15/2021 at 4:52 PM, TwoCitiesCapital said:

So who cares that donuts were up 50% over the past 2-years? That impact is already captured in today's inflation figures and bond yields. All that matters going forward is if they go up another 50% or more over the next 2. B/c if they don't, the impact is disinflationary.

 

 

 

Quoted these above comments b/c they're all relevant to what is happening now as demonstrated by lumber and housing. Substitute donuts w/ "lumber".  

 

Lumber is now down 50% from it's 2021 highs just a few months back. It is still up ~100% from the price YoY, but that is a far cry from the 400% YoY rise that was seen in Q1. If these prices persist, the inflationary impact over the next 6 months shrinks dramatically from Q1 and will be a -50% YoY change in price by the time we get to Q1 2022. 

 

In addition, Redfin has suggested home buying activity is down 18% from the high point in 2021. Consumers respond to inflation - marginal demand is typically less at higher prices. That is unless if wages keep up. And thus far wages are NOT keeping up with the rise in home prices. I'm not predicting a dramatic drop in home prices - but a flattening from here is disinflationary if that translates to flattening of implied rents. 

 

We're probably not quite to the end yet. Many commodities, particularly energy, are holding strong and we might still have an infrastructure bill coming. But I imagine we'll start to see these things flatten out, or roll over, in the next 6-months and everywhere you look will be disinflation. 

 

[wabuffo]

it's a good reminder of how little I know, and how far outside my circle the macro world is. 

 

Me too.... still learning.

 

wabuffo

[Munger_Disciple]

wabuffo,

 

Interesting hypothesis on the relationship between higher tax rates and higher inflation. Do you think this relationship holds in other countries? I think most European countries seem to have higher overall tax rates than the US but there wasn't much inflation in the Eurozone during the last decade. 

 

-MD

[muscleman]

Thank you wabuffo. Could you please share some more analysis on why deflation in 2000 later caused the housing bust in 2008? I thought the loose lending standard was the cause. What's your analysis on housing right now?

[Guest]

On 6/25/2021 at 9:26 AM, wabuffo said:

Can you expand on this? "Common sense" would seem to say that higher taxes would decrease inflation since it reduces the money supply. I'm out of my element here so your insight is much appreciated (as always).  

 

There is a difference between tax RATES and tax REVENUES.   Economists (and the Fed) always seem to assume that a higher tax rate will lead mechanically to higher tax revenues - thereby reducing the deficit and vice versa.  It just ain't so.   Here's a chart of US Federal Receipts as a % of GDP (since we measure deficits on the same basis as a % of GDP).

 

 

In the 1950s and early 60's the top US tax rate was 91% (!!)  During the late 80's the top rate was down to 28%.  Other than recessions which always reduce tax revenues, Federal tax revenues always seem to bob around 16-17% of US GDP - whether rates are high (90%) or low (20%).  

 

However, I believe that the high rates of the 1950s-1960s created inflation.  It was masked at first by the US peg to gold but inflation exploded out into the open after the peg was severed in August 1971.   The great inflation of the 1970s was tamed, not by Volcker (I am in a minority in this as I believe Volcker was ineffective as a Fed Chairman as well as I’m a big skeptic on how much power the Fed actually exerts on inflation) but by the huge tax cuts of the Reagan administration.   The top rate was 70% when Reagan began his Presidency in 1980 and was down to 28% when he left in 1988. 

 

After Clinton cut the capital gains tax rate too in 1997 to 20% (and significantly relaxed the tax on gains from selling one's house) - these additional tax cuts actually led to deflation as the budget deficit slipped into surplus from 1998-2001.   This one-two of 1) increasing the after-tax equity value of the nation's housing stock - plus 2) causing deflation -- sowed some of the seeds for the housing crisis to come.  But that's another story.....

 

wabuffo

 

Thanks, Bill. That's a very interesting perspective and very different from the standard narrative. Always enjoy reading your thoughts. 

 

To me, a major reason inflation has been tame since the 80s is due to globalization and general wealth inequality. I mean, if the average middle class person has a lower paying job (adjusted for inflation), that has to affect inflation. If look at the current system as incredibly screwed up and I am expecting a significant, course altering scenario in the not terribly distant future.  

 

In my opinion (which isn't worth much) the only reason the economy is functioning at a reasonable level is due to "unlimited" government debt and artificially low interest rates. This all works well for investors for now but it's not "real". The government is basically creating money (piling up debt) to keep the wealthy on top and to keep things running. 

 

When this system breaks, it's going to be a bloodbath. What would things look like if the government were more disciplined like it was in the past (ie not creating trillion dollar deficits)? What would the market look like if not pandered to by the Fed? Where would interest rates be if left to their natural tendencies?

 

I'm not trying to turn this into political waste, but there are reasons that both sides are getting crazier and crazier. A fair system keeps people in the middle - a screwed up one makes people more radical. 

 

However, I'm always ready to be schooled. So feel free to tear me apart.

[SharperDingaan]

Think of inflation in the global context.

You export inflation when your inflation rate is higher than the other guys - you do that by offshoring your supply chain, and paying for the cheap goods in a reserve currency (USD). Domestic manufacturing and jobs, move to where production costs are substantially cheaper -  in return you get cheap goods, and less domestic inflation. Globalization really took off in the 80's, and has only recently begun to dial back.  

https://en.wikipedia.org/wiki/Globalization

 

NA is now onshoring its supply chains again (protectionism). So expect greater domestic inflation pressure, offset by ageing population, and changing tech (gas to EV vehicles, blockchain, etc). The chinese mystery - is whether domestic consumption is robust enough, to replace diminished exports as supply chains onshore?

 

Our own view (at the global level) is mostly net neutral NA inllation, impacting different segments of society very differently. China as a net neutral as well albeit with greater domestic stimulation, and focus on maintaining the Yuan/Renmimbi peg. Their current crypto crackdown is for a reason.

 

SD

   

 

[TwoCitiesCapital]

On 6/25/2021 at 5:01 PM, TwoCitiesCapital said:

 

 

 

 

Quoted these above comments b/c they're all relevant to what is happening now as demonstrated by lumber and housing. Substitute donuts w/ "lumber".  

 

Lumber is now down 50% from it's 2021 highs just a few months back. It is still up ~100% from the price YoY, but that is a far cry from the 400% YoY rise that was seen in Q1. If these prices persist, the inflationary impact over the next 6 months shrinks dramatically from Q1 and will be a -50% YoY change in price by the time we get to Q1 2022. 

 

In addition, Redfin has suggested home buying activity is down 18% from the high point in 2021. Consumers respond to inflation - marginal demand is typically less at higher prices. That is unless if wages keep up. And thus far wages are NOT keeping up with the rise in home prices. I'm not predicting a dramatic drop in home prices - but a flattening from here is disinflationary if that translates to flattening of implied rents. 

 

We're probably not quite to the end yet. Many commodities, particularly energy, are holding strong and we might still have an infrastructure bill coming. But I imagine we'll start to see these things flatten out, or roll over, in the next 6-months and everywhere you look will be disinflation. 

 

 

Chicago PMI came in today. Dropped to 66.1 vs expectations of 70 and a 75.2 from the prior month. The sharp drop is primarily caused by decreases in new orders and a reduction/slowing in order back logs. 

 

Reduction in supply constraints. Lower consumption. Disinflation. 

 

[Spekulatius]

On 6/17/2021 at 1:26 PM, wabuffo said:

Bond market is even LESS convinced of inflation after the Fed meeting acknowledging it and suggesting they'll accelerate rate hikes from prior projections. 

 

You are ascribing motivation when all that's happening is due to the plumbing.   The Fed turned on a valve ever so slightly (5bp) and of course the fluid dynamics took over.   Reverse repo jumped over $230b a few minutes ago (to a record $755.8b).

 

All while the US Treasury is reducing its net issuance of securities temporarily.   The Fed should've stood pat on IOER.

 

wabuffo

 

Interesting the treasury's cash balance has been going up (mostly due to taxes received and treasury's issued) not down as contemplated. it doesn't seem like they want to draw this down. Now at $852B.

[wabuffo]

Interesting the treasury's cash balance has been going up (mostly due to taxes received and treasury's issued) not down as contemplated. it doesn't seem like they want to draw this down. Now at $852B.

 

Good catch Spek!   It went below $600b in mid-June and looked like it was on track.  Then Yellen started going public about the looming debt ceiling at the beginning of August.  I believe something has been worked out as part of the infrastructure deal with the Republicans.   Because the US Treasury isn't just raising it due to less spending, their issuance of US Treasury securities has really ramped up since mid-June.

 

We'll see - and worth monitoring in July.  But something tells me a deal will be announced soon.  That means the downward pressure on yields might relax a bit (though yields never compressed as much as they should have if the TGA continued to slide down towards $150b.

 

wabuffo

[COBFInfinity]

When do you change the headline to "Fed CAN keep the rates low"?

[Gregmal]

5 minutes ago, COBFInfinity said:

When do you change the headline to "Fed CAN keep the rates low"?

Probably as soon as you're ready to start trading the "Fed Can't Keep Rates Low" theme again. So much of this seems to be about consensus/expectation and the trading thats follows. 

[COBFInfinity]

37 minutes ago, Gregmal said:

Probably as soon as you're ready to start trading the "Fed Can't Keep Rates Low" theme again. So much of this seems to be about consensus/expectation and the trading thats follows. 

I didn't make that trade in the first place. I think rates will still low indefinitely. I have doubts the Fed will raise the Fed Funds rate for many years to come.

[Gregmal]

Haha yea no I didnt mean "you" just a general "you" as in first person. When everyone thinks one thing is inevitable, its usually time for a change in direction. And vice versa. Even if rates are headed higher, the sentiment gets skewed on a short term basis and needs to settle so thats theres people on the other side of the trade. 

[KFS]

This may have already been shared elsewhere, so my apologies if this is a duplicate post.

 

The Power of the Fed | Watch S2021 E5 | FRONTLINE | PBS | Official Site

 

 

[gfp]

On 7/1/2021 at 6:54 PM, wabuffo said:

Interesting the treasury's cash balance has been going up (mostly due to taxes received and treasury's issued) not down as contemplated. it doesn't seem like they want to draw this down. Now at $852B.

 

Good catch Spek!   It went below $600b in mid-June and looked like it was on track.  Then Yellen started going public about the looming debt ceiling at the beginning of August.  I believe something has been worked out as part of the infrastructure deal with the Republicans.   Because the US Treasury isn't just raising it due to less spending, their issuance of US Treasury securities has really ramped up since mid-June.

 

We'll see - and worth monitoring in July.  But something tells me a deal will be announced soon.  That means the downward pressure on yields might relax a bit (though yields never compressed as much as they should have if the TGA continued to slide down towards $150b.

 

wabuffo

 

 

Hey wabuffo - thanks for all your educational posts on this.  It's been interesting to follow along.  The TGA balance seems to be back on track, declining most days here in July.  I noticed this CNBC article today, where only one of the 'experts' citied vague 'technical factors' as a contributor.

 

Daily statement -

https://fsapps.fiscal.treasury.gov/dts/issues

Wednesday's balance down to $657.542 Billion

https://fsapps.fiscal.treasury.gov/dts/files/21071400.pdf

 

https://www.cnbc.com/2021/07/16/the-mystifying-bond-market-behavior-could-last-all-summer.html

[wabuffo]

Hey wabuffo - thanks for all your educational posts on this.

 

gfp -- I'm really happy my ramblings are adding some value here....

 

 

wabuffo

Edited July 16, 2021 by wabuffo

[Guest]

Bill,

 

What are you thoughts on this? This seems related to the (same?) thing you've been talking about lately but perhaps I'm wrong. 

 

https://www.bloomberg.com/news/articles/2021-07-05/zoltan-pozsar-sees-a-1-trillion-problem-for-money-markets-ahead

[Cigarbutt]

^After wabuffo, i would say Mr. Pozsar is the person to turn to for an interesting and valuable perspective about these matters.

His notes are short and he uses helpful analogies (ie toilet tank mechanism analogy). His perspective was helpful when there was a repo 'crisis' in September 2019 (repo rates were shooting higher then, when it was realized that there was a level of excess reserves that was not, in fact, excessive, under present regulatory and capital restraints). So much for tightening and the  i- could-stop-any-time-i-like mentality.

 

His most recent take (and short term technical outlook vs debt ceiling discussions and all) is included here:

https://plus.credit-suisse.com/rpc4/ravDocView?docid=V7r9LA2AN-Vvd1

Mr. Pozsar describes a situation where basically all the cash that was 'spent' from the account held by the Treasury at the Fed has been rotated to the RRP facility (through money market funds). He expects the RRP to continue to build up. It appears that the Treasury will aim for about 450B in the account for the summer transition, a level higher than prescribed but apparently justified because of 'extraordinary' circumstances.

 

If you think it's possible to determine if the level of traffic at the Times Square intersection is a good indicator of the New York economy, then you may think that it's helpful to look into issues related to the central financial plumbing but it's mostly technical stuff, a topic for which Mr. Pozsar's provides a useful perspective.

The underlying fundamental assumption though is that market participants will cooperate in good times and collaborate in less good times. The momentum trend for now is for the Fed to continue to provide, ad hoc, more temporary technical adjustments that tend to get larger over time (as a % of the real private economy) and that tend to become permanent.

[wabuffo]

Bill,  What are you thoughts on this? This seems related to the (same?) thing you've been talking about lately but perhaps I'm wrong. 

 

PS, Zoltan has probably forgotten more about the US monetary system than I could possibly ever know and understand. 

 

So first of all you don't mess with the Zoltan!

 

 

The way I understand his argument is that he is picking on specifically the Fed's decision to expand the overnight reverse repo and to pay (in his opinion) too rich an interest rate on it (5bp).   He thinks this will cause a giant rotation between MMFs,  corporate treasurers and banks that due to the large flows involved could cause a problem somewhere in some corner of the monetary system.   He describes this move as the Fed "sterlizing" the massive growth in bank reserves/TGA drawdown due to the pandemic.

 

His thesis is that MMFs are going to shed T-Bills as they mature and plow into the o/n reverse repo facility because they can get 5bp and barbell their maturity profile.   This will, in turn, take deposits out of the banking sector as corporate cash holders go into T-Bills (better yields than banks or MMFs offer).   The result will be trillions of deposits moving out of the banking sector and reserves circulating back to the Fed via the o/n reverse repo.   I'm not sure why this rotation poses risks - but Zoltan thinks it might, at the margin.

 

wabuffo

Edited July 17, 2021 by wabuffo

[no_free_lunch]

Canada's central bank will hold the line while inflation runs at and beyond the high end of it's inflation target.  I continue to believe that inflation will be primarily to assets and less so to consumer goods that make up CPI.    It seems the central banks will just ignore inflation as long as possible and keep rates suppressed.   I am not sure how it plays out, so many possibilities, but given that a number of commodities are now coming back down and given how long ago the money printing happened, I could see the inflation hit being transitory.

 

Quote

Still, the good news related to an accelerating recovery could be partially offset by consternation over the inflation forecast, since it shows the central bank has chosen to put employment ahead of its target for annual increases in the Consumer Price Index.

 

The Bank of Canada’s two-year forecasts almost always have the CPI at two per cent at the end of the projection period, because, typically, interest rates would be adjusted to bring about that outcome. For now, the central bank predicts CPI inflation of three per cent this year, 2.4 per cent in 2022 and 2.2 per cent in 2023.

 

https://financialpost.com/news/economy/bank-of-canada-keeps-interest-rate-at-0-25

[Libs]

On 6/11/2021 at 10:31 AM, Libs said:

If this pans out, TLT July 30 $146 calls and SCHW July 30 $70 puts will be multi-baggers. 

 

 

The SCHW puts doubled and the TLT calls were an 8-bagger.

Talk about being right for all the wrong reasons.....

[wabuffo]

the TLT calls were an 8-bagger.

 

 

wabuffo

[Libs]

I should be applauding you!