A Hook or a Bend

May 16, 2021

by Steve Stofka

Eight-year-old Gwen shot out the back door, soccer ball in hand. “Dad!” she yelled. He released the safety handle on the mower as she ran across the yard to him. “Mom said she’ll take me to the game but you need to help me warm up.” When her dad bounced the ball to her, Gwen made a series of estimates of the ball’s trajectory, then corrected her estimates with the actual path of the ball as it bounced along the ground to her. As the ball neared her, she made a final OLS estimate of the ball’s destination, planted her feet and swung one foot at the ball. The side of her toe grazed the surface as it skittered past her and rolled toward the backyard fence. “Darn!” she said.

The Federal Reserve has had a lot of experience at estimating the trajectory of inflation. Just as everyone gets better with practice, so has the Fed. Gwen’s use of statistical methods is instinctive and unconscious; the Fed’s approach is quite deliberate and focused on the medium term. Unlike the Fed, the stock market acts with a short-term focus. Trading algorithms trained to react in milliseconds to key words in a data release make buy and sell orders. Human traders follow their lead, not wanting to be caught out in the open. If a trader makes a wrong turn but is among a crowd of traders that have made the same turn, they are less likely to come under scrutiny. While the market jogs along the beach, the Fed cruises offshore, watching for larger trends.

Because of the shutdown last April, economists estimated a strong uptick in prices as many states and localities began lifting sanctions and people spend money. Survey estimates of April’s inflation was high, about 3.6%, but the actual report showed an increase of 4.15%. By comparing the index this year to the index in April 2019, the rise over the two years was 4.3%, an average of 2.1% per year, exactly the average inflation since the year 2000. The rise was entirely due to “base effects,” a comparison of a data point with a previous data point that was abnormally low. On a vacation trip we slow down from 60 MPH to 30 MPH as we go through a town. When we speed up again on the other side of town, we have doubled our recent speed, but have returned to our average speed.

Our inflation expectations have stabilized over the past twenty years because we have been going the same 2.1% speed averaged over each quarter. For twenty years beginning in 1980, inflation began to decline .1% per quarter. It was like riding a bike on an almost level street with a barely noticeable decline. The pedaling lessens just a bit. Since 2000, the average quarterly change in inflation is a big fat zero. Any change becomes alarming.

Inflation has increased 3% over the past three months. A similar uptick occurred in the 4th quarter of 2009 as the economy emerged from a deep recession. The Fed computes a probability of inflation being greater than 2.5% and it rose to 60% this month, an increase from 20% last month (Series STLPPM). A similar jump occurred in April 2000 and April 2005.

A mainstream economic model depends on the assumption that workers estimate price changes and respond to their estimates with higher wage demands. Karl Marx, the 19th century economist, regarded this assumption as a fanciful notion. We pay attention to prices just as Gwen pays attention to the soccer ball, but the precision of our estimates degrade over longer periods of time. Every spring we remark on the increase in gas prices. Gas prices go up in the spring every year when refineries switch over to summer gas, which is more expensive to make. Really, we ask? Funny, I don’t remember that. Next year we will forget again. We lead busy lives and don’t have the mental storage to keep track of seasonal changes. It’s why we need multiple reminders about the tax filing deadline every year.

The Fed has a lot of data and a long memory. The Fed has adopted a wait and see approach to assess whether upward price pressures are due to base effects, supply bottlenecks and price surges typical in the initial recovery. Is this a jig and a jag of the coastline or a true bend in the land? Alan Greenspan, the second longest serving Fed chairman, reacted quickly – too quickly and too strongly – to inflationary pressures in 2004-2005 after the long slump of 2001-2003. He did not want to relive the slow recovery of a decade earlier after the 1990 recession. Those policy choices helped create the financial environment that led to the financial crisis. The Fed has more effective tools and data than it did then. Experience is a good teacher.


Photo by Jeremy Bishop on Unsplash. Coastline of O’ahu, U.S.

Finger Pointing

April 18, 2021

by Steve Stofka

Some restaurant employers complain that they can’t find workers and blame the stimulus payment and the extension of unemployment benefits. Workers complain that businesses are not willing to pay for the additional health risk of close contact with the public. Child-care remains an ongoing obstacle for many. Pick your target – the bums in Washington and their relief programs, cheap business owners, belligerent customers, or unmotivated employees. Oops, almost forgot one other culprit – the Covid virus. Finger pointing does not build solutions. Finger touching does.

In its March survey, the National Federation of Independent Business reported (2021) that 42% of owners reported that they could not fill a job opening, yet only 28% reported offering higher wages. Some expressed their concern that unemployment benefits were too generous, reducing the demand for jobs.

In a recent study, Gabriel Chodorow-Reich and his colleagues at Harvard (2018) found that an extension of unemployment benefits had only a small macroeconomic effect on unemployment, employment, job vacancies, and wages. However, they noted that some studies focusing on particular industries and workers have found greater effects from more generous unemployment benefits.

In macroeconomic models benefits for employed or unemployed workers does affect the unemployment rate. Benefits for the employed raise the input cost of labor and causes an increase in the price of a product. An increase in price leads to a reduction in demand. Employers respond to that demand reduction by laying off employees or not adding to their workforce. Unemployment benefits reduce incentives for workers to find work. States charge employers a fee for additional benefits, further driving up labor costs. However, in the aggregate, a change in benefits has only a small effect on wages and unemployment.

In a crisis, providing relief to specific populations and business sectors is difficult. When the CARES act was passed at the start of the pandemic, the paycheck protection aspect was designed to help small businesses. Big corporations took advantage of loopholes in the law’s language and exhausted that targeted relief for small businesses. Big business got big by being voracious, leaving little for the competition. A government that enacts broad relief measures are criticized for giving relief to those who don’t need it. We would rather blame each other than blame a virus.


Inflation expectations have an effect on wages. If workers expect higher prices in the near future, we want higher wages to cover our living costs. We see the price of gas go up from $2 per gallon to $2.80 per gallon in the past six months and reason that a lot of prices will be going up. We listen to the news in our car and hear inflation is up such and such a percent. We check the price of hamburger or some other grocery item. For the sake of simplicity, some economic models assume that consumers are knowledgeable about setting inflation expectations. We don’t have the time to be experts, so we guess at it and correct our expectations as we get new information.

In a recent paper, Ehsan Ebrahimy (2020) and fellow economists at the International Monetary Fund studied the effects that pandemics and wars had on inflation. Pandemics generated uneven swings in prices during the pandemic, but the recovery period brought an offsetting of those price swings. They found no net inflation effects from pandemics like the Spanish flu.

Expectations contribute to inflation. The price of residential toilet paper during the Covid crisis is a small example of this phenomenon. Different production plants make commercial and residential toilet paper because consumers are willing to pay more for a softer product. In the first months of the pandemic, panic buying and hoarding caused a shortage of toilet paper and a rise in price. Manufacturers like Kimberly-Clark built more production of residential toilet paper and store shelves were restocked in recent months. Responding to the increased inventory, people started using the toilet paper they hoarded. Now there is a surplus of toilet paper and prices have dropped below pre-pandemic levels.

Unlike pandemics, war involves the destruction of  physical capital, factories and offices. In the recovery periods following war, the IMF researchers found a persistent inflation in developed economies because some of the productive capacity had been destroyed. When there was less supply to meet demand, prices went up. Even a country not directly damaged in a war, like the U.S. in the past two world wars, suffered lasting inflationary effects in the post-war recovery periods. During WW2, the U.S. used up a lot of raw materials and production to make weapons. Following the war, inflation shot up over 10% in the U.S., five times the current rate. Following that inflation spike, the economy fell into recession, which caused a price plunge, followed by another spike in inflation to over 7%. The inflationary shock waves following the war took seven years to dissipate.

The researchers concluded that there was little evidence to support a belief in a sustained inflationary trend during the recovery from this pandemic. That does not rule out the possibility of uneven short-lived price rises. As shown above, expectations have an effect on prices.

We are more comfortable when we humanize the causes of inflation, pointing the finger at “those people.” We prefer to live in a world of intent, not random chance. Attacks on Asian-Americans have increased as if someone born and raised in America had something to do with the Covid virus. Employers blame Congress or unmotivated job applicants, who blame heartless employers. As Rodney King said, “Can’t we all just get along?” (Sastry & Bates, 2017). We can use our fingers to connect, not blame.


Photo by Humberto Arellano on Unsplash

Chodorow-Reich, G., Coglianese, J., & Karabarbounis, L. (2018). The macro effects of unemployment benefit extensions: A measurement error approach*. The Quarterly Journal of Economics, 134(1), 227-279. doi:10.1093/qje/qjy018. Retrieved from https://scholar.harvard.edu/files/chodorow-reich/files/ui_macro.pdf

Ebrahimy, E., Igan, D., & Peria1, S. M. (September 10, 2020). The Impact of COVID-19 on Inflation: Potential Drivers and Dynamics. International Monetary Fund Research. Retrieved from https://www.imf.org/~/media/Files/Publications/covid19-special-notes/en-special-series-on-covid-19-the-impact-of-covid-19-on-inflation-potential-drivers-and-dynamics.ashx

NFIB. (2021, April 13). Small business owners struggle to find qualified workers. Retrieved April 17, 2021, from https://www.nfib.com/content/press-release/economy/small-business-owners-struggle-to-find-qualified-workers/

Sastry, A., & Bates, K. (2017, April 26). When L.A. erupted in anger: A look back at the Rodney King riots. Retrieved April 17, 2021, from https://www.npr.org/2017/04/26/524744989/when-la-erupted-in-anger-a-look-back-at-the-rodney-king-riots

Inflation Not

April 4, 2021

by Steve Stofka

I will keep this short on Easter weekend. The March Labor report that came out two days ago surprised to the upside, but I am not convinced that this will be a robust recovery this year. The relief act passed a month ago may give the kick needed. Despite the inflation warnings of some, the employment trends don’t signal inflationary pressures this year.

The unemployment rate declined from 6.8% at the end of last year to 6.2% at the end of March. However, the rate is still 1.7% above the 4.5% long-term natural rate of unemployment, an estimate of what the unemployment rate could be if available labor and other resources were employed. A year ago, the unemployment rate stood at 3.8%.

The labor force shrank by .2% this past quarter, about the same as the last quarter of 2017 and the 3rd quarter of 2015. Considering there is a pandemic, that shouldn’t be worrisome, but it is unusual for the labor force to shrink in the first quarter of the year. The last time was in 2011, a time when it seemed there might be another global recession. It’s not a sign of a robust recovery.

Total Employment is still 4.5% below last March, but Construction employment is only 1.2% down from last March. Even though Construction is only 5% of employment, it’s direction signals positive secondary movements in the economy.

There is a formula economists use to estimate the output gap in the economy. When it is positive, that signals some degree of inflationary pressures. When negative, as it has been for most of the past decade, that signals low inflation. We won’t get the first estimate of first quarter GDP for a few more weeks, but the employment data this past quarter estimates a small positive gap and little inflation.

Happy Easter, folks, and stay safe!


Photo by Sebastian Staines on Unsplash

The Dog That Bit

March 28, 2021

by Steve Stofka

At a Senate Banking Committee hearing this week, Fed Chairman Jerome Powell responded to Republican concerns about inflation. The American Rescue Plan signed into law two weeks ago had little Republican support. Without the passage of the law, millions of Americans would have been subject to eviction in the middle of March. Republican Senators expressed few worries about inflation in 2017 when they passed a tax cut that had the same ten-year cost as the American Rescue Plan. It can be difficult to separate the genuine economic concerns about inflation because the topic is used as a political tool.

Mr. Powell reassured Senators that the Fed has the tools to curb inflation. What they lack are the tools to counter deflation. Once the Fed sets interest rates at zero, they cannot lower them, a situation called the Zero Lower Bound. Higher inflation is a persistent worry among older politicians and voters who experienced the high inflation of the 1970s.  Since then, the Fed has been given far more power by Congress to prevent a repeat of that decade’s stagflation, the unusual combination of high unemployment and high inflation.

Inflation is one of the many human behaviors that is a function of expectations. Let’s say that, ten years ago, I got scared by a neighbor’s dog who got loose and almost bit me. I changed my route home to avoid the dog. The homeowner may have put up a chain link fence to keep the dog inside the yard, but I don’t trust that the fence can contain the dog. The homeowner could have moved or the dog has died and the threat no longer exists, but my behavior has permanently changed. If I walk on the opposite side of the street, and I don’t see the dog out in the yard, that doesn’t mean that the dog is not a threat.

Fear keeps us alive. A six-year-old may have seen a small spider crawling up a wall, imagines that it could crawl inside their ear while they are sleeping and doesn’t want to sleep in their bedroom. Many of us stop worrying about spiders while we are sleeping, or we think we do. As we grow up, our spiders mature. We lose sleep worrying about financial and relationship issues, our health or our job. Inflation is one of those grown-up spiders.

In the popular understanding, inflation is higher prices. Economists understand inflation as higher wages, the main component of most goods and services. Inflation is both a short-term and medium-term process. In the short run, if demand exceeds capacity to meet that demand, prices will go up because workers have more bargaining power and wages go up. However, as Chairman Powell has noted, the insidious aspect of inflation is that not all prices and wages go up at the same time. Inflation distorts the distribution of income and, in the medium run, affects the accumulation of wealth.  

Economists anticipate a return of demand this year; there is a lot of pent-up buying power. Credit card delinquencies are near all-time low, barely above 2%. They were almost 7% in the summer of 2009. The charge off rate is 2.6%, 8% less than it was in 2009. The country has the capacity to meet that demand. There are still ten million unemployed and capacity utilization is below 80%.

There is one troublesome area – housing, which makes up a third of the Consumer Price Index, one of the measures of inflation. For the first time since World War 2, household formation declined in 2020 (FRED Series TTLHH) in response to the pandemic. Last year, many millennials and Gen Z just starting their adult life moved back in with their parents.

Housing supply remains tight. The National Assn of Realtors announced that there were now more real estate agents than homes to sell. The number of housing starts has increased since the housing crisis more than a decade ago, but there are only 7 starts per 1000 working age adults 16-64, slightly above the number of starts during the 1990 recession after the savings and loan crisis.

In response to the Covid crisis, the growth in housing prices (HPI) has shot up from 2% annual growth to over 10% since last March. Although a small part of the total economy, the housing market and the 5% of the labor force that it employs is like the tail that wags the dog. Growth in construction employment went negative last year and is still negative at -4% (FRED Series USCONS). The last time it went negative was in the spring of 2007, six months before the 2007-2009 recession and financial crisis.

This trend is a powerful deflationary force that counteracts inflationary forces that might occur in the 2021 recovery. Understanding those deflationary forces and lacking the tools to combat deflation, the Fed is watchful but less concerned about inflation. One of the forces acting as a brake on inflation is our own expectations of inflation. At the hearing this week, Powell noted that those expectations have become anchored at low rates over the past two decades. During the 1970s, expectations were unanchored. People expected inflation to be as much as it was the past year or worse.

The anchoring process occurs slowly and changes slowly. People who are less than 50 have formed different expectations based on their life experience. Older Americans may still be suspicious, watchful for the least sign of a phenomenon that imprinted on them when they were younger. In the 1970s, people who would not think of stealing, stole gasoline from their neighbors to get to work. Neighbors in New York City beat each other up over their place in line to get gasoline. Retired people in subsidized housing froze to death because they couldn’t afford the skyrocketing costs of heating their home.

“Don’t go that way,” older Americans  say. “That dog could bite you.” Younger Americans ask, “What dog?”

We make our journey through life avoiding that dog, the one that bit us. Our choices do not keep us safe from a dog biting us. What protects us from a dog bite is the choices of others, the ones that dog owners make to install fences or to keep their pet inside the house. We live in community with others; that makes our lives more convenient, but we are more vulnerable to the choices that others make. The pandemic has focused our attention on that fact, and those who have lived through this past year are imprinted.


Photo by Tillmann Hübner on Unsplash

The Association – A Split

August 25, 2019

by Steve Stofka

A few things before I continue the saga of our mountain community. Bond yields have sunk to remarkable lows as the prices of those bonds climb higher in response to global demand for safe assets. Governments have borrowed trillions since the financial crisis, yet there is not enough debt to meet demand.

The private market created a huge supply of “safe” assets called Collateralized Debt Obligations, or CDOs, based on house mortgages. When the housing market imploded, it left a big hole in the market for safe assets. As countries around the world have adopted capitalistic market structures, the living standards of millions of people have improved and that has led to more savings in search of safe investments.

The U.S. still pays a positive interest rate on its debt and that is attracting a lot of foreign capital to our country – capital that is driving down the interest rates on our savings and pension assets. Unlike some other countries, capital moves freely across U.S. borders. It doesn’t wait in crowded spaces behind chain link fences.

Donald Trump’s family business relies heavily on borrowing, and most of that has come from a single source, the German firm Deutsche Bank. No other bank is willing to risk capital on a family business with a history of failure. The family’s business depends on the free movement of capital across national borders, yet Trump himself is adamantly opposed to the free movement of labor across borders.

Capital requires a legal framework of property rights protection, a robust banking system capable of servicing that capital, and a political system that protects the profits generated by investment from graft and corruption. Labor requires a social framework in addition to a legal system that enforces basic personal rights. Capital comes to this country because we spend a lot of money to nurture and protect it more than some other countries. Labor comes to this country for the same reasons – a higher return on their effort, an educational system that nurtures their families, a social and legal system that offers some protections.

“They’re taking our jobs!” some people complain of immigrant labor, yet few Americans are affected by an immigrant labor force that takes mostly lower paying jobs. The flow of capital into our country creates a competition that affects many more Americans – anyone who has a savings account, a pension fund, a 401K, an IRA. Where is the outcry against foreign capital?

Let us return to those dear souls who inhabited an abandoned mining town. In last week’s story, they had formed a homeowner’s association which created Money, Debt, and traded with another community called the Forners.

The board of the homeowners’ association complained often about the expense of handling the Money that it had created. The association decided that it would be more efficient to reduce the use of paper Money. It gave each homeowner a bank account and a Money shredder which scanned and tabulated the Money that each homeowner shredded. Homeowners didn’t have to go to the community center when they needed to pay another homeowner or the association. When they did receive Money, they deposited it in the shredder, which added the amount to their balance. When they wanted to pay someone, they tapped some buttons on their shredder and the amount went from their account to the other homeowner’s account. Paying their monthly homeowner fees was so much more convenient.

A homeowner called Mary decided to re-open the old restaurant, but she would need more Money than she had. What to do? The association could print the Money and loan it to her. Mary would put up 10% of what she needs, and the association would print the other 90%.  She would pay the money back over time with interest. One of the homeowners asked, “How will we be paid if we do work for Mary’s restaurant?” Someone answered, “With the same Money that you get paid when you work for the association.”

That was acceptable to everyone. With the extra Money earned by fixing up Mary’s restaurant, several other homeowners put down deposits and opened businesses with loans from the association (Note #1). The association held a mortgage on each business, but the business owner decided how to run the business and received the profits from the business.

When Stan’s business failed, the homeowners discussed what to do. Stan had spent the printed Money that the association had loaned him, so the Money had not disappeared. Like all the printed money, it was spread around the community. The effect of Stan’s business failure was the same as if the association had started the business, hired people to do work, paid them and then closed the business after a time. The printed Money went out into the community but never made it back to the association in the form of loan payments. Someone said, “There is extra Money in our community because Stan’s business loan won’t be paid back.”

They agreed that this was so but what to do about it? They all had some extra Money because of Stan’s business loan. “What if more businesses fail?” someone asked. “What will we do with all the extra money the association has printed?”

“Prices will go up,” someone else said. “That’s what happened last time.”

“If more businesses failed, I would be more careful and buy less stuff,” another offered. Several heads nodded. “I’d deposit some extra Money in the shredder.”

“Well, that doesn’t make the Money go away,” someone argued. “The money is still in your bank account with the association.”

“But prices won’t go up because people are spending less Money, isn’t that right?” someone asked. That was the confusing part. The last time there was extra Money, prices went up. But in this case, prices were likely to go down if more businesses failed and there was extra Money.

Someone stood up and said, “I’ve got the answer. When we all worked fixing up Stan’s business, the Money was exchanged for our labor and supplies. Since the Money was exchanged for goods and services, there is no extra Money.”

Someone else countered, “What if we all started businesses, borrowed Money from the association and we all failed? There would be a lot of extra Money.”

The other person answered, “Yes, the amount of circulating Money would be suitable for a thriving community. Too many people with a lot of Money and nowhere to spend it would drive up prices. But just one or two business failures has such a small effect that it is negligible.”

They decided to continue printing and loaning money but formed a loan committee whose job was to review an applicant’s business plan before loaning the money.

Bob, the community’s propane dealer, bought his supplies from the Forners. One month, the Forners got very angry at the whole community and would not sell propane to Bob. He contracted with another community for propane but there wasn’t enough for everyone’s needs. Bob raised the price of propane then began rationing propane by selling only to those who were in line at his station at 6 A.M. After two hours, he shut off supplies until the next day. Some homeowners threatened Bob and so he had to hire a few people for extra security (Note #2).

Mary used a lot of propane for cooking, so she had to spend several hours each day buying propane. Naturally, she raised prices to account for the additional time and higher price of propane. Homeowners ate fewer meals at Mary’s and she had to let go of several employees.

As prices rose, some homeowners who had bought association debt at low interest rates began to complain. “We loaned the association money at 5% interest and prices are going up at 10% a year. We’re losing money!”

Everyone agreed that this wasn’t fair, but no one knew what to do about it. Should they cancel the old debt and reissue debt at higher interest rates? That would lead to higher homeowner fees for everyone. “You want us to pay extra so that your interest income will keep up with inflation? Why should I take money out of my pocket and put it in yours?”

Tempers flared. “I’m not loaning this association money ever again,” complained one homeowner and several stormed out of the clubhouse. True to their word, these homeowners would not renew their loans to the association unless it paid much higher interest rates. After several months, the Forners resumed propane deliveries but a vicious cycle of higher prices had started. Homeowners had to pay higher association fees and wanted more money for their labor to pay those higher fees. No one knew how to fix the situation.

“We need to charge high interest rates on the Money we print and loan to homeowners for their businesses and homes,” a board member said.

“Are you crazy?!” Several complained. “Rates are already too high. People can’t afford to start businesses or buy a home!”

“We need to raise them so high that it will hobble the economy for a while,” the board member said. “That’s the only way to bring prices down. It won’t take long.”

It took much longer than anyone anticipated, and the economy declined for almost two years. This period of higher prices followed by high interest rates caused a divide among the homeowners – between those who relied on the association for services and help during hard times, and those who formed a deep distrust of the association (Note #3). No one fully understood how deep the divide would grow.



  1. The process where loans generate income for others which generates more loans is called the Money Multiplier in economics.
  2. In the 1970s, two gas embargoes led to similar circumstances.

This is a retelling of the high inflation of the late 1970s, followed by nose-bleed interest rates that caused back-to-back recessions in the early 1980s. The recession of 1981-82 was the most severe since the 1930s Depression.  

Slow Growth

April 21, 2019

by Steve Stofka

Happy Passover and Happy Easter. Now that tax day is past, let’s raise our heads and look at long-term growth trends of real, or inflation-adjusted, GDP. For the past seventy years real GDP has averaged about 3% annual growth. In the chart below, I’ve charted the annual percent change in a ten-year average of GDP (GDP10, I’ll call it). As you can see on the right side of the graph, growth has been below average for the past decade.

In 2008, growth in the GDP10 crossed below 3%. Was this due to the Financial Crisis (GFC) and the housing bust? No. The GFC barely figured into the computation of the ten-year average. The housing market had been running hot and heavy for four to five years, but this longer-term view now puts the housing boom in a new perspective: it was like lipstick on an ugly pig. Without the housing boom, the economy had been faltering at below average growth since the 1990s tech boom.

The stock market responds to trends – the past – of past output (GDP) and the estimation of future output. Let’s add a series of SP500 prices adjusted to 2012 dollars (Note #1).

For three decades, from the late 1950s to the mid-1980s, the real prices of the SP500 had no net change. The go-go years of the 1960s raised nominal, but not real, prices. Investors shied away from stocks, as high inflation in the 1970s hobbled the ability of companies to make real profit growth that rewarded an investor’s risk exposure. From the 2nd quarter of 1973 to the 2nd quarter of 1975, real private domestic investment lost 27% (Note #2). In less than a decade, investment fell again by a crushing 21% in the years 1979 through 1982.

In the mid-1980s, investors grew more confident that the Federal Reserve understood and could control inflation and interest rates. During the next decade, investors bid up real stock prices until they doubled. In 1996, then Fed chairman Alan Greenspan noted an “irrational exuberance” in stock prices (Note #3). The “land rush” of the dot-com boom was on and, within the next five years, prices would get a lot more exuberant.

The exuberance was well deserved. With the Fed’s steady hand on the tiller of money policy, the ten-year average of GDP growth rose steadily above its century-long average of 3%. A new age of prosperity had begun. In the 1920s, investment dollars flowed into the new radio and advertising industries. In the 1990s, money flowed into the internet industry. Construction workers quit their jobs to day trade stocks. Anything less than 25% revenue growth was the “old” economy. The fledgling Amazon was born in this age and has matured into the powerhouse of many an internet investor’s dream. Thousands of other companies flamed out. Billions of investment dollars were burned.

The peak of growth in the ten-year average of GDP output came in the 1st quarter of 2001. By that time, stock prices had already begun to ease. In the next two years, real stock prices fell almost 50%, but investment fell only 12% because it was shifting to another boom in residential housing. As new homes were built and house prices rose in the 2000s, long-term output growth began to climb again.

From the first quarter of 2006 to the 3rd quarter of 2009, investment fell by a third, the greatest loss of the post-war period. In the first quarter of 2008, growth in the GDP10 fell below 3%. In mid-2009, it fell below 2%. Ten years later, it is still below 2%.

The Federal Reserve has had difficulty hitting its target of 2% inflation with the limited tools of monetary policy. There simply isn’t enough long-term growth to put upward pressure on prices.  Despite the low growth, real stock prices are up 150% since the 2009 lows.  A prudent investor might ask – based on what?

The supply side believers in the Trump administration and Republican Party thought that tax cuts would spur growth. In the first term of the Obama administration, believers in Keynesian counter-cyclical stimulus thought government spending would kick growth into gear. Faced with continued slow growth, each side has doubled down on their position. We need more tax cuts and less regulation, say Republicans. No, we need more infrastructure spending, Democrats counter. Neither side will give up and, in a divided Congress, there is little likelihood of forging a compromise in the next two years. The stock market may be waiting for the cavalry to ride to the rescue but there is no sign of dust on the horizon.

Economists are just as dug in their ideological foxholes. The Phillips curve, the correlation between employment and inflation, has broken down. The correlation between the money supply and inflation has also broken down. High employment but slow output growth and low inflation. Larry Summers has called it secular stagnation, a nice label with only a vague understanding of the underlying mechanism. If an economist tells you they know what’s going on, shake their hand, congratulate them and move to the other side of the room. Economists are still arguing over the underlying causes of the stagflation of the 1970s.

A year ago, I suggested a cautious stance for older investors if they needed to tap their assets for income in the next five years. The Shiller CAPE ratio, a long-term evaluation of stock prices, is at the same level as 1929. At current prices in a low growth environment, stock returns may  struggle to average more than 5-6% annually over the next five years.



  1. Adjusted for inflation by the Federal Reserve’s preferred method, the Personal Consumption Expenditures Price Index (FRED series PCEPI). Prices do not include dividends
  2. Real Gross Private Domestic Investment – FRED Series GPDIC1.
  3. A video of the 1996 “irrational exuberance” speech

Inflation Measures

“Everyone is entitled to his own opinion but not to his own facts.” – Sen. Daniel Patrick Moynihan

September 30, 2018

by Steve Stofka

The above quote has been attributed to the former Senate Majority Leader. People repeat the quote when discussing a contentious subject. We are often convinced that we have the facts when our facts may indeed be arbitrary. Let’s take the case of real or inflation-adjusted income. Has the average real wage declined or risen in the past decades? The calculation depends on which measure of inflation we choose.

There are two measures of inflation, the Consumer Price Index (CPI) and the Personal Consumption Expenditure Price Index (PCE). The CPI relies on surveys of what consumers buy. The PCE is based on surveys of what businesses sell (Note #1). The CPI uses a fixed basket of goods, regardless of changes in the prices of items in a basket. If the weekly basket of goods includes two pounds of ground beef, that two pounds never changes in response to lower prices. It is static. The PCE does adjust for price changes. If the price of a pound of ground beef went down thirty cents, the PCE calculates that a family bought a bit more ground beef and a little bit less chicken, for example. It is a dynamic measure.

People drive fewer miles and buy more fuel-efficient cars as the price of gas increases BUT only after a certain dollar amount. Our purchasing patterns are both static and dynamic. Because we are creatures of habit, our buying patterns are resistant to change. Within a certain price range, we will continue to buy the same items. Outside of that range, we do make changes because we want to optimize our choices.

In the past forty years the CPI has calculated an annual rate of inflation that is over ½% higher than the PCE rate. That small difference compounded over forty years amounts to 23%. That large difference tells two very different stories. Using the CPI, the average worker has lost a few percent in inflation adjusted hourly wages. Using the PCE, on the other hand, the average worker has enjoyed real gains of 20% in the past forty years (Note #2).

Our most volatile disagreements are in areas where facts are difficult to observe. The household survey data that underlies the CPI is unreliable because people living busy lives are not accurate journal keepers of their daily purchases. On the other hand, surveys based on business sales are inaccurate because people stock up on items whose prices decline.

Even when facts are readily verifiable, the interpretation of those facts varies with context. In arriving at our version of the meaning of those facts and their context, we subtract a lot of observable data.  We must filter reality because we cannot manage such a large amount of information. Because we filter our perceptions, eyewitness testimony is unreliable. Although our perceptions are inaccurate, we must act on those perceptions and hope that they are accurate enough. That same reasoning guides economists, politicians, and those in the social and physical sciences. We would all have more constructive discussions if we understood the imperfection of our perceptions.



1. The Difference between CPI and PCE {Federal Reserve}

2. Using the average hourly wage for production and non-supervisory employees.

The Reputation of Money

To be respected, authority has got to be respectable. – Tom Robbins

September 9, 2018

by Steve Stofka

Most nations create their own money, a super power of the modern state. The politicians and central bankers of each country have the responsibility to maintain the reputation of its money. Each nation is both the creator and net seller of its money, able to lower but not raise its comparative value. To raise that value, each nation depends on others to be net buyers of its money.

Nations carefully study the behavior of each other’s central banks. Argentina cut interest rates in January 2018 even though the country was experiencing high inflation. This action was the opposite of good central banker behavior, and hurt the reputation of the Argentine peso, which has lost half its value since January. Money traders suspected that the Argentine central bank had become captive to political control. Few trusted a politician with money super powers.

The reputation of a nation’s money rests on the steadiness of its tax revenues. As I have noted before, revenue from the sale of nationalized resources acts as a tax. Those commodity revenues do not build a money’s reputation as much as the tax revenues from the economic production of a nation’s people and businesses.

A nation can print its own money at little cost. A greater supply of anything, given a constant demand, lowers the price of that thing. The real cost of printing money is borne by the nation’s people and businesses who use that money for daily exchange. As a money’s value declines, that loss of value acts as a sales tax on each money unit exchanged. Let’s call that the king’s tax. This undeclared tax revenue does not build a money’s reputation.

A nation supports the reputation of its money by using its super powers with restraint. When a nation receives most of its tax revenues from its own internal production, that is a sign of a healthy economy, with a reasonable monetary and fiscal policy. When the king’s tax (inflation) and commodity resource revenues exceed half of a nation’s revenue, the value of its money becomes like two day old bread.

A nation’s money rises in reputation when it is bought, and there are two reasons for buying a nation’s money: 1) buying goods and services from that nation, and 2) loaning money to the governments and businesses of that nation. In 2017, China, the United States and Germany were the top exporters, putting their currencies in demand (Note #2). Loans to borrowers in emerging markets are often priced in U.S. dollars, the current reserve money of the world. If the money in that nation loses its value against the dollar, the borrowers effectively pay a king’s tax as they make their loan payments (Note #1). Typically, a nation will blame the tax on rapacious money dealers.

A nation’s money reputation relies on several factors that a nation can control: inflation, tax revenue and the source of that revenue. A nation is judged on its current and historical behavior with money and debt. Its political structure and the independence of its central bank are important factors as well. On an international stage, its money must compete with other nations in all these categories. Call it the daily beauty contest – no swimsuits.


1. EMB is a basket of emerging market debt priced in USD (http://etfdb.com/etf/EMB/). It is off 5% from its high at the beginning of the year and pays a dividend of 4.6%. Its annual return for the past ten years was 6.5%, the same as a long Treasury ETF like TLT. A broad bond index fund like Vanguard’s BND earned 3.8%.

2. Germany uses the Euro, not its own national currency. In 2017, China exported $2.35 trillion, the U.S. $1.55T and Germany $1.45T. Visual Capitalist picture graph. The site is a picture book for curious minds. Here’s one on the biggest employer in each state. For southern states, the answer is Wal-Mart. Universities and health care systems are prominent employers in many states.

Related: The U.S. owes $6.2 trillion to the rest of the world. China’s share of that debt is $1.8 trillion. The U.S. holds $125 billion in foreign reserves, similar to the amount Turkey holds. As the world’s reserve money, the U.S. holds enough foreign reserves to counter any distortions in currency markets.



In a survey of 5000 workers, Gallup found that only 51% had a single full-time job.  36% were gig workers.

Since 1991, real purchase only house prices have gone up 1.7% annually. FRED series HPIPONM226S / PCEPI, index 3/1991 = 100. Real rents and owner equivalent rent (OER) nationally have gone up 8/10ths percent annually. This is about half the rate of home price growth. Urban residents must pay an extra price. In Denver, rental prices have gone up 1.9% annually since 1991. OER has risen 1.7% annually. No doubt, California cities have even higher annual growth rates than national averages. Owner Equivalent Rent is a BLS-calculated rent that a homeowner pays themselves for use of the residence. This includes mortgage, repair and maintenance costs on the home.

The Hunt, Part 2

July 22, 2018

by Steve Stofka

Last week, I showed the inputs to the credit constrained economy as a percent of GDP. I’ll put that up again here.


This week I’ll add in the drains but first let me review one of the inputs, bank loans. Focus your attention on that period just after 9/11, the left gray recession bar,  and the end of 2006, just to the left of the red box outlining the Great Recession on the right.  For those five years after 9/11, the banks doubled their loans to state and local governments, a surge of $1.4 trillion. The banks increased their household and mortgage lending by $5.3 trillion, or 67%. Why did banks act so foolishly? Former Fed chairman Alan Greenspan couldn’t answer that. We have a partial clue.

For 4-1/2 years after 9/11 and the dot-com bust, there was no growth in credit to businesses, a phenomenon unseen before in the data history since WW2. The banks reached out to households, as well as state and local governments because they needed the $1 trillion in loan business missing on the corporate side (#1 below).

There are four drains in the economic engine – Federal taxes, payments on loans, bad debts and the change in bank capital. State and local government taxes are not a drain because those government entities can not create credit. The change in bank capital reflects the changes in the banks’ loan leverage and their confidence in the economy. During the 1990s and 2010s the sum of the inputs and the drains remained within a tight range of about 1/7th of GDP.


The results of bad policy during the 2000s are shown clearly in the graph. In addition to the surge in bank loans, the Federal government went on a spending spree after 9/11. There was too much input and not enough drain. The reduction in taxes in 2001 and 2003 exacerbated the problem. There was less being drained out. Asset prices absorb policy mistakes until they don’t – a life lesson for all investors.

Let’s add in a second line to the graph – inflation. The rise and fall of inflation approximates the flows of this economic engine model with a lag time of several months. I’ve shown the peaks and troughs in each series.


Look at that critical period from 2006 through 2007. The Fed kept raising rates in response to rising inflation (the red line), driven primarily by increases in the price of oil.  The Fed Funds rate peaked out at 5-1/4% in the summer of 2006 and stayed at that level for a year. The Fed misread the longer term inflation trend and contributed to the onset of the recession in late 2007. The net flows in the engine model (blue line) indicated that the long term trend of inflation was down, not up.

Where will inflation go next? Using last week’s theme, follow the hounds! Who are the hounds? The banks. The inflow of credit from the banks is the primary driver of inflation. Why has inflation in the past decade been low? Because credit growth has been low. Where will inflation go next? A gentle increase – see the slight incline of the blue line at the right of the graph. Contributing to that increase were last year’s tax cuts. Less money is being drained out of the engine.

Too much flow into the economic engine or an improper setting of interest rates – these mistakes are absorbed by assets, which are the reservoirs of the engine. Stocks, bonds and homes are the most commonly held assets and most likely to be mispriced. During the early to mid 2000s, the mistakes in input were so drastic that the financial crisis seems inevitable when we look in the rear view mirror. During the past eight years, the inputs and drains have remained steady, but interest rates have been set at an inappropriate level. Again, we can anticipate that asset prices have been absorbing the mistakes in policy.



1. In the last quarter of 2001, loans to non-financial corporate business totaled $2.9 trillion and had averaged 6%+ growth for the past decade. Anticipating that same growth would have implied a credit balance of $3.9 trillion by the end of 2006. The actual balance was $3.1 trillion.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.


Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.


When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.


  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).