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First off, this is certainly not investment advice.
This is a chart of the annual Fed Funds Rate (adjusted by the CPI-U) vs. the return on various physical commodities (also adjusted by the CPI-U). At first glance, it just looks like a shotgun blast. However, there is clearly at least some order within the chaos when you add in linear regression trend lines.
Even though there is a tremendous amount of noise, these five different commodities all say almost exactly the same thing. If the real Fed Funds rate is low, it is time to own hard assets. If the real Fed Funds rate is high, it is time to sell hard assets. This lends truth to the saying that you should not fight the Fed.
I bought gold and silver for the first time in my life back in 2004. I know exactly why I did it. It is still fresh in my mind. My gut said that earning 1% in three month treasury bills when inflation was clearly higher than that was not a good thing. I didn't know how long it would go on. The Fed pretty much forced me to own something of substance. Since I'm a saver by nature, I chose rocks. I already had a house. I can understand why renters might choose to buy. It surprised me that the rocks did so well. It surprised homeowners that real estate did so well. I just wanted a hedge against inflation but I got so much more than that. If you can believe in that chart above, you'll see that I actually bought a piece of heavily leveraged inflation. It seems a very small change in the Fed Funds rate can (not always) have a dramatic effect on commodity prices. Why? We live in an overleveraged society. Everything is overleveraged. Just look at how many hedge funds we have. That's my opinion and I'm sticking to it.
In 2006, when interest rates were somewhat back to normal I sold my hard assets. I had a nice profit. I removed my leverage. It is one year later and I still don't know if it was a good plan or not. I'm still worried about inflation, but I'm also worried about deflation. In order to know what to do I have to know what the Fed is going to do. Anyone know? It looks to me like the Fed is willing to fight this a bit, perhaps even long enough to get a bit of disinflation (or dare I say it, worse).
Right now I'd say the Fed Rate is just about neutral, at least as far as hoarding rocks is concerned. It is possible that deflationary forces will soon be at play and that the Fed will cut rates. That still doesn't tell me if I should own rocks again though. If inflation falls at the same rate the Fed Rate does, it is all a wash in my opinion.
I also have a personal opinion about gold. It is not a miracle investment. I do not believe it will protect you during a serious deflation. I think a lot of people are missing the point on when gold is a good investment and when it isn't. It does best when you simply can't earn a decent real rate of return on treasuries (after inflation) OR people fear they can't earn a decent real rate of return on treasuries. That's gold's primary purpose. It protects you if the currency becomes untrustworthy (and earning negative rates of return on treasuries is not something that inspires trust, lol).
What happens during a serious deflation? The CPI-U would drop. Cash stuffed under your mattress would earn a decent real rate of return. Why on earth would you want to buy anything? Just hoard cash. Hard assets would fall in price and heaven help the housing market. That's the stuff Great Depressions are made of. I think this is unlikely. Bernanke will drop (cash) until we stop hoarding paper.
What happens during a serious inflation? Assuming interest rates can't keep up (think 1970s) that's an easy one. Buy hard assets. Get rid of your cash. I don't think this outcome is likely, but I can't rule it out either. If home prices start going up again from here we better start investing in wheelbarrows though.
What happens if we do what Japan did? That one is tougher. Japan appeared to have serious deflation on the face of it (especially in their housing markets), but there wasn't all that much deflation in their CPI (not like our Great Depression anyway). In that environment, perhaps you are not earning enough interest to make hoarding cash worthwhile (the chart above implies you need more than 2%, for what that's worth, it's just a rear view mirror looking chart, and we could be moving into some seriously uncharted territory). I'd suggest that maybe commodities could do well in that environment. Maybe. I just don't know.
For those who are concerned that I'm using the CPI-U, it really doesn't matter much. The only thing on the chart that would change is where the neutral Fed Rate would be. That's for each person to decide individually. We all have opinions on it. I happen to think that the CPI-U is actually fairly reasonable. I do think there are (or have been) enough deflationary forces to offset the inflationary ones we've been seeing. Based on the price of most commodities over the last year I'd say the Fed is neutral right now.
I think the Fed is really hoping that inflation comes down soon (very soon). Unfortunately, the timing of all this couldn't be worse. Last fall we had a commodities selloff. Year over year inflation is therefore lower than it would otherwise be. If we don't get another commodity selloff soon, the headline number is going to make rock hoarding look fun again. I think Bernanke knows this. He simply can't afford to let this get any more out of hand than it already is.
You can probably guess what I think about the future based on the name I've chosen. I'm sitting in TIPS (treasury inflation protected securities), I-Bonds, and short-term treasuries. I joke to some friends that if we're right to be stagflationists they'll do better than me, but if I'm wrong I'll do better than them. I'm in the wimpy version of stagflation insurance. TIPS, to me, are unleveraged inflation insurance. I just don't want to be leveraged anymore (unless forced again).
All hard assets have risen at an incredible rate for the last few years. We are shocked, horrified, that housing prices are in such a bubble. However, if this chart of mine has any merit at all (there is a LOT of noise) then perhaps this is just what one would expect if interest rates were held way too low for way too long. All the world is in a bubble. Or alternatively, all the world's currencies just got a haircut. It's all relative I suppose.
Just my two cents (which pales in comparison to the five hundred trillion cents racked up in mortgage debt recently).
Edited 9/13/07: Improved formulas, updated chart.
9 comments:
Very intersting column, but I have to disagree with your take on inflation. It is true that there has been deflation on consumer goods, but to a large extent these are goods that are made overseas and for the most part are not required purchases. The CPI does not take into account taxes, which have exceeded the CPI for the last 5 years, nor does it take into account that many of the most inflationary items, such as fuel, insurance, taxes, etc must be paid. Hence if there is less money floating around, there will be intnese price pressure on those items where puchase is an option.
While I disagree with your inflation comments, the rest of your data is very interesting and well worth reading. Thanks
anonymous,
Thank your for your comments.
I think we just have a difference of opinion over the fine details but are actually in agreement on much of this. I didn't call myself Stagflationary Mark for nothing. :)
My argument is based on the price of consumer goods that I buy. If that's all there was to the story I wouldn't be a stagflationist.
Like you, I have a really bad feeling about how many dollars we've shipped overseas. That's monetary inflation (not the same thing in my opinion) and I agree that those dollars will more than likely come back to haunt us someday in the future.
I tend to see taxes as a different issue. Inflation is a relatively hidden form of confiscation. Taxes are a different form of confiscation. When it all comes down to it, Greenspan said in a speech many decades ago that there can be no safe store of value in a welfare state. If the government wanted my money and or hard assets it has many means to take them from me.
As for the grimy details of the CPI itself, I'd agree that those who buy a lot of stuff they don't really need are having a field day and those who simply buy what they need are doing much worse. Just so you know, I'm not having a field day, lol.
However, the market cares very little about individual people and their possible suffering. It's just trying to figure out how to make a buck, as usual.
Interesting analysis. "Real annual commodity price growth" is for what period?..the 12 months following the corresponding fed funds rate data point?
SM, nice scatter plot. I've intuitively sensed that was what the situation was but it's far better to be able to quantify it. I prefer to use a more aggressive measure of CPI, but as you mention, that's merely a minor detail.
OT, but I've also been thinking of the banking history during the depression. Back then there were many banks that were outside of the federal reserve system. They accounted for the majority of the failures which allowed the FED to get a better grip on the financial system. All of these new financial companies are in much the same situation. I could see the FED allowing them go under so that it gained control over them, directly or indirectly. It's tough to divine their day to day actions though. In a sense they have to keep people guessing so that their actions don't become a "crowded trade" before they themselves take it. I hope Ben is a good bull fighter...
david,
Great question!
The short answer is yes. 12 months later, in theory, you might expect to get a reward.
Your question has also prompted me to improve my data slightly and offer how I am calculating it.
It is probably easiest to simply desribe a particular data point.
In 1975 the annual average Fed Funds Rate was 5.82%. The CPI (Dec to Dec) was 6.90%. That put the Real Fed Fund Rate at -1.01% in 1975.
(1+0.0582)/(1+0.069)-1 = -1.01%
(I originally just subracted to find the spread, but this way is techincally more accurate.)
The price of oil was $7.67 in 1975 and $8.19 in 1976. The CPI from the average of 1975 to the average of 1976 was 5.80%. The real gain in oil was then 0.93% from 1975 to 1976.
$8.19/($7.67*(1+0.058))-1 = 0.93%
(This is the second improvement I made to my chart. I was using the same CPI adjustment for both the Fed Rate adjustment and the commodity adjustment.)
This chart clearly isn't all there is to it though. It's a bit like saying that you should buy stocks in the year 2000 just because stocks are supposed to always go up, if you know what I mean.
I'm not going to risk posting the new chart with the data improvements right now but I will soon. I'm still a bit new at this and I don't want to risk losing these comments until you get a chance to see them.
The chart looks virtually identical to the one I posted anyway. The noise is and was drowning out these relatively minor improvements.
eengineer,
What surprised me most was the explosiveness of the climb. Even the dealer who sold me precious metals couldn't understand why anyone would think gold would do better than inflation.
It makes sense though. In order for it to be a good long-term store of value, it must behave like a coiled spring. Each year interest rates hold it down is one more year of coiling.
Lately, it is a bit like a Jack in the box. Every time Bernanke gets the lid closed, the music starts back up and it pops out at him again. ;)
I do not envy Bernanke's job.
Thanks. ALso, when you use Dec-Dec CPI, is it *lagging*?...that is, could you have done the calculation at the time and predicted the commodities outcome, or would you have to wait a year and see what actually happened to the CPI in order to predict what the commodities outcome would have been according to the model?
david,
If you followed that particular model to the letter, you'd be needing the average Fed fund rate for the year (January to December), the average CPI for the year (December of last year to December of the current year), you'd be buying the commodity at the average price for the year, and selling it at the average price the next year.
It doesn't get much tougher than that. Everything needs a cyrstal ball. Sorry! Therefore, this particular model is a hindsight model to show why things happened the way they did.
The good news is that all the model is really trying to do is tell you if you are in a bear market for commodities or a bull market. It probably doesn't have to be accurate to the minute and you could probably get a pretty good idea just using your gut. If the Fed rate is 50% and inflation is 10,000%, let's just say we all might want to be stocking up on canned goods. ;)
These things tend to be many years in duration if history is any indicator. It has been many years already. Who knows how it will end (and hopefully it will end or we'll be starring in a Mad Max movie soon).
Another danger here is that there are up to 9,000 hedge funds playing in this space and you can bet they've got some fairly sophisticated computer models trying to make sense of it too.
"9,000 hedge funds playing in this space and you can bet they've got some fairly sophisticated computer models"..and probably 8,000 of those hedge funds are using variants on the same model, which makes for some interesting feedback loops....
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