What Is Not Seen

Recently we saw inflation numbers; both CPI and PPI reach record high levels. The consumer price Index in U.S. showed its biggest yearly gain since 1991 with a 5.02 percent increase since last year. Some analysts have correctly noticed how monetary inflation, measured by MZM (Money with Zero Maturity) has decelerated some what during the last couple of weeks.

Now, the million dollar question seems to be: when will price inflation slow? Looking around, we see a mixed bag of forecasts ranging from tomorrow and never. In reality inflation is really persistent. By this I mean, that once you experience a rising inflationary pressure it’s hard to make it go away, it stick to you like flypaper.

Looking back several years, I have plotted the yearly change in headline CPI in the graph below.

To get a rough measure of persistency we can look at the so called Auto correlation function, where correlation is computed for inflation with regards to its subsequent “lags”.

The result is perhaps more perplexing than one first think. In the graph below we see that inflation today is still affected by the inflation rate 140 month or almost 12 years ago!

No wonder Paul Volcker had to raise interest rates to 20 % in the 70s in order to break the back of inflation.

Based on this historical fact, I don’t intend to give a precise date when I think inflation will come to a halt. But instead, I here like to point out the strong tendency for inflation to “hang around”, for those who think otherwise.

In chess, when the king is trapped, with no exit, he’s checkmate, and game is over!

Now, looking down at the global economic chessboard, during the last couple of decades the U.S. has been wearing the crown. However, this time around Paul Kasriel at Northern Trust, believes that he might be checkmate. He writes:

Our base case economic scenario is that the U.S. economy entered a recession in early 2008, will remain in a mild recession throughout 2008 and will begin to experience an anemic recovery in the first half of 2009. The base case includes a sharp deceleration in inflation in the not-too-distant future as energy prices stabilize and then retreat due to a slowdown in the growth of global demand for energy. The Federal Reserve will maintain the federal funds rate at 2% through the first half of 2009. In the second half of 2009, when economic growth picks up enough to stop the upward trend in the unemployment rate, the Fed will start raising the funds rate.  

Our risk case scenario is that the U.S. dollar begins to fall precipitously coinciding with a rise in Treasury bond yields. U.S. inflation does not moderate because of the depreciation in the dollar. As a result, the Federal Reserve is forced to raise the funds rate even in the face of a rising U.S. unemployment rate. This would be “checkmate” for the U.S. economy, turning a relatively mild recession into a severe one. Why might the dollar dive? Because the U.S. Treasury is forced to issue more debt in order to recapitalize either Fannie/Freddie/ the Federal Home Loan Bank System/FDIC, and the rest of the world balks at being the buyer of last resort for U.S. government debt. As this is being written on Friday, July 11, a hint of this is happening. Rumors are swirling that the U.S. Treasury will have to recapitalize Fannie Mae and Freddie Mac. Rather than resulting in the usual flight-to-quality bid for U.S. Treasury securities, yields on Treasury coupon securities are rising and the dollar is falling. Another factor that could precipitate a further sharp decline in the dollar might be the severing of the pegs that foreign monetary authorities have maintained between their currencies and the U.S. dollar. The byproduct of these pegs has been upward pressure on the inflation rates in these foreign economies. If these monetary authorities can no longer tolerate this imported inflation and sever their currency pegs to the dollar, the dollar would likely go into a tailspin. 

 

For the last couple of years I have been working in the financial sector, as an analyst, mathematician and finally as a fund manager. Now I’m happy to announce that I, from the 1st of September this fall, will start pursuing a doctorates degree in economics at Umeå University, at full time. As some of you have noticed, the posting on this blog has slowed some what during the last couple of weeks. This has been the major reason why. Naturally, this change in occupation has meant quit a bit of effort, getting things in order, making the necessary adjustments, so on and so forth. But I’m planning to be up and running again as usual, in just a short while, so stay tuned!

With the election day getting closer, predictions about the outcome are getting plenty. The latest pollster numbers indicate that more than 80% of Americans think the country is on the wrong track, and only 28% believe that the president is doing a good job. From numbers like these, one can easily draw conclusion that the election already is a done deal. But how good a prediction are they really? As every other survey, there is always a margin of error: people may answer dishonest, or may have a vested interest on one side, etc. Also, questions like: If the election were held today, who would you vote for? do not account for the fact that the elections are held in the future. Some thing else is clearly needed. 

When it comes to the business of forecasting prices, future markets surve as a platform where traders agree to buy or sell merchandise at some future date. Reasonably such interaction should result in better predictions, than say pollsters. As Hayek pointed out, market prices have a dual role, except for allocating resources to their most productive use, they also contain information of their value. When people have a vested financial interest at stake, the above mentioned problems with polls could easily be avoided with futures.

This brings me to IEM or the Iowa Electronic Markets. Like future markets such as CME (Chicago Mercantile Exchange), IEM provides a futures market for political election. By looking at future prices for the current presidential election, we get a better picture of the probable outcome. By watching the price paid for a democratic versus a republican victory-future, we get the percentage probabilities for both parties geting the majority of votes, as can be seen in the picture belove:

We can see that the Democrats have been in favor, pretty much all the time since June 14th 2006, when the history started. But looking at the graph we see that the republicans gained support early on this year. 
At the moment, the likelihood for a Democratic victory are 62.8 percent probability versus 32.5 for a republican victory. 

The election is held 4th of November later this year. Who will win is by no way certain. Lots of things can still happen. Don’t just listen to the pollsters, and do remember to check the IEM futures market in the upcoming months!