The lies we tell ourselves

Here are two: interest rates will go back to normal and collective DC plans are a good idea

Photo by Kenny Eliason on Unsplash

Hello,

Welcome to Known Unknowns, a newsletter that can’t predict the future—and neither can you.

Slow to wake up to our new reality

It feels like everyone is straining to read the tea leaves. Core inflation is 4.6% instead of 4.7%—looks like a soft landing is back on! One thing is for sure: no one knows anything, but they will keep making predictions anyway.

It concerns me that it seems like markets, the Fed, and policymakers are operating under the assumption that eventually we’ll get our old economy back. Or after this rather unfortunate hiccup, inflation will fall to below 2% and we’ll go back to near-zero interest rates. Maybe, but I would not bet the farm on it. Though that is what we are doing.

Here’s a case for higher rates. It seems like we are giving up on inflation. And I realize every market commentator, many Wall Street economists, and even the Fed still believe the expectations hypothesis (where expected short-term rates—Fed policy—determine long-term rates), but the data keeps rejecting it. Longer-term rates contain inflation expectations and risk premiums, and a big part of that risk premium is inflation risk. Perhaps we forgot this when inflation became low and predictable. But inflation risk is a thing again. And if the Fed is pretty much done with its work, the level of inflation will be higher, and higher inflation is usually more variable. This all adds up to higher rates, even higher real rates.

Though who knows? Maybe all our problems will go away. But I would not make a big financial bet on any one scenario. Especially that one.

I wrote for Bloomberg that the government is still acting like we live in a zero-rate world. Spending is 24% of GDP, which used to be wartime levels, and our plans to spend keep growing. Next up is a middle-class welfare state: tax credits for higher earners, more subsidies on health care, a very generous income-based student loan repayment program (which is effectively ongoing forgiveness), and industrial policy that is increasingly looking like an expensive guaranteed jobs program rather than a way to boost our industrial capacity.

When rates were zero, lots of people argued it was the time to spend big. That’s debatable, but a reasonable argument if you make smart investments and lock in low rates (we did neither). But you don’t commit to more entitlements because one day rates will change. We are levering up, and if rates don’t go back to near zero, we make need to have a tough conversation we’ve never had before.

But won’t the coming recession take care of inflation?

Don’t count on it.

You can’t blame the government for wishful thinking. Markets are already counting on rate cuts later this year. I suppose they think monetary policy works on long, variable lags, and maybe it has already done enough to cause a recession, or just an immaculate credit contraction.

But if you look at past recessions as a guide, a mild recession will not bring inflation down to where the Fed wants it. And a comparison to past recessions may be too optimistic, since the Philips curve is not as steep as it used to be. The Fed reckons a 4.6% unemployment rate will bring inflation to 2%. Perhaps, but that is certainly on the optimistic side.

It seems markets are counting on the Fed to do what is has done the last 30 years: cut rates at the slightest whiff of economic trouble. But that could mean more inflation—and then where are we? It means a less powerful Fed, and that is a big loss.

Monetary policy worked, or seemed to work, in bad times because it had the credibility to cause pain when it needed to. If we assume the Fed lacks the will or ability to bring inflation down, that means it is also less powerful when we need it to boost the economy too.

It's the risk, not the level

It feels like we are relearning all the reasons why inflation is bad. And this excellent story from the Washington Post is a big reminder why. It is not just that prices go up; it is that inflation introduces more uncertainty into your life. Effectively, inflation acts as a salary cut. We assume in finance that a $100,000 annual salary is worth more than an income that is $80,000 some years, $120,000 the next—just because it means more certainty and allows you to make plans and know how much rent you can pay. Inflation turns that certain $100,000 into the risky salary, but with almost all downside risk.

The risk is why there are higher real yields in a higher, less-certain inflation environment, and the risk is also why inflation is really terrible for households.

Sigh, Social Security

I spoke to one of my favorite Pension Geeks, Andrew Biggs, about the prospects of reforming Social Security. The latest Trustee’s report was just released, and the run-out-of-money date has been pushed up one year to 2034.

And yet things still don’t look too good for reform right now. But it turns out some policy makers are looking to try collective defined contribution (DC) plans. This is where there is a sovereign wealth fund that invests in risky assets to fund benefits. If returns are not high enough, taxes go up to make up the difference or we just cut benefits.

Something similar is popular in the Netherlands. Personally, I hate collective DC. I think we sometimes fall into a trap (for many things, not just pensions—one reason why I love pensions is they often offer a useful metaphor for life) where we say defined benefit (DB) plans have problems and DC plans have their problems too, so if we make a hybrid, we’ll get something better. But really we just create something even worse.

Are we really going to increase taxes when markets are down? That is normally when there is a recession—and people don’t have money. Or if you are a pension fund, do you ask employees to pay up when their wealth is down, or just because of mismanagement they had no control over? Not likely.

I don’t love it. But I want to give these policymakers points for creativity and putting an idea out there. It is better than burying your head in the sand and counting on 0% interest rates forever.

Small banks on the run

Small- and medium-sized banks were already disappearing. But the events the last few weeks may be the end. As expected, much more regulation is coming their way. And compliance costs are not trivial, especially if you are not J.P. Morgan. It makes the smaller banks much less competitive.

Also, it is not clear what the insurance limit is for banks that are not “systemically important.” I don’t have a firm view on the right level of deposit insurance, but whatever it is, we should not be vague about it. The lack of clarity is a good reason to get money out of small banks. That and rising yields on money market funds that are looking much better than what your bank account is giving you.

This may turn out to be an issue because small- and medium-sized banks do a lot of retail and commercial real estate lending. If they go away, what happens there? Or vice-versa?

If the market has changed to where credit should be more expensive and smaller banks don’t have the scale to compete, so be it. But I am less comfortable with that outcome if it is the result of confusing policy and onerous regulations.

In other news

Some levity from France.

Until next time, Pension Geeks!

Allison