Inflation and the Common Knowledge Game

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  1. “the only thing that changes behavior is when the little girl (what game theory would call a Missionary) announces the Emperor’s nudity loudly enough so that the entire crowd believes that everyone else in the crowd heard the news. That’s when behavior changes. That’s when behavior changes FAST.”

    Smacked me right between the eyes.

    Thanks, Ben.

  2. I’ll repost this from elsewhere but I’ll tweak it for this topic.

    Here’s how this works, and it’s pretty obvious to anyone paying attention:

    1. No, inflation isn’t real.
    2. Ok maybe inflation is real but it’s only going to hurt the wealthy.
    3. Akshually it’s a good thing that inflation is here, we never said it wasn’t, and frankly we think it’s pretty {insert undesirable ad hominem} that you’d even object in the first place because now poor people are making more money.
    4. (After some polling comes in) Oh shit, maybe inflation isn’t a good thing and maybe it doesn’t help the poor after all. Somebody :tm: needs to do something about this.

    The playbook is pretty standard and frankly it bores me that nobody has come up with anything more clever than this.

  3. Avatar for jrs jrs says:

    I was born in the early 80s, so as Ben implies I have no experience with inflation. Does anyone have a good read on exactly what the inflation playbook or common knowledge to protect oneself from inflation was the last time it happened in the 1970s?

    I did read John T Reed’s Protect Your Life Savings From Hyperinflation and Depression. Reed was a real estate investor in the 1970s and has done a lot of research on other inflationary periods throughout history. Reed has obvious political biases and he needs a good editor, but I basically learned 2 things about inflationary times from this book:

    1. The value of bonds will usually decrease. The value of stocks, surprisingly to me, will be variable. Sometimes they go up in inflationary times, sometimes down.

    2. The best way to protect myself and my family from ruin during inflation (and depression!) is to own everything we will ever need, today, or the means to produce it, as much as possible. Of course, this can be a very expensive strategy. Reed writes about how his father’s family owned a farm in West Virginia during the Great Depression and their life pretty much went on as usual since they were self-sufficient. But it was a hard life and Reed’s father hated it, moving to the city and eventually becoming an alcoholic.

    Do we agree that this was the common knowledge of the 1970s? Or is Reed’s perspective an outlier?

    I am also curious for Ben or someone else to unpack this quote specifically in the context of inflationary times:

    Your embrace of the cult of Vanguard, at least as that cult is expressed today as the worship of passive index funds, will give you pain rather than comfort.

    I am no longer a big fan of index funds (“but compared to what?”). But naively, I would think that owning index funds is riskier in deflationary times than inflationary. Since in deflationary times you know everything is correlated to move down together, no?

  4. I’ve read Powell’s speech from last week 3 or 4 times. Partly, because of the change in the way he talked about pandemic now contributing to inflation vs. deflationary in the past. Conveniently, now everyone this week believes omicron is weaker and the pandemic is effectively over, so supply chains will normalize in 2022.

    That has and continues to seem “too easy”, but I guess the next pivot point is trying to predict when everyone figures out we “are being too optimistic”.

    For some reason, all I can think about is Goldman reiterating Dalio for 2022, saying “Cash is trash”.

    Screenshot 2021-12-08 113756

  5. Avatar for bhunt bhunt says:

    Don’t have a view on John T Reed, @jrs , but I’ll try to unpack that quote about passive index funds.

    Your embrace of the cult of Vanguard, at least as that cult is expressed today as the worship of passive index funds, will give you pain rather than comfort.

    The basic idea here is that a) there’s not a Fed-supplied liquidity tide lifting all equity boats in a tightening cycle, and b) as we’re seeing in the tech sector today, there are a lot of losers and not just all-winners when the narrative barge changes course and starts moving in the other direction. Specifically, I think we’re looking at a prolonged period of multiple contraction for “story stocks”, which will hit the largest S&P 500 sector weighting - tech - the hardest.

    Bottom line - I think that there’s ‘space’ for stock-picking to work again as these tectonic plate narrative regimes shift, which is (relatively) bad for passive index funds and particularly bad as you’ll see real assets (as opposed to financial assets like an index fund) go up more sharply and with a big drum-beating narrative.

  6. Avatar for jrs jrs says:

    I think I understand. So your quote is contingent on (a) the Fed raising rates (etc) rather than letting the party continue. And your (b) boils down to that old quote about swimming naked when the tide goes out. So you’re not speaking of inflation in isolation, but rather as coupled to the government’s likely response to it.

    The Boglehead narrative is that active stock-picking does not work and has never worked. And to the extent that it does work, it is ultimately due to insider information in one way or another. The narrative is that multiple papers have been published showing eventual reversion to the mean for most or all active strategies studied, meaning the pickers just got lucky.

    That part of the narrative still rings true to me, although maybe it’s just a crutch for my own financial ignorance and laziness. (And if so, then I am one of millions of doctors and other non-financial professionals who are so fooled. And our Missionaries like Jim Dahle and William Bernstein are similarly fooled.)

    So, to perhaps unfairly frame this in the Boglehead way: Are you aware of any study or other evidence showing that any active strategy consistently made money, +/- before our current water became a thing?

    (Now that I write it out like this, I see that this question may be impossible to answer rigorously, as it seems common knowledge among active investors that soft insider information was much easier to get before the 1990s or so.)

  7. Avatar for Zenzei Zenzei says:

    Can I suggest a different avenue of inquisition to arrive at an understanding of how the Water may be changing?

    Personally, I am very interested in the idea that the game is not shifting between “active” and “passive” but between content and system. In other words, that what is happening is not really about the content in the system (the securities themselves) and strategies on how to play them, but about structural changes to the system itself; changes that are redefining the game.

    For example, Bogle argues that above a certain level of indexing the system equilibrium breaks down. I’ve seen estimates that it happens around 80% active. We are currently around 40% or so which suggests we are halfway there. If this view is correct, at what point in the run from 0-80% does the disequilibrium start to make itself felt? Is it linear decay? Exponential decay? Etc?

    And more interestingly, if the disequilibrium in the system pushes the market into a one-sided NGU regime - I wonder what happens to “reversion to the mean”? And if that breaks down - what happens to most of our conventional financial theory?

    Anyway - hopefully this helps you think differently about markets in a constructive way. :slight_smile:

  8. Great book to read as an investor. Not being a polyanna here btw, just being a shrewd clear eyes full hearts guy.

  9. It appears the “common knowledge” regarding inflation, has also made it to the White House. In my opinion, really stupid to try and get in front of this number with a presidential speech.

  10. Avatar for bhunt bhunt says:

    LOL. Completely agree, @Carl_Richards . I guess the print tomorrow is REALLY bad!

  11. Avatar for jrs jrs says:

    Thanks, this makes sense. I got this from Green’s video as well and it reaffirmed my decision to spend some of my spoils on LEAPS protective puts on my index funds. Would like a cheaper option but I’m no Spitznagel of course.

    I wonder which book Bogle discusses this in and whether he has any solutions. Seems there are subtleties to his original ideas which were forgotten in the mass market.

    If Ben’s theory is correct, and if you are also correct that it’s unknowable what happens next, then buying and holding real assets seems just as likely to win (at least in the personal context of avoiding ruin) as picking stocks based on those real assets. Of course, it’s not necessarily either/or if one has the resources.

    What is “one-sided NGU regime”? My Google returned nongonococcal urethritis, which I agree would not make for a fun market.

  12. Avatar for Zenzei Zenzei says:

    NGU = Number Go Up - a bitcoin culture reference.

  13. image

    Question for the pack from a caveman.

    CPI printed today at 6.7%
    PPI and unit labor costs are closer to 9-10%

    Will this mean higher inflation going forward?
    Is the difference being hedonically adjusted away?
    Are corporations eating the difference and earnings will slow?


  14. Lots of great questions. I don’t presume to have all the answers. Sometimes they aren’t apparent until right before. But you are looking in the right places, and that gives you at least a chance for first mover advantage.

    You could also own the means to barter for

    … Or to barter for it. Or serve those in such a position. My grandparents seemed to do relatively well owning a meat locker and a dairy in a small farming community. The grain elevator owner did really well until a Co-op started.

    Obviously whatever the opposite is. The opposite is not shorting. The opposite is whatever benefits from a relative shift in capital / investment to the smaller end, maybe even away from public markets. Maybe buying a local, small strip mall instead of a major REIT will work. Or what about investing in, or serving small local businesses?

  15. I think the CPI is massaged more than the PPI.
    Shadowstats analysis (former Fed economist John Williams is the founder) posts that when using the 1990 methodology the CPI would be over 10 % !
    When using the 1980 methodology, it would be 15% !!!

    Recall that since 1980 the BLS changed the methodology for calculating CPI 5 times.
    Each time it lowered the #. Shocking I know.

    So no inferences can be taken from the differences between PPI, Labor Costs and CPI

  16. Avatar for Pat_W Pat_W says:

    I find it most helpful to look at the inflation numbers for particular categories of goods. Inflation in meats is quite high. It is also higher in housing and health care. Those are the major expenses for most families so a CPI that gives weight to the cost of electronic devices, which tend to get cheaper, is already a bit off the rails for my needs.

  17. Avatar for Zenzei Zenzei says:

    What’s fascinating about all of this is that the first note that brought me to ET was:

    Worth a re-read, particularly Ben’s tirade about the BLS…

  18. Indeed, a prized classic. The original intro of Neb Tnuh is awesome:

    For Neb, hell is other people who want to talk about markets or politics. It’s not that Neb is so certain that he has the answer for what’s going on, for why his Twitter feed is a dumpster fire, for why the markets seem like a bad joke and why politics seem like “Black Mirror” re-runs. No, Neb is positive that he doesn’t have an answer, that he’s definitely not in on the joke."

  19. I would submit to The Pack the following data from the most recent CPI release at for your analysis and observations.

    These are the most recent 12-month and 1-month changes in CPI - summarized at the indent-4 level. Black bars are the headline. Red is higher and blue is lower. (I’m happy to share the files for your own slicing.)

    At the risk of not falling in line with the cool kids, this would appear that inflation woes are due in large part to rising fuel costs and not necessarily a monetary policy error, per se. From these data, it seems fuel, cars, and items where shipping costs are most impactful to price are where most of the inflation lie.

    I would wonder if inflation is more a result of OPEC and the oil companies rather than a monetary policy mistake.

    I cannot be the only one coming to this conclusion. It would explain Biden’s November release of the strategic petroleum reserve. Of course, policymakers could never tell us what they are really thinking - you can’t handle the truth!

    I sense that this isn’t a monetary policy issue. It’s probably more than just a fuel issue, too. Supply chain and China fit in there somewhere.

    This puzzle will work itself out and the answer will seem obvious, after the fact. Today, I don’t know that Jay Powell and the Eccles Building gang are where the blame lies.

  20. But I can’t help but think the Fed has a seat in the back room. As such, watching the Fed presser- having some background in the performance arts, I’m able to get some use.

    If I had enough interest, and had a bored intern, I would have them go back for the last year of pressers and analyze reporter questions, and which answers Powell read from a prepared statement. It’s frankly amazing to me that with virtual meetings that he reads from the podium instead of a teleprompter. That one, I’m not sure if it’s a bad performance, or they don’t really care.

    Either way, I’m intellectually curious which journalists are leading roles in the theater. Not sure that it’s important enough to take the time myself, mostly because I trust ET to give me plenty of prediction into changes by the play narrators.

  21. I don’t see anything the Fed did yesterday that will slow down the rate of Increase in Inflation.

    They will continue to print money to fund gov’t spending programs (until April)
    They will keep extreme Negative Real rates at least throughout 2023 (based on their dot plots)
    They remain concerned about upsetting financial markets

    Nothing that changes the “Inflation is Here” new Common Knowledge
    Inflation simply gets increasingly embedded via the wage/price spiral that Ben has noted

    The Fed seems to be betting on “Hope” that Inflation will diminish
    “Hope” is not much of a strategy, but it does defer their own psychological “Pain”

  22. The BLS numbers are conveniently insulated from a large majority of current inflation.

    From 2008 - present, markets have had “Certainty” knowing the Federal Reserve has had their back.

    From March 2020 to present, markets have had “guarantees” with zero interest rates and zero risk of business failure.

    Trying to parse whether it’s zero interest rate policy, the first $4 trillion of QE from 2008-2020 or the 2nd $4 trillion of QE from March 2020 to present is a policy error, well, seems, I don’t know… Is there even a debate?

    Now, we are entering a period of “Uncertainty”, because every choice in an inflationary world has consequences. Want to remove QE, raise rates? Growth slows. Want to maintain current policy that it’s “transitory”? Risk hyperinflation, growth slows.

    With high-yield debt everywhere, markets won’t wait for Powell to discern winners/losers, which is what’s happening today. I have no doubt the Federal Reserve can stop inflation, but there will be consequences.

  23. At the risk of an “OK Boomer” response, I see the Narratives stretched to near breaking points. Yet, the Wall Street machine trots out the backtest to keep the hope up that all of the plates will keep spinning. A set of forces underpinned what the Bank Credit Analyst calls the Debt Supercycle the past 40 years. In no particular order:

    1. Real interest rates dropped from double digits to negative over 40 years.
    2. Nominal rates fell further as inflation also ebbed from high single digits to sub 2% (CPI).
    3. Debt replaced equity in capital structures as it got cheaper and cheaper.
    4. Leverage increased as asset prices became the bulwark for credit rather than cash flow.
    5. Credit creation became global and financed by all manner of non-bank entities.
    6. Valuation multiples expanded due to the math of lower rates, entities stuffed with capital that must deploy it, and the eventual loss of safe income derived from the asset class of bonds.
    7. Demand was pulled forward due to wealth effects and the availability of credit.
    8. The system is fragile during credit stress as the recessionary periods create “bank runs” that wipe out levered capital and dry up the credit needed to keep the system growing.
    9. Central banks are tasked with both easing and trying to provide backstops when financial conditions tighten.

    And, here we are.

    Inflation is BAD. Not only because Central Bank toolkits are bereft of strategies to neutralize it other than things that tighten financial conditions (higher interest rates, less credit creation). Inflation is also unpredictable in the ways it impacts business costs, revenues, margins, and free cash flow. It also undermines confidence when consumer incomes fail to keep pace with it.

    Inflation is really bad if Central Banks lose control of the Narrative. If they do, numbers 1-7 listed above all head in reverse. #8 recurs. Instead of #9 riding to the rescue by easing - the inflation in the system keeps them sidelined and in many cases actively tightening.

    If Inflation truly becomes persistent over the next few years it will not be easy to find investments that win. The most recent US experience with high inflation featured 10% plus bond yields and single digit P/E multiples that made financial asset valuation more resilient to higher inflation. As a thought experiment, value a real estate portfolio at an 8% cap rate instead of a 4% cap rate. With the type of leverage typical in those portfolios there is no equity left.

  24. Tomorrow, Primo Missionary J Powell is scheduled to speak at his Nomination hearing to Congress. In the past decade or two risk markets have typically rallied into a Fed Chair’s public speaking engagements, confident in the assumption that they would have soothing dovish statements .

    Now that Common Knowledge about Inflation is beginning to change, it’ll be instructive as to how the market acts before his commentary. I’m old enough to remember the market absolutely trembling before Fed Chief’s public statements, back in the ancient times when the Fed was fighting instead of encouraging Inflation.

    It will also be instructive the phrase-ology Powell uses. I don’t think it possible to thread the needle anymore but who would have thought the word “transitory” (when they applied it to Inflation) would have been so powerful ?

  25. Given the dramatic rally yesterday pm and over night , I can guess that there remains the sense that Fed chairmen are still there to support risk markets

    If Ben & Rusty are right that the Missionary is carrying a different tune, I would think there will be disappointment with the Powell’s comments

    And if Powell does re-emphasize the need to stop Inflation, what are the odds that Chuck Schumer (or another politician) will be saying “Get back to work Mr. Chairman” ?

  26. 7% YOY out this morning. The last time inflation was here was in 1982. Compare where interest rates were in 1982.

  27. Avatar for 010101 010101 says:

    The United Nations Food and Agricultural Organisation food price index is 28.1% higher across 2021 than in 2020.

  28. Remarkable how much trust and complacency there is out there.

  29. I thought Powell’s testimony indicated he was going to stay Firmly BEHIND the curve.
    “If we see Inflation, we will then raise rates” he said.
    That doesn’t work when Inflation is embedded (like now)

    Curious what other members of the Pack think

  30. This chart from Jeffrey Gundlach’s market charts call yesterday. From Minack Advisors. Fiscal policy filled in the gaps - underpinning inflation. The future course of fiscal stimulus will say much about the rate of inflation ahead.

  31. Interest rates below inflation levels will allow Gov’ts to erode the value of their high levels of outstanding debt without having to resort to overtly punitive taxation. The bigger the difference, the quicker it will go. I expect the CB’s will be constantly testing the wind for levels of disaffection and adjust their soothing verbal output accordingly.

  32. Right, that’s the Ray Dalio prescription for fixing things.
    As we discussed, I think this is a highly unfair one, unfair to the majority of Americans that bear the biggest brunt of Inflation.

    I don’t even think it’ll work because as Inflation rages (and without the discredited OER calculation by BLS at over 10% today) it will tear the country apart politically. That “strategy” takes years to play out, no way the Middle Class sits idly by and accepts this latest gov’t policy prescription.

  33. Disposable income GREW $2 trillion above trend in '20 and another $3 trillion in '21 while in the private sector income is still below trend.

  34. It is unfair but so is shoveling more money out the door than is brought in through taxation.

    I’ve no idea how people will react. While the times are different than post WWII, human behavior hasn’t changed. The “money illusion” is pretty powerful.

  35. Long existing commodity producers (especially food & energy). The lack of reinvestment in those sectors is a set up for violent repricing.

  36. I see the headline from Reuters declares without any evidence that inflation is close to peaking…I guess they haven’t spent much time looking at how rents lag housing prices.

  37. I can fix it ——for rents change the formula to just include NYC rent control units.


  38. Tippy Top Analysts in the Eccles Building. Forecast Summary from Dec '20 attached. Since the print is small, Core PCE for 2021 was expected to be a range of 1.7-1.8%, this was a substantial uptick from the 1.6-1.8% in the prior forecast. November of '21 actual was 4.7%, December drops on 1/28

  39. This came out right around the time I was on a Zoom with one of our company’s PMs. It was him, me, and two other people in my office, so it was an intimate conversation. Small group settings allow for a lot more detail to be discussed. When I asked him how they were positioning their various long equity portfolios to account for inflation he assured me that the Fed’s target of 2% was not going to be “meaningfully overshot”. This is not a dumb guy who just lucked into his job. How in the world did he get it so wrong? How is it possible that a dumbass like me (and a ton of very sharp people in the Pack) saw this coming but the super smart guys who manage billions and the Fed officials who literally do this for a living missed it? Hell, even forecasting 1.8% and having it print at 2.1% wouldn’t have been that embarrassing. But to miss by so much is just…I genuinely don’t get how that’s possible.

  40. My guess is that the more people’s time is tied up with work, the less time they have for actual thinking and the more their thoughts are the product of whatever echo chamber they live in. That said, I’m very interested to hear what others on here who are closer to this think about this question.

  41. Many factors but I keep coming back to FISCAL POLICY. The Fed couldn’t, or at least didn’t, pencil in any of the Trump or Biden fiscal packages in the forecasts. When $3 trillion deficits in back to back years show up and the Fed balance sheet picks up the tab to hold the debt issued, Voila! Trillions in everyone’s pockets with service spending potential crimped due to Covid.

  42. How did PMs and the Fed miss it so badly ?

    1. They Rationalized, they wanted Inflation to not be a problem because that makes life so much harder for them.
    2. Fed economists are almost all trained in Neo-Keynesian/Monetary activist school.
      Academia doesn’t teach Austrian, doesn’t teach Friedman/Money Supply, doesn’t teach Classical economics.
    3. And Powell is a Lawyer, he counted on the economists to tell him what to do.
  43. Powell was very much aware of the economic law , I remember him distinctly saying that we needed to unlearn it. Last Feb —I was on a plane heading home from Pinehurst and I had my “ this time it’s different” moment I was watching his testimony for the Senate and was responding to a question from Kennedy (La).

    The hubris of that exchange was truly frightening.

  44. Avatar for 010101 010101 says:

    They look at a nation. It is their habit. Their philosophy is one of the many, not of themselves. They see a garden that is alive, vigorous, vibrant and burnished with the righteous fire that is America. They are ultimately correct. It is the power of this gospel, to convert a wayward public, to shepherd the US back into the fold. While He is in the chair He is the light of the world.

    Let’s face it, interest rates ain’t the flaming sword that guards the gates of Paradise
    (AKA cheap goods for the many and rising asset prices).

  45. That is Nobel class contortionism. Speechless.

  46. I don’t think Powell “missed it”, firmly believe he knew exactly what was coming, they were trying to buy time with “transitory”. The narrative now, and you could hear it in Powell’s testimony yesterday, this economy is plenty healthy enough to withstand rate hikes. Here is the money quote:

    Then there’s Bullard, with the narrative that rate hikes sooner will be more effective than later. Pretty hilarious when you think they could have at least started in 2021, but now he makes the statement.
    Screenshot 2022-01-12 220918

    I keep saying to myself “observe, don’t predict” , but sure feels like air is coming out of the balloon.

  47. Avatar for 010101 010101 says:

    Interest rate hikes did NOT strongly correlate with a reduction in aggregate broad money.
    This chart says the legend of Volker was narrative control.

    ‘Prices, thou shalt reduce’ sort of thing but without Charlton Heston.

  48. Most people are worker bees. Most are not curious. We all have our swimming lanes, but few are curious enough to take the time and learn outside of those lanes. Less so without an immediate financial incentive. What has worked before gets replayed over and over.
    I suggest the following: I am positive that most of us here are coyotes.

  49. That observe don’t predict thing is just so damn difficult.

  50. That observe don’t predict thing is insanely difficult for this Y chromosome. It is my “alpha move”. It is my “bang my head against the wall and wonder why I have a headache”. And I still have those days. It’s worked miracles for my poker game, work in progress in trading. #ItsTheHandsYouDontPlay

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