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Why Inflation Expectations Matter A Lot For Theory

The fallout from the Rudd article on inflation expectations (that I described here) is still percolating around the internet. Duncan Weldon just wrote “We Have No Theory of Inflation” which discusses the issues from the empirical side. In this article,…

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This article was originally published by Bond Economics

The fallout from the Rudd article on inflation expectations (that I described here) is still percolating around the internet. Duncan Weldon just wrote “We Have No Theory of Inflation” which discusses the issues from the empirical side. In this article, I am re-writing and expanding on some points that I noted in my previous article. If inflation expectations do not behave as predicted by neoclassical models, that is a critical problem that cannot be easily dealt with by adding epicycles to the models.

A Theory Cannot Test Assumptions

I constantly harp on the assumptions made by neoclassical economics. The reason for this is that a theory cannot test its underlying assumptions, so they need to be rock solid.

To illustrate this, I will use an example that should be familiar to readers who took (and remember) high school physics: the Newtonian (or pre-Relativity) inverse square law of gravity.

If we take a textbook that covers Newtonian mechanics, it will state as an assumption that gravity is an attractive force between two bodies that is proportional to the product of the two bodies’ masses, divided by the square of the distance between them. (The formal version of the law would need to be expressed with vector notation, which I will skip.)

If we use the terminology of applied mathematics, the inverse square law is an assumption. (It is perhaps more likely to see the inverse square law described as a “hypothesis” — which can be re-phrased as a “working assumption.”) We can use the inverse square law to make predictions about other things, such as the properties of planetary orbits, and that “normal-sized” bodies will all accelerate at the same rate towards the earth in a vacuum. However, we cannot say that the inverse square law is a “prediction” of Newtonian mechanics.

All we can do with the inverse square law is to validate whether its implications are observed in nature. Until General Relativity rolled up, nobody was able to find anything that convincingly contradicted it.

There is nothing wrong with making assumptions: any applied mathematical model has to make some. In the case of gravity, newer theories (e.g., General Relativity) started with different assumptions, and one of the implications of those assumptions was that the inverse square law was approximately correct.

Back to Macro

We can now look at neoclassical dynamic stochastic general equilibrium (DSGE) models with this in mind. What do we see?

The first thing to note that in order to qualify as DSGE model, it has to have all of the properties listed below. The second observation is that the neoclassical establishment blocked any macro theory paper from their journals unless it qualified (whether that policy has changed is unclear, since I don’t waste my time looking at neoclassical articles any more).

  • Dynamic. The model must be specified in terms of agents that are forward looking, with decisions based on optimisations using forward values of economic variables. (There is the issue of whether we should conflate forward pricing with realised outcomes over calendar time.)

  • Stochastic. The model must include random variables (although deterministic models can pop up as a special case). In practice, decision rules are based on the mathematical expectation operator of forward variables.

  • General Equilibrium. All decisions are based on optimisations based on spot/forward pricing that are market-clearing levels.

I will skip the stochastic part, on the basis that it is really only of interest for formal discussions of the empirical testing of the models.

Market Clearing Requirements

It is a safe generalisation that the DSGE literature in practice spends as little text as possible in discussing equilibrium. I will not offer a suggestion as to why this is case, although I have strong opinions on the matter. Instead, I will discuss a point that I have never seen discussed: what are the requirements for market clearing of “expectations”?

We have a straightforward example of such a market: the rates market (e.g., fixed income not including products with credit risk). We can either trade or infer forward rates, which are the “risk neutral” expected values of the underlying spot rate. (E.g., the 5-year rate 5 years forward is the expected value of the random variable that is the 5-year spot rate starting 5 years in the future, using the risk-neutral probability distribution.) I apologise for dropping “risk neutral probability distribution” into my text, but it can be easily interpreted as the probability distribution implied by taking mid-market fixed income option prices.

So long as the reader understands how the rates market trades, they know exactly how any market based on “expected values” would trade.

We can then ask: what do we need for a market to function in the way posited by DSGE models? We need market participants to make binding orders that at the minimum specify a quantity and price. The exact mechanism by which the market is then “cleared” depends upon market structure, which can vary.

Why are these necessary?

  • If orders are not binding, then participants can input whatever orders they want with no repercussions, and so they can go nuts. “I will buy one kajillion widgets at eleventy-billion dollars a piece!”

  • If the orders do not specify a price or quantity, they are useless. (“I will pay four score nine-ten million dollars per widget!” — and buy zero widgets.)

Forecasts Cannot Be Cleared!

When mainstream economists talk about “inflation expectations,” they either refer to surveys, or possibly inflation pricing inferred (somehow) from inflation-linked markets. Putting aside the linker market, we immediately see that they do not meet the above requirements.

Returning to the rates market, we can immediately see the problem. The 1-year forward of the 10-year rate is an extremely useful figure, in that it gives us an economic breakeven for a directional position in that rate. Conversely, the consensus opinion of street economists for the forecast 10-year rate one year from now is a worthless piece of information (other than for providing entertainment).

DSGE models assume market clearing of forward values of prices like wages and the aggregate price level. You cannot clear opinions, you can only clear orders. The models assume that it is possible to trade wages and the aggregate consumer good forward.

Note that inflation-linked breakevens do not qualify: they represent pricing on a derivative instrument, and do not allow purchases of the underlying good. Furthermore, they at best cover the CPI basket, and not wages — which also have to be traded forward to match the models.

Inflation Expectations Are Simple in the Model World

Within the mathematical model, expected prices are very easy to deal with: you just look up the price quote in the market.

This means that there is no reason for agents to disagree about expected inflation and so forth: they can all see the market.

The only way that agents can disagree is that if they incorporate the equivalent of a term premium: the observed forward pricing is a risk-neutral measure, but they believe future realised values are somehow biased versus the risk neutral measure.

Such a variant poses problems for other parts of the model structure. Things like budget constraints use the risk-neutral expectation for future variables. After all, if every agent (including the government) can plant the expected values of future values wherever they want because of “risk premia,” those future values do not practically constrain the agent.

What Are The Testable Predictions?

What are the predictions made by DSGE models about inflation expectations?

  • Everyone trades goods and wage contracts in the spot and forward markets.

  • Everyone is aware of the market pricing for forward goods and wages.

  • They make plans for the future based on that market pricing.

Well, it is clear that this is not the case, given the absence of forward markets for most goods, services, and wages.

My belief is that the standard defence against that observation is that neoclassical economists are mainly aware of the lack of required forward markets, yet observed behaviour is supposed to result from real world agents acting “as if” the forward markets exist.

The problem with this is straightforward: in the absence of forward markets, there is no reason for forecasts to clear, and so actual behaviour is invariably incoherent. Given the importance of large firms in the economy, we cannot pretend that there is an infinite number of agents whose errors cancel out — a few CEOs going nuts can cause a major disruption.

Agent-Based Models to the Rescue

I would argue that only an agent-based model of some sort could handle the issues raised by the incoherence of internal inflation forecasts. The model structure is sufficiently complex to allow for agents following complex decision rules while at the same time interacting in “simple” markets.


Although mainstream economists enjoy making textual assertions about their models that are not backed by the mathematics, it is clear that DSGE models fit very uneasily with the types of “inflation expectations” we work with in the real world (mainly surveys). You need to have models in which agents have forecasts about the future, but without a market mechanism to enforce coherence of expectations. Such a model structure would not qualify as a DSGE model.

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(c) Brian Romanchuk 2021

Author: Brian Romanchuk

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US markets scale fresh highs on upbeat earnings, housing data

S P 500 and Dow Jones closed at record highs for the second consecutive day on Tuesday October 26 while Nasdaq rallied as quarterly results kept the…

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S&P 500 and Dow Jones closed at record highs for the second consecutive day on Tuesday, October 26, while Nasdaq rallied as quarterly results kept the markets in high spirits.

The S&P was up 0.18% to 4,574.79. The Dow Jones Industrial Average rose 0.04% to 35,756.88. The NASDAQ Composite Index gained 0.06% to 15,235.71, and the small-cap Russell 2000 was down 0.72% to 2,296.08.

Traders were further encouraged by the Commerce Department’s positive economic data, which showed new home sales jumped 14% to 800,000 units in September, the highest level since March. However, higher home prices still remained a major worry.

Energy and utility stocks led gains on the S&P 500 index, while industrials and communication services stocks were the bottom movers. Nine of the 11 sectors of the index stayed in the positive territory.

General Electric Company (GE) stock rose 2.19% in intraday trading after reporting its third-quarter earnings. Its adjusted profits were 57 cents per share, above the analysts’ estimates of 43 cents a share. However, its revenue fell by 1% YoY to US$18.4 billion in the quarter.

Shares of United Parcel Service, Inc. (UPS) were up 7.38% after reporting better-than-expected results. Its revenue increased by 9.2% YoY to US$23.2 billion in Q3, FY21.

Lockheed Martin Corporation (LMT) stock tumbled 12.48% after it trimmed its revenue forecast. Its net sales fell to US$16.02 billion in Q3 from US$16.49 billion in the year-ago quarter. In addition, it lowered its revenue forecast for FY2021 due to supply woes.

In the energy sector, Exxon Mobil Corporation (XOM) surged 2.30%, EOG Resources, Inc. (EOG) rose 1.39%, and Occidental Petroleum Corporation (OXY) gained 1.28%. Devon Energy Corporation (DVN) and Baker Hughes Company (BKR) rose 2.37% and 2.88%, respectively.

In utility stocks, NextEra Energy, Inc. (NEE) increased by 1.57%, Southern Company (SO) jumped 1.03%, and Exelon Corporation (EXC) rose 1.10%. DBA Sempra (SRE) and AES Corporation (AES) advanced 1.24% and 1.59%, respectively.

In the communication sector, Alphabet Inc. (GOOGL) rose 1.33%, Facebook, Inc. (FB) fell 4.52%, and Twitter Inc. (TWTR) declined 1.27%. Match Group, Inc. (MTCH) and News Corporation (NWS) plummeted 2.51% and1.17%, respectively.

Also Read: General Electric Co (GE) revises guidance upward after Q3 profits

Also Read: Raytheon (RTX) raises sales guidance, 3M (MMM) narrows EPS outlook

Nine of the 11 sectors of the S&P 500 index stayed in the positive territory.

Also Read: Eli Lilly (LLY), Novartis (NVS) profits up on robust sales growth

Futures & Commodities

Gold futures were down 0.70% to US$1,794.10 per ounce. Silver decreased by 1.55% to US$24.212 per ounce, while copper fell 0.71% to US$4.4958.

Brent oil futures traded flat at US$85.44 per barrel and WTI crude was up 0.85% to US$84.47.

Bond Market

The 30-year Treasury bond yields were down 2.06% to 2.042, while the 10-year bond yields fell 1.55% to 1.610.

US Dollar Futures Index increased by 0.15% to US$93.953.

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Failure To Bury “Transitory” Inflation Narrative Risks Sparking Biggest Fed Error In Decades: El-Erian Warns

Failure To Bury "Transitory" Inflation Narrative Risks Sparking Biggest Fed Error In Decades: El-Erian Warns

Authored by Tom Ozimek via The…

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Failure To Bury “Transitory” Inflation Narrative Risks Sparking Biggest Fed Error In Decades: El-Erian Warns

Authored by Tom Ozimek via The Epoch Times,

Failure on the part of the Fed to toss its stubbornly-held “transitory” inflation narrative and act more decisively to rein in persistently high price pressures raises the likelihood the central bank will need to slam on the brakes of easy money policies much more forcefully down the road, risking avoidably severe disruption to domestic and global markets, according to Queen’s College President and economist Mohamed El-Erian.

In stark contrast with the mindset of corporate leaders who are dealing daily with the reality of higher and persistent inflationary pressures, the transitory concept has managed to retain an almost mystical hold on the thinking of many policy makers,” El-Erian wrote in an Oct. 25 op-ed in Bloomberg.

“The longer this persists, the greater the risk of a historic policy error whose negative implications could last for years and extend well beyond the U.S.,” he argued.

Consumer price inflation is running at around a 30-year high and well beyond the Fed’s 2 percent target, to the consternation of central bank policymakers who face increasing pressure to roll back stimulus, even as they express concern that the labor market hasn’t fully rebounded from pandemic lows.

The total number of unemployed persons in the United States now stands at 7.7 million, and while that’s considerably lower than the pandemic-era high, it remains elevated compared to the 5.7 million just prior to the outbreak. The unemployment rate, at 4.8 percent, also remains above pre-pandemic levels.

At the same time, other labor market indicators, such as the near record-high number of job openings and an all-time-high quits rate—which reflects worker confidence in being able to find a better job—suggest the labor market is catching up fast. Businesses continue to report hiring difficulties and have been boosting wages to attract and retain workers. Over the past six months, wages have averaged a gain of 0.5 percent per month, around twice the pace prior to the pandemic, the most recent jobs report showed.

Besides measures of inflation running hot, consumer expectations for future levels of inflation have hit record highs, threatening a de-anchoring of expectations and raising the specter of the kind of wage-price spiral that bedeviled the economy in the 1970s. A recent Federal Reserve Bank of New York monthly Survey of Consumer Expectations showed that U.S. households anticipate inflation to be 5.3 percent next year and 4.2 percent in the next three years, the highest readings in the history of the series, which dates back to 2013.

El-Erian, in the op-ed, argued that the Fed has “fallen hostage” to the framing that the current bout of inflation is temporary and will abate once pandemic-related supply chain dislocations will abate.

“It is a framing that is pleasing to the ears, not only to those of policy makers but also those of the financial markets, but becoming harder to change,” he wrote.

“Indeed, the almost dogmatic adherence to a strict transitory line has given way in some places to notions of ‘extended transitory,’ ‘persistently transitory,’ and ‘rolling transitory’—compromise formulations that, unfortunately, lack analytical rigor given that the whole point of a transitory process is that it doesn’t last long enough to change behaviors,” he wrote.

El-Erian said he fears that Fed officials will double down on the transitory narrative rather than cast it aside, raising the probability of the central bank “having to slam on the monetary policy brakes down the road—the ‘handbrake turn.’”

“A delayed and partial response initially, followed by big catch-up tightening—would constitute the biggest monetary policy mistake in more than 40 years,” El-Erian argued, adding that it would “unnecessarily undermine America’s economic and financial well-being” while also sending “avoidable waves of instability throughout the global economy.”

His warning comes as the Federal Open Market Committee (FOMC)—the Fed’s policy-setting body—will hold its next two-day meeting on November 2 and 3.

The FOMC has signaled it would raise interest rates sometime in 2023 and begin tapering the Fed’s $120-billion-a-month pandemic-era stimulus and relief efforts as early as November.

Some Fed officials have said that, if inflation stays high, this supports the case for an earlier rate hike. Fed Governor Christopher Waller recently suggested that the central bank might need to introduce “a more aggressive policy response” than just tapering “if monthly prints of inflation continue to run high through the remainder of this year.”

“If inflation were to continue at 5 [percent] into 2022, you’ll start seeing everybody potentially – well, I can’t speak for anybody else, just myself, but – you would see people pulling their ‘dots’ forward and having potentially more than one hike in 2022,” he said in prepared remarks to Stanford Institute for Economic Policy Research.

The Fed’s dot plot (pdf), which shows policymakers’ rate-hike forecasts, indicates half of the FOMC’s members anticipate a rate increase by the end of 2022 and the other half predict the beginning of rate increases by the end of 2023.

For now the market is pricing in a more hawkish Fed response in 2022

Tyler Durden
Tue, 10/26/2021 – 16:49

Author: Tyler Durden

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Kimberly-Clark Forecasts Price Increases as Inflationary Pressures Accelerate, Supply Chain Disruptions Worsen

In yet another sign that inflation pressures are proving to be a lot more than just transitory, Kimberly-Clark (NYSE: KMB)
The post Kimberly-Clark Forecasts…

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In yet another sign that inflation pressures are proving to be a lot more than just transitory, Kimberly-Clark (NYSE: KMB) — the maker of staple household goods such as Kleenex tissues, Huggies diapers, tampons, and toilet paper— has sounded the alarm over impacts of rapidly accelerating prices and supply chain headaches.

Shares of Kimberly-Clark tanked to a six-month low after the company cut its annual forecast due to rising inflation and supply chain disruptions. Third quarter net income stood at around $469 million, which equates to approximately $1.39 per share, against the $472 million— or $1.38 per share reported during the same period one year ago. The company reported an adjusted earnings per share of $1.62, which failed to meet consensus estimates calling for $1.65.

“Our earnings were negatively impacted by significant inflation and supply-chain disruptions that increased our costs beyond what we anticipated,” said Kimberly-Clark CEO Mike Hsu. As a result, Hsu warned that the company will be implementing price increases across a variety of goods in an effort to offset implications of supply chain woes and subsequent acceleration in commodity costs. “We are taking further action, including additional pricing and enhanced cost management, to mitigate these headwinds as it is becoming clear they are not likely to be resolved quickly,” he added.

However, Kimberly-Clark is far from being the only households goods company to sound the alarm over the effects of global supply chain disruptions and a persistent inflationary macroeconomic environment. Recall, General Mills, P&G, among others, have all issued warnings about impending cost-push inflation, as companies contend with margin compression that is further exasperated by ongoing labour shortages.

Information for this briefing was found via Kimberly-Clark. The author has no securities or affiliations related to this organization. Not a recommendation to buy or sell. Always do additional research and consult a professional before purchasing a security. The author holds no licenses.

The post Kimberly-Clark Forecasts Price Increases as Inflationary Pressures Accelerate, Supply Chain Disruptions Worsen appeared first on the deep dive.

Author: Hermina Paull

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