Saturday, May 30, 2009

Inflation, Schminflation; the 10-year is a steal; Fed on hold till 2011

Warning--long post. Bottomline: inflation is headed down for the next 12-18 months at least. The Fed won't raise until 2011, possibly 2012, and that too only if the sanguine economic outcome obtains. The 10-year US treasury is a screaming buy. You can play it through IEF, TLT, options on them.

No sooner have the stock markets rallied, inflation-hawks, hyperinflationistas, so-called bond vigilantes have come out of their foxholes in full force. The long end of the yield curve has sold sharply, the 10-year yield up from its low of 2.07% earlier this year to a high of 3.7% a few days back. The usual arguments-- "we are printing money up the wazoo," "US federal debt burden is unsustainable," Chinese don't want to hold Treasuries,"--are back in full force. Of course, no one really bothers to explain how we are actually going to get to high inflation from the current deflationary environment. Printing money, running deficits are axiomatically supposed to create inflation, if not today, definitely someday in the indefinite future. Never mind that printing money and running deficits for a long, a very long time, has not exactly been very successful in creating inflation in Japan, let alone hyperinflation.

Anyway, since we are interested in the mechanisms of inflation and not content with axiomatic assertions, I will explain why a rising inflation trend is far away. First, there cannot be any sustained rise in inflation without a sustained increase in inflation in nominal wages. Unit labor costs are the dominant influence on inflation in the long run (see chart below).

Low labor cost inflation is the main reason why headline inflation has been relatively low even when commodity prices were zooming in 2007-2008, unlike what happened in the 1970s and early 1980s. Take a look the following chart of PPI (producer price index) broken up by stage of processing. Crude goods inflation has been almost as high as in the mid 1970s reflecting commodity price rises, whereas in finished goods, where the labor input is predominant, inflation did not rise as much as back then.



Now, let us look at compensation inflation, which is the main driver of unit labor costs (productivity is important at low levels of inflation, but if we are talking about raging inflation, changes in productivity are insignificant). The ECI, published by the Bureau of Labor Statistics (BLS) is the most comprehensive measure of compensation costs. It is broken into wages and benefits. I show below wages and total compensation.


Unfortunately, the series gos back only to 1976. Nonetheless, the basic point is clear. Compensation inflation is low and declining. Of course, rising unemployment rate is putting immense downward pressure on wages. Back in the 1970s, even with high unemployment, was inflation remained at high levels and did not start coming down until Volcker jacked up interest rates to 20%, creating what was then the worst recession in the postwar era. Higher levels of unionization, oligopolistic industries, and limited global competition meant that workers could ask for and get pay raises to compensate for inflation, thus sustaining the wage-price spiral. Fat chance of that happening today. Also, the overall unemployment rate covers up a major distinction between the 1970s--a distinction that goes to the heart of why workers had more bargaining power back then. Take a look at the unemployment rate of men over 25.

Compared with the 1970s, the unemployment rate of men over the age of 25 is much worse today. The overall, unemployment rate in the 1970s was driven by a huge increase in the labor force--thanks to baby boomers and an increase in the participation rate of women. The economy actually created a huge number of jobs but was overwhelmed by the increase in supply. Unemployment was disproportionately concentrated in the recent entrants. Older, experienced workers had more stability and thus greater bargaining power. That is certainly not the case today. Today's situation, like the early 1980s, suggests a steep decline in wage inflation (see the ECI chart). Given where it is starting from, outright deflation wages is very likely.

Lastly, if you look at the chart of ECI, which plotted along with the unemployment rate, you can see that to get wage inflation trending up again, the unemployment rate probably needs to come down to 5 percent or lower range. The unemployment rate today is at 8.9% and rising sharply. After the last recession, it took about 2 and a half years after the official business cycle trough (November 2001) for the economy to start adding jobs. The Fed started to hike rates only after that. And this was in the midst of a housing bubble. We may well not see job growth before 2011. Even if we do, it will take much longer to get the unemployment rate down a number that is see as politically acceptable and potentially inflationary down the line. Yet, the market has convinced itself that inflation is just around the corner.

Sunday, May 17, 2009

Notes on India's Elections

I am an economist and usually don't comment on politics. However, remember that economics started as political economy. 
The results of the recently concluded elections have shocked some and thrown the supporters of BJP into despondency.  In despair, the wrong lessons are being learned and (foisted upon by those who would like the BJP disappear). Here are my quick thoughts:
  • Let me start with the positives first (positive reinforcement and all that!). The Left has been decimated. As that astute sage Rajaji said long back, the communists are the number 1 enemy. Growing up in Calcutta in the 1970s and 1980s, I remember how the left used to rail against dynastic politics. Back then the Congress was the enemy number 1 for the left. It is amazing how the Left was willing to support the same dynastic Congress to tackle the current perceived enemy number 1--the BJP. The frog made a deal with the snake. Well now, the snake is reaching out to your own family member. The Left got a shellacking in its impregnable Bengal bastion. Actually the Bengal results point to a broader pattern (more on that later). The left lost all the border states except Cooch Behar. Now, those are incidentally the states that have the highest Muslim presence. Essentially, the Left has been left holding the Bengali Hindu votes. Nandigram was ostensibly the trigger behind the Muslim desertion of the Left. But somehow I doubt that. Those votes are not coming back. There is a lesson in this for the Bengali Hindu bhadralok as well.
  • The BJP did NOT lose because of Varun or Modi. On Modi, the last time I checked , the BJP won 15 seats out of 26, more than it did in 2004. BTW, Gujarat has been heavily hit by the global recession--diamond cutting in Surat, textile exports. So, some loss was expected. But Modi held ground. In fact, the BJP did well in all its bastions where there was no infighting. If people are put off by polarization, then BJP should have lost in Karnataka. BJP's loss in Rajasthan reflects infighting as well its Achilles heel--the problem of caste. The Gujjar reservation fiasco is still fresh. In UP, the BJP has no leader worth his salt. MM Joshi, Rajnath Singh are all washed up old geezers. Actually Varun's success amid this ruin, points to the potential for Hindu consolidation.
  • Mayawati and Mulayam did not exactly get wiped out. But like the Left in Bengal they lost the Muslim vote. Muslims recognize that Congress is now their best bulwark. From mayawati's statement it appears that she is still trying woo Muslims back. it may work at the state level. However, it will not work at the national level. The OBC-muslim alliance is not workable going forward. OBCs have been the rising force. They are an upwardly mobile group, seeking to assert their place in the sun. Muslims essentially act out of a defensive mindset (in some ways like the Left). With the Brahmin-Bania no longer in power, the OBCs in the North have nothing against Hindutva per se. In fact, most of the ascendant BJP leaders in the North are from OBC background (Swapan Dasgupta has made the point that BJP is now an OBC party). In that sense, the recent elections were a setback to the rising OBC aspirations.  Narendra Modi is an OBC. Kalyan Singh is an OBC. BJPs future lies with the OBC.
  • BJP should quit trying to woo the mythical urban middle class that somehow can't stand Varun's polarizing remarks. The urban middle class did not come out to vote. The turnout in Bombay was shameful. if after 26/11, BJP can't win in Bombay, it will NEVER win in Bombay.
  • Just as with the Republicans in the US, the minorities will NEVER vote for BJP. In fact, they actively set aside their difference to vote against the BJP--Exhibit Kanyakumari. I have always suspected that there are many more Christians (especially in TN) than the official 2% figures. I distinctly remember having classmates in IITM who were christians but availed of the SC quota (which legally is not available to Dalit Christians).  I think the entire 22;5% SC+ST will eventually become Christians --too much global and domestic money working toward that goal. This has clearly had some effect in Tamil Nadu, Andhra and Orissa. Like the Left in Bengal, Laloo in Bihar, Mulayam and Behenji in UP, the Dravidianist Tamils (non-Christian ones) are eventually going to get their comeuppance. Their brethren in Sri Lanka were left to hang dry by a DMK that did nothing and yet was never punished. The wily coot Karunanidhi played this game well tactically but this may turn out to be the beginning of the end of the middle caste hegemony in Tamil Nadu.
  • The industry seems to be relieved that the Congress will now not have the Left holding back on reforms. This is poppycock. The Congress under the Gandhis has never been for reforms. For the record Manmohan Singh is a puppet and was always a puppet. Manmohan Singh the reformer title was gained under Rao, who was the reformer behind the facade. Manmohan Singh was the apolitical face put on reforms. The Congress inherited a sound economic foundation in 2004 and the global economy was soaring for the next four years. That papered over atrocious economic policy (save the exemplary job done by the RBI under sagacious YV Reddy).  The fiscal deficit is now soaring and for a developing country, India has one of the highest debt-to GDP ratios. India is turning Latin America when Brazil and Mexico are decidedly turning their back to the failed policies of the past. Nonetheless, the immediate future is not bleak. The fall in oil and other commodity prices is a boon for India, which is a net commodity importer. Besides, India, unlike China is driven by domestic demand. The long-term future is however bleak. Argentina's experience is instructive. Argentina was the 6th richest country in the world in 1900. Then it started voting in the Perons (equivalent to the Gandhi family in India). Decades later, it is a middle income country and a pariah in the international financial markets.