Why we are wrong about inflation


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Hello. For some reason writing about inflation makes me feel a little guilty, like I’m forcing my readers to eat spinach or conjugate irregular verbs. But it is worth remembering why the topic is so important. In the transitional versus tacky debate, the market has put all its strengths on the transient. This is mostly visible in bond yields, but it is also linked to equity valuations. The odds of several years of inflation well above (say) 3% seem slim to me, but if this is how the dice fall, we’re going to have some crazy times. So please be indulgent with me and read on. Email me: [email protected]

Do we have inflation like the 1950s?

I often describe inflation as the thing that everyone is always wrong about. In my adult life, there was only one thing to say about it that didn’t come back and bite your ass: “It goes lower, and it stays lower, whatever happens and forever. ” Anyone who said anything other than that ended up sounding stupid.

Of course, inflation neurotics can be justified in the end. But it’s worth asking why so many people have been wrong for so long. In this context, this blog post from Gabriel Mathy, Skanda Amarnath and Alex Williams is interesting. He argues that when we think about inflation, we should think more of the 1950s and less of the 1970s. Here is their statement from the standard account of the 1970s:

“The unemployment rate became too low at the end of the 1960s (3.4%), which triggered inflation through a Phillips curve dynamic. This inflation then caused workers and policymakers to revise their inflation expectations upwards, and those higher expectations turned into a higher rate of inflation over the next decade. This tug-of-war then continued until the Volcker Fed raised rates enough to trigger a major recession, which reset everyone’s inflation expectations.

MA&W is right: talk to 100 people about inflation, and 95 of them will talk about it like this. Most of us only have three tools in the box. One: a Phillips-curvey idea that there is a certain level of unemployment below which any economic stimulus effort must lead to inflation. Second: the idea that inflation expectations are self-fulfilling prophecies because pricing officials try to get ahead of them. Third: to say “inflation is always and everywhere a monetary phenomenon” without thinking too much about what that could mean exactly.

And when those are the only concepts of inflation you have, the conclusion you will come to is that the Federal Reserve better be vigilant.

But the 1950s, MA&W point out, saw very low unemployment at the start of the decade, and an “explosion of inflation” that followed, and no shock interest rate tactics were used. to bring it down.

So what was the difference? In the 1950s, inflation rose rapidly as America headed for war in Korea, but:

“Once it became clear that the Korean War would not require the same magnitude of economic overhaul or active management as World War II, inflation expectations quickly normalized. . . The explanation of “inflation expectations” that this experiment implies centers on world events, rather than on previously realized values ​​of inflation. This version adds some empirical realism, but sacrifices the idea that inflation – once started – will create a self-sustaining upward spiral. Instead, inflation rises and falls as expectations about the future change.

In the 1970s, MA&W thinks, the problem was not an expected and realized inflation spiral, but a retooling of the economy that led to persistent bottlenecks and labor markets that could not. disappear. The difference from the 1950s was not about expectations; the underlying economic changes were simply much larger.

The bottom line, of course, is that the economic changes we see today are not as dramatic or permanent as those of the 1970s, and even if they last for a few years, inflation expectations should not. scare us, and we don’t need to worry about a policy error.

MA&W wants a super tight job market (their blog is called “Employ America”). So, like everyone else, they have a political agenda. I am not defending their theory. I don’t know enough about economics to assess it properly. But I am convinced that their starting point is correct: any serious thinking about inflation must begin with accepting that the oldest and most widely accepted opinion has turned out to be wrong.

Aswath Damodaran on ESG

When I say that environmental, social, and governance investments hurt the world, people assume I’m exaggerating for effect; that what I’m writing is click bait. Nope. I’m sure the industrial ESG investment complex is well-intentioned, but I’m also convinced the world would be a better place without it. To use Tariq Fancy’s analogy, the industry sells wheatgrass juice as a cure for cancer: it won’t help; it reduces the chances that the patient will seek the right treatment; and it is not cheap.

It’s a lonely point of view, so I was happy to find that New York University professor and widely cited evaluation expert Aswath Damodaran shares the same point of view. He makes some of the points that Fancy and I have made, but he sets them out much more clearly and more rigorously than the two of us, and adds new wrinkles.

I must note that he and I disagree on one point. He believes that what constitutes good corporate behavior is always going to be contested, so the lack of correlation between ESG rating systems cannot be resolved. I believe consensus on key issues (climate change, supply chain transparency, shareholder rights, executive compensation) is possible. This is why the ESG industry likes to talk about this issue. It is resolvable, unlike other ESG contradictions and conflicts.

Damodaran makes two key points with particular elegance. The first is that at equilibrium, it makes no sense to insist that ESG portfolios can outperform non-ESG portfolios:

“The idea that adding an ESG constraint to investing increases expected returns is counterintuitive. After all, a constrained optimum can at best correspond to an unconstrained optimum, and most of the time the constraint will create a cost.

This is the best expression I’ve read of the simple truth that marketing ESG funds that does good by doing good is just bullshit.

Then, he clarifies the important point (also mentioned here) that ESG attributes can only generate outperformance during periods of transition, when investor preferences change. Subsequently, the cost of capital differentials must signify an underperformance:

“During the adjustment period, highly rated ESG stocks will outperform weak ESG stocks as markets slowly incorporate ESG effects, but this is a one-time adjustment. Once prices break even, well-rated ESG stocks will have higher values, but investors will have to be satisfied with lower expected returns. “

But above all, it asks a crucial question:

“If ESG is a flawed concept, perhaps fatally, and if the flaws are visible to everyone, how to explain the huge push [for it] in business and investment contexts? ”

The answer is that ESG is a deep trough that investment fund managers, accountants and consultants can feed on. Damodaran’s card on this is a delight:

A good read

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