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In 2019 market participants have viewed moves in inflation asymmetrically. Phases of decline, although largely noise, they treated as concerning – thinking that perhaps it’s a slide into deflation (an unlikely event historically). By contrast, the recent acceleration has been largely ignored.
Primarily, this divergent perception reflects a skew on the part of FOMC policy makers. They tend to treat downside inflation surprises more seriously than upside surprises in a world where inflation has been slightly below target since it was introduced in 2012 (never mind that it was substantially above the Fed mandate of price stability for about 50 years before that).
Recent Fed statements suggest that the FOMC might well respond to higher inflation by refraining from raising interest rates anew until inflation breaches 2.5%. I think this approach is unduly risky, given the cyclical state of the economy, but it is tenable if the bond market goes along with it. Refraining has the advantage of aligning with the political calendar, since it is unlikely for any inflation acceleration to broach 2.5% until after the election. This leaves the election winner with a potential problem heading into 2021, however.
Inflation is not Unusually Low
Much of the narrative for US inflation in 2019 depends on the notion that it has been unusually low. There is also a widespread perception that inflation has behaved differently from the rate projected by Fed models: given such a low unemployment rate, the inflation rate should surely be higher. But I would caution against such new age thinking.
A quick scan of inflation rates since 1994 does not suggest that the recent trend in inflation has been particularly unusual (Chart 1). As is almost always the case, the core personal consumer expenditure deflator has risen as a slower clip than the core CPI (the gap averages just below 0.5%-point; in September, it was 0.7%-points).
Looking at the last two late-cycle episodes in the post-1994 era, we see a paradox: the late 1990s experienced core inflation that was even lower than it has been in recent quarters. Core inflation was higher during the 2005-6 late-cycle episode, when there was greater slack than either now or in the late 1990s.
Other Measures of Inflation have Picked Up
Other central banks have developed alternative methods of measuring core inflation. Some of these measures have been adapted to the United States by regional Federal Reserve Banks. The Atlanta Fed has developed the ‘sticky’ CPI—a measure of inflation where the components change relatively infrequently (about 2/3 of the CPI and dominated by services). The Cleveland Fed has developed a trimmed-mean measure, which excludes outlier m/m price increases, whatever their source may be. Both measures have accelerated significantly from low readings nine years ago.
Meanwhile, a simple inflation framework used by former Fed Chair Janet Yellen in a 2015 speech has worked well in 2019. This model posits inflation to be driven by its own lagged values, by inflation expectations, by a measure of aggregate slack, and by the relative price of imported goods. This model does a pretty good job of capturing recent swings, including the dip down from a peak in 2018 to a recent trough in 2019 (Chart 2).
What Would it Take to Push Inflation to 2.5%?
I have used the Yellen model to illustrate my (new) projected path for US core PCE deflator inflation over the next two years (Chart 5). This path projects inflation to be 1.8%oya in 19Q4, 2.2%oya in 20Q4, and 2.4%oya in 21Q4. I assume that inflation expectations are anchored at 2% throughout.
I further assume that the unemployment rate drops to 3.3% in 20Q4, before picking up towards 3.75% in 21Q4. Most important of all, I project the relative import term to shift from a drag on inflation of 0.2%-points in 19Q3 to a boost of 0.25%-point in 21H2. This would be consistent with a firming in goods pricing as the global manufacturing recession ends in 2020, followed by some weakening in USD. I assume this to be partly the result of relative US weakness in 2021 and partly the result of a more difficult US political environment.
Bottom-up Measures of Inflation Still Weak
While I believe the Yellen model deserves highlighting as a useful approach to thinking about US inflation, I remain of the view that a bottom-up approach is also important. There are key components of the US CPI (and core PCE deflator) where movements are driven by sectoral, idiosyncratic factors, rather than the top-down macro variables in the Yellen model.
The two most important sub-components are housing (measured through various rent proxies) and medical care inflation (particularly important to the core PCE deflator). Both measures of rent peaked at the turn of 2016-17 and have drifted down, net, since then (Chart 3). A similar development occurred in previous late-cycle episodes, constraining the acceleration in aggregate inflation. Developments in health care inflation are even more extreme (Chart 4). The collapse in drug price inflation from 5.2%oya in 16Q4 to -0.4%oya in 19Q3 has very little to do with underlying economic conditions.
Bottom line: Upside Risks to Inflation in 2020
Top-down models suggest core inflation could head towards 2.5% in 2020. A reacceleration in goods price inflation, stronger global growth, and a lower dollar could contribute towards this. Bottom-up models are less clear-cut. Nevertheless, viewing recent inflation trends as historically unusual is misplaced and inflation is still alive and present.
While most markets like equities and bonds have well-established valuation models, FX markets often baffle people. What anchors the value of a currency? Well, there are a number of valuation approaches: Purchasing Power Parity (PPP), Behavioural Equilibrium Exchange Rate (BEER), and the Macroeconomic Balance (MB). But which is best? A new ECB paper, The predictive power of equilibrium exchange rate models, puts these three to the test. It finds that the simplest, PPP, is probably the winner, while the more complex and much favoured MB is the least useful.
Purchasing Power Parity (PPP)
PPP is the simplest and most enduring FX model. It states that currencies should move in a way that neutralises changes in price indices (inflation) between countries.
PPP is typically estimated for a currency by taking the average of the real exchange rate over a historical period (the sample). If today’s real exchange rate is above or below that average, then the currency is deemed overvalued or undervalued respectively.
In this paper, the authors apply the Consumer Price Index (CPI) to the spot exchange rates to compute the real exchange rate between 1975 and 2018. And rather than looking at bilateral exchange rates, they calculate trade-weighted exchange rate baskets. They find that the sample average for most currencies is stable except for the Swedish krona (SEK), Swiss franc (CHF), and the New Zealand dollar (NZD) (Figure 1).
As for the latest valuations, their estimates suggest that the USD, NZD, CHF, and Australian dollar (AUD) are overvalued. Meanwhile the SEK, Japanese yen (JPY), Norwegian krone (NOK), British pound (GBP), and Canadian dollar (CAD) are undervalued. The euro (EUR) is moderately overvalued (Figure 1).
Behavioural Equilibrium Exchange Rate (BEER)
PPP implicitly assumes that the real exchange rate is mean-reverting around the sample average. But at least in theory, there are reasons that the real exchange rate could exhibit a trend. FX models that attempt to find economic indicators explaining these trends are typically called Behavioural Equilibrium Exchange Rate (BEER) models.
The most common economic indicators used are productivity (GDP per capita used in this paper), net foreign assets, and terms of trade (export prices divided by import prices). Increases in the three variables would normally lead to a higher “equilibrium” or valuation for the currency.
The authors run regressions with the exchange rate on one side and these variables on the other side to arrive at the equilibrium values. They find that productivity and terms of trade have the expected sign (positive) but not net foreign assets. Moreover, they find that as time goes in their sample, the size of the coefficients for all three variables declines, which suggest BEER model estimates would start to converge to PPP estimates.
As for the latest estimates (end-2018), they find that USD, CHF, EUR, and NZD are overvalued, while SEK, GBP, NOK, AUD, and CAD are undervalued. JPY is about fairly valued.
Macroeconomic Balance (MB/FEER)
MB, or the fundamental equilibrium exchange rate (FEER) model as it is elsewhere known, is an altogether different approach to FX valuation. Here we need to solve a system of equations to find the level of the real exchange rate compatible with the dual goal of achieving internal and external balance. Put simply, what move in the exchange rate could bring the current account back into “equilibrium”?
To do this, you must work out what the level of the current account would be if the output-gaps in each country were closed. We would also need to determine a target current account, which would be the “equilibrium” level. Finally, we would need to estimate the relationship between real exchange rates and the current account. This means estimating import and export elasticities to the exchange rate. Armed with this knowledge, we can determine how much of an exchange rate move is required to move from the output-gap adjusted current account to the target “equilibrium” current account.
In the paper, the authors simply use the current value of the current account rather than the output-gap adjusted current account as the starting point. For the target current account, they use a forecast for the current account based on productivity, net foreign asset, and terms of trade (they run a regression for this). Then, for the relationship between the exchange rate and the current account, they use import and export shares of GDP (for the size of the trade sector), assuming the export elasticity is zero (exporters take the world price) and the import elasticity is one.
The resultant FX valuation estimates are much more volatile than either the PPP or the BEER versions. In some instance they are even more volatile than the real exchange rate itself. As for the latest values, they show that CAD, GBP, and NOK are overvalued, and that EUR is undervalued. USD, AUD, JPY, NZD, and SEK are fairly valued.
The big question is which models are best to forecast currencies? The authors approach this question this using in-sample and out-of-sample data. They look at four different time horizons: 3 months, 1 year, 3 years, and 5 years. For the sake of simplicity, I focus on their 3-year results.
They find that across all currencies 60% of the PPP models’ mis-valuations are corrected within three years, 72% of the BEER mis-valuations, and 26% of the MB’s. On that metric, BEER wins, closely followed by PPP, and MB lags far behind.
For individual currencies – PPP is the winner for GBP and NOK; BEER is the winner for AUD, CAD, EUR, JPY, NZD, SEK, and USD; MB has no winners
Here, the authors compare the cumulative forecast errors of the model using out-of-sample model estimates. They compare these to a random walk model – i.e. using today’s estimate as the best forecast for the future (a bit like tossing a coin). They see how much better the models can perform relative to the random walk model.
On this metric, they find that the PPP and BEER models are joint winners, while MB loses out again. On an individual currency basis, they find that the BEER model does best for commodity currencies (AUD, NZD, and CAD) as well as for JPY (a major oil importer), while PPP does best for USD, GBP, EUR, and NOK. MB does best for SEK, though only marginally outperforms the random walk (Figure 4).
The results conform to the work I’ve done over the years. For valuations, simplicity is best. PPP is the best bet in most cases except for commodity-affected currencies where BEER outperform. But the more complex (and much loved by economists) MB (or FEER) models are terrible for forecasting. This is unsurprising given the number of assumptions and estimates required for them. MB’s only consolation is that it may have some predictive power for the Swedish krone – the one currency that most valuation models fail on.
There are so many websites, blogs & podcasts that it's hard to keep on top of it all, so it's always useful to have a source that picks up stuff you've missed
Global Macro Hedge Fund Manager
I been reading your stuff, very interesting…I have been forwarding your mail list to people saying that it's a good list to be on!
Global Macro Hedge Fund Manager
Frankly, I love how different this is than everything else I look at. For me, quick reads hitting major points are preferred rather than in depth reports
Global Commodity Corporate