Cullen Roche (00:03:57):
And so in a traditional economic model, QE looks like it should be inflationary or even hyperinflationary when they’re doing trillions and trillions of dollars of it. But from a really, I think basic household perspective, all the household did was exchange the composition of its assets. And so the Fed’s response to… COVID was very, very similar. They had this huge balance sheet ramp up, they cut rates, they did all the same sort of stuff that they did during the financial crisis. But the difference between the financial crisis and COVID was that the treasury was the one that really ramped up their balance sheet and had this huge explosion. And so that’s why I was much more worried about inflation coming out of COVID than I was with the financial crisis, because of the treasuries humongous response.

Cullen Roche (00:04:49):
And so while I got the direction of inflation right, I think the tricky thing with all of this has obviously been the magnitude and the longer lasting effect of it. And I think a lot of that is just that I didn’t think there’d be… God, I didn’t think we’d still be talking about this thing at this point. Who could have predicted the Ukraine war, which Russia basically shuts down one of the largest commodity producing countries in the whole world. So there’s been all these sort of weird impacts that have, I think elongated the impact of inflation and made it a much trickier environment to navigate.

Cullen Roche (00:05:30):
But to me that’s the big lesson coming out of this, is the treasury and fiscal policy is really, really important. And that’s really important to understand going forward, because again, let’s put this in perspective. In 2021, as of the end of June at this time last year, the treasury had run a deficit of $1,7 trillion. These are huge, huge numbers again. So at this time last year, we’re still in the throes of really heavy duty fiscal stimulus responding to COVID. So far this year, through June of this year, the treasury has run a deficit of $137 billion. I mean, in terms of the way the US government usually spends and runs a deficit, this is almost a surplus, which is very, very unusual. So on a relative basis, there has been a huge fiscal tightening. So people talk about the Fed and how the Fed has raised interest rates. And a lot of that has caused this sort of retrenchment in demand and tightening of the economy. And the thing that’s lesser talked about is this huge decline in the relative size of the government’s deficit.

Cullen Roche (00:06:50):
I think when you combine these two things, raising interest rates is a very, very powerful mechanism, because especially in a time right now, it can cause a lot of turmoil in the housing market. We’re starting to see that already. And if you adhere to the theory that the US economy basically is a housing economy, well that’s troublesome from a demand perspective. So high mortgage rates have snuffed out demand for mortgages, made it basically unaffordable for… they’ve locked out another 40 million people with the rate increases from the last few months. So huge, huge numbers. So demand is coming way back, and that has this huge knock-on effect through the whole economy, because when you think about everything that goes into a house, think about the demand for how furniture now goes down, and refrigerators and appliances and all these other things that have a knock-on effect through housing.

Cullen Roche (00:07:45):
But then when you combine that with the fiscal retrenchment, there’s been a big, big government tightening. So we had this big explosion in government spending, in government stimulus in general, and now we’re having a big, big give back. And if the government had continued to do these big programs in perpetuity, that would’ve worried me. I hesitate to say anything like hyperinflation, but a much more prolonged, a 1970s style rate of inflation, where you had double digit inflation that lasted for basically 10 years, that’s a much more plausible scenario under those circumstances. But right now the opposite is happening. And so, how fast will it come down? I think it’s going to come down relatively slow, but I think that we’re now… I think disinflation, meaning a falling rate of positive inflation is going to become fairly well entrenched in the economy over the course of the next 18 to 24 months.

Stig Brodersen (00:08:44):
On your wonderful blog pragcap.com, you said, and I quote, “There is no chance of hyperinflation. I would argue that the risk of deflation is substantially higher at this point than the risk of hyperinflation.” Could I please ask you to elaborate on that?

Cullen Roche (00:09:00):
Yeah, so I think going back to that forward-looking expectation of a recent trend in the fiscal retrenchment, and the Fed’s big attempt to really snuff out inflation, I think that the risk of deflation now becomes greater, because I think that these are both very, very outlier events. So we’re talking about pretty unusual things to begin with, but the risk of a mini 2008 repeat, where let’s say housing prices. I expect housing prices to fall 5% to 10% over the course of the next 18 months, and that’s kind of my base case. So housing is going to be relatively weak I think over the course of the next year at a minimum. There is a chance that I’m wrong about that, that the Fed response is much bigger than we expect, that they’re much more aggressive and much more prolonged with it than we expect. And that housing falls more than I expect.

Cullen Roche (00:09:59):
I mean, housing boomed so much during the pre-COVID period and then the COVID period that you could easily get a 20% retracement in house prices. It wouldn’t surprise me at all if something like that happened, and that would have a very big negative impact on the economy. I think that if that happened, by the time that plays out, let’s say it’s 2024 and housing prices have fallen 20% from their peak, I think at that point, there’s a very good chance that CPI readings and the Fed’s preferred measure core PCE, Personal Consumption Expenditures is negative at that point. And that’s just going to be a function of demand just falling off of a cliff, and this huge knock-on effect from the negative housing market.

Cullen Roche (00:10:46):
So to me, that’s a much, much more likely scenario than a hyperinflation, because in large part, because if you’ve read my research in past years, you know that hyperinflation generally occurs under very, very unusual specific scenarios, usually scenarios such as very corrupt regimes, a government losing a war, a complete regime change in the government, these sort of really seismic events that are very disruptive at a government level. And the government usually responds to that by then printing huge amounts of money. So while we’ve technically printed a lot of money in the last two, three years, you haven’t had this big sort of disruptive geopolitical event at a government level that I think has caused a complete collapse in the faith in the currency. And in fact, I would argue that if anything, what we’ve seen in the last, especially the last 12 months is, if anything, we’ve seen increasing demand for the dollar in a relative sense.

Cullen Roche (00:11:50):
So to me, it’s very hard to envision… yeah, if we were having this discussion and we were sitting in Nigeria or something, it would be a totally different discussion. But when you’re talking about the world’s reserve currency, you’re still talking about on a relative basis. And even if you believe all fiat currencies are trash, the US dollar is the least trashy of the trashy currencies. So it’s very hard for me to envision a scenario where you get this huge collapse in demand for the currency in large part, just because the US economy’s important role in the global economy, and combine that with just the fact that you don’t have the environment for this sort of seismic shift in faith in the currency.

Stig Brodersen (00:12:38):
One of the major macro trends has been globalization, which have been inherently deflationary. For example, not pushing up wages in the US that otherwise would have if Americans had not imported the same amount of goods from countries with cheaper labor. Another is the major demographic trends. Could you please explain how demographic trends can be inflationary or deflationary?

Cullen Roche (00:13:01):
Well, long term trends in demographics around really the whole world are pretty alarmingly worrisome for economic growth, and it’s one reason why… it’s interesting. We went through this… I think that the last 100 years were really, they were sort of unusual. When you look at economic trends, the really long term economic trends, 1% to 2% growth was pretty normal. That was kind of the status quo. And we had this really unusual period where, especially in a lot of the developed world, the populations boomed. And so you had obviously the Baby Boom and things like that, where at a very basic economic level, more people means more demand. It means more output, more things are going to be created. And so, from a crude economic level, you can argue that future economic growth is essentially… well, we can be more productive or we can produce more people which will produce more demand, which will produce more stuff. And that’s sort of a crude economic model, but it’s generally in the long run. That’s generally how economic growth works.

Cullen Roche (00:14:04):
So seeing these declines and even slowdowns in demographics is worrisome, just because it’s foreshadowing of lower growth. And I think again, Japan has really been the playbook for all of this stuff. Whether you even look at QE and fiscal policy, or if you look at their demographic trends, and what’s been going on there, and the very low rate of economic growth there. And I think that’s already playing out across the entire developed economic system. And it’s hard to see that changing, especially in the US, we’re seeing this sort of reversal of some of the hyper-globalization trends, where the US is becoming a little bit more of a closed economy, a little more abrasive towards immigration. And some of the things that have really benefited the United States in terms of… you can essentially argue that immigration is stealing other people from another country and benefiting in economic terms, because you’ve got this multiplier in terms of people.

Cullen Roche (00:15:09):
And that’s especially true in the United States where we haven’t just grown by having positive immigration trends. We’ve grown in large part, because we’ve benefited from a very high quality immigration. Our education system has attracted a lot of people that have built enormous valuable companies here and goods and services. So there’s been an even bigger multiplier effect through that effect in the United States, and a lot of that’s reversing now. So it’s a little bit worrisome to see the decline in demographics because it’s foreshadowing of lower growth. So it’s one of these big secular trends that I think in the long run makes it hard to foresee really even moderately high inflation, something like, or a return to the 1970s. Because again, going back to the ’70s, a lot of that was population boom. People don’t talk about how the ’70s were still the back end of the… really some of the most productive years of the Baby Boomers.

Cullen Roche (00:16:13):
So you had this huge demand boom at a time when you had supply shocks and things like that. And you’re not going to have those trends going forward, because we just don’t have the population growth that we did back then. So yeah, it’s worrisome. But when you combine that with things like technology growth, and the coming fiscal retrenchment and things like that, it’s hard for me to imagine that some of those big secular headwinds won’t be things that are kind of anchoring inflation to some degree.

Stig Brodersen (00:16:46):
So let’s dive deeper into inflation. Could you please explain the concept of velocity of money and whether that’s an important concept to understand inflation.

Cullen Roche (00:16:54):
This is a tricky one. So in the traditional old monetarist methodologies, you would argue that something like MV = PY, which is basically that money times velocity equals price times growth basically. It’s a crude sort of model, and I’ll explain why. Because you can back out velocity based on what your definition of money is. So when you look at the front end of that equation, M x V, well, the tricky part about that is you have to define M. So if you assume that M, for instance, is bank reserves, well when you run your model based on that, and you look at MV = PY, well what does that mean for inflation and economic growth? Well, you assume that it means that demand will increase. So quantitative easing technically is an increase in M under a traditional sort of monetarous model. Well, that should increase P in the long run, assuming that you don’t get a big surge in V.

Cullen Roche (00:18:11):
But when you reverse that, you go through the math on it, well if P doesn’t increase, then V has to have declined. So you can kind of back into this model where when you look at… this has been a common excuse for why QE didn’t cause inflation, people will argue, well V just went down. Well, of course V went down because P didn’t go up. But the problem with that is that when you look at quantitative easing, well the problem there is that your definition of M was wrong the whole time, or at least your definition of M was, I think, very, very loose to a point where, because you didn’t understand the difference between treasury bonds and reserves.

Cullen Roche (00:18:56):
Well, like I said before, quantitative easing was just this asset swap. So technically we increased the quantity of M. But if you included treasury bonds and the definition of M, well from a private sector perspective, all that happened was the amount of M was swapped. The Fed created more reserve M and eliminated from the private sector, treasury bond M. So there was this clean asset swap. And so the velocity of money went down in part because you could argue that quantitative easing, for instance, coming out of the financial crisis, was deflationary. Basically what the government did was they reduced the value of the M that they created, because they reduced the amount of interest they were paying. And that’s what quantitative easing does.

Cullen Roche (00:19:51):
So there’s this interesting theoretical debate about was quantitative easing inflationary or was it deflationary? And I’m not really sure. I mean, there’s all sorts of knock-on effects from quantitative easing and interest rate impacts and things like that, and I don’t have a strong, definitive view. But I suspect that quantitative easing is far less powerful than people generally suspect.

Cullen Roche (00:20:14):
So getting back to the question with the velocity of money, it’s this very tricky thing to really articulate, because you have to have an accurate definition of M, and I prefer to use… I don’t think you can use a black and white definition of what M is. I think that in my view, money is something that exists really on a scale. I argue that stocks have a certain degree of moneyness, and this concept of moneyness is important because treasury bonds, while they may not be strictly money, they have a certain degree of moneyness. And so when you think of things in this sort of scale rather than a black and white model, the world gets a lot more difficult to put into this strict mathematical model like the velocity of money likes to define. And so to me, I don’t find money velocity to be a very useful metric, just because I don’t think you can strictly define what M is in this mathematical sort of sense.

Stig Brodersen (00:21:22):
Cullen, every week, The Economist publishes economic and financial indicators for the 43 biggest economies in the world. And there are only three countries that have a positive budget balance, Denmark, Norway and Saudi Arabia. If you don’t know what the budget balance is, it’s the balance between total public expenditures and revenue in a specific year. So if you look at the US, -5.9% of GDP, Euro area, -4.4%, Communist China, that’s -6.2%, so it’s across the board. Does spending more money than you bring in create inflation?

Cullen Roche (00:22:01):
That to me is one of the big lessons of COVID, is that when governments run big, big deficits, you have the risk of rising demand. And especially when you don’t produce the aggregate supply to meet that aggregate demand, you get a price increase. And so, yeah, that’s one of the important lessons coming out of COVID. I think this gets into a really interesting theoretical debate of, in the long run, it makes sense that balance sheets, I mean, in a fiat monetary system, balance sheets basically need to always expand. My deficit is somebody else’s surplus. In order for you to be able to save, you essentially have to rely on somebody else running a deficit to be able to create the financial assets to allow you to be able to save. And that can come from… it could come from the government, it could come from me, it could come from the corporate sector, it could come from the rest of the world sector.

Cullen Roche (00:22:58):
So this balance sheet expansion doesn’t have to come from the government, but it has to come from somebody in the long room. And that’s, I think, an important thing to understand about how any credit based system, you can get into this really interesting theoretical debate though about whether or not does that deficit have to come from the government sector. And I don’t know, honestly. I mean, gosh, I wrote a book called the Pragmatic Capitalist, so I’m obviously amenable to capitalism more so than socialism. And I’m pretty skeptical of the idea that the government can do things as well as the private sector in general. I think that when it comes to government spending, I think that the government generally should do things that the private sector simply cannot or will not do.

Cullen Roche (00:23:56):
So for instance, like operating a military is the perfect thing for a government to be doing, because the private sector doesn’t want to do that, can’t make money from doing it. It’s pretty hard to make money when you rely on killing your workforce and blowing things up. That’s not a very profitable business endeavor. So things like that that have a negative net present value, those are perfect things for the government to do. And socially we benefit from those things because obviously if you have to go to war, that’s something that needs to be done. And you kind of accept the reality that, oh, during war time, maybe making money isn’t the most important thing in the long run.

Cullen Roche (00:24:39):
So that’s all well and good, but you get into this debate about, should the government then try to do things that have a positive net present value? That’s essentially the role of the private sector, is that all of us in the private sector, we’re trying to add value and run operations that are essentially adding present value to people in the future. And we do that by trying to run businesses, or at a household level, trying to generate a net income basically. So the things that we do, they have to add value to other people, whereas the government in a lot of ways, the government can just do things that are socially good to some degree, that maybe they don’t have a positive net present value at the aggregate level. Maybe they’re more charitable in terms of the way that they’re being done. And so, you get into this big debate of whether or not operating an economy to just run profits is in the best interest in the long run, versus should we do things that are more charitable in nature that take care of the social wellbeing of the country.

Cullen Roche (00:25:48):
For the most part, I think that the developed world and the United States has done a pretty good job managing that balance of government spending versus having a big, mainly capitalist, private sector-run economy with a pretty large government sector attached to it. But a government sector that, for the most part, does a lot of funding of financing and things in the private sector, but for the most part, doesn’t do a lot of crazy, large negative net present value projects like you see in places like, for instance, I’d argue that a lot of the… I mean Latin America’s the perfect example of how not to run this balance of private sector versus public sector. And the United States, for the most part, has done a pretty good job. You could argue that the last few years were really tricky in terms of navigating COVID and that we did a lot more than we should have, obviously in retrospect, but for the most part, it’s a tricky debate.

Cullen Roche (00:26:50):
I tend to lean towards the view that the government should sit back and do these negative net present value projects; put out fires, run the military, and then manage the court system, and kind of back off. Running a budget balance that’s a negative budget balance in the long run is not necessarily bad. And I think running at least a… having a government that runs a negative budget balance to some degree, even while it might be inflationary, it could still be perfectly consistent with generating social good in the long run. So I hesitate to say that running deficits is inherently bad, even though obviously we know now from COVID, for instance, running really, really large negative deficits is… it can have a hugely inflationary impact. And so, it’s this balancing act where in the long run, I think you want a government that’s regulating the economy to some degree, and you want a government that is operating a military and doing these things that the private sector doesn’t want to do, but nobody really knows the exact right balance.

Stig Brodersen (00:28:01):
Yeah, and I think you bring up such a good point because it’s also so value-driven, what is it that you want? And based on what you want and what your values are, you can come up with, this is how much the government should be included or not be included, or should you even run a deficit in the first place?

Cullen Roche (00:28:16):
Yeah, it’s so subjective. It’s so subjective. You get into this debate about living standards. It’s one thing that I’ve always said and written about a lot on my website, that living standards in the United States have boomed in the last 100 years. You could argue that people today live better than at any point in human history. Which is weird to think about when you look at things like, if you look at metrics like government debt, or the value of the US dollar, you see this all the time, I talk about it a lot. The value of the US dollar technically has declined in purchasing power terms by 95% over the course of the last 100 years, but living standards have boomed.

Cullen Roche (00:28:58):
So it’s this weird, very subjective debate where yeah, at a basic sort of economic level, you have a decline in purchasing power, but living standards have actually increased substantially. And that’s in large part because we’ve produced a huge amount of real goods and services that have made life just better in general. But it’s also highly subjective and different countries obviously value different stuff. Europeans value very different things than Americans do. So yeah, people like different stuff and it becomes this very subjective, argumentative debate about value judgment.

Stig Brodersen (00:29:38):
It was a lot more political charged, I guess what I said before with my previous questions than I originally intended, but let me take you from the frying pan into the fire. The next question here is tricky, because many of our listeners are already thinking about retirement, and inflation is really hard to pin down. Whenever you consider your portfolio and your financial needs when you retire, you’re looking at hopefully decades to come. How do you include your inflation expectations in your asset allocation for retirees who have to live off their portfolios?

Cullen Roche (00:30:12):
This is a hard question. I’ve advocated increasingly in recent years, I’ve become a big, big advocate of all-weather portfolios. And I’ve always loved that concept of having an allocation that protects you no matter what the scenario is, whether it’s the… for people who aren’t familiar, the classic sort of all-weather portfolio was Harry Browne’s Four Quadrant all-weather, which basically was, it was deflation, inflation, recession, and expansion. And basically his really simple model for that was that you wanted to own gold for inflation, you wanted to own stocks for growth, you wanted to own treasury bonds for deflation, and you wanted to own cash for recessions. And so you had this very simple 25% four quadrant breakdown of the portfolio, that the theory was that this would protect you from all environments.

Cullen Roche (00:31:11):
And I’ve always been… the thing that has always sort of I think made me reluctant about adopting that sort of a model and really embracing it aggressively is the holding of 25% gold and 25% cash just always from a basic portfolio theory perspective struck me as that’s too much, too much in both. Who knows what’s going to happen with… if for some reason the demand for gold was replaced by the demand for Bitcoin, let’s say for instance, in the next 100 years, well, your inflation component there might not do anything. And so we’ve kind of seen that in the last few years, for instance. Gold hasn’t done as well, considering the inflation that people might have expected, and actually a broader basket of just commodities has done much, much better.

Cullen Roche (00:32:02):
So for me from a financial planning perspective, I think you have to take inflation in this… the asymmetric risk of it into consideration. And for most people, I always say the stock market in the long run is a pretty good inflation hedge, in large part because corporations, they basically earn a profit by buying things at whatever the rate of inflation is and then trying to mark them up. And so in the long run, something like the S&P 500 tends to be a pretty good inflation hedge. You see years like 2022 though, where you can go through periods where the stock market goes down, and in real terms, the stock market is down what, 25%, 30% this year. And so you can get periods where the stock market volatility doesn’t protect you in the short term. And that’s where a lot of this gets tricky.

Cullen Roche (00:32:55):
For most people I always tend to, from a financial planning perspective, I think you have to look at this holistically. So for instance, do you own a home? I think housing in the long run tends to be… or really owning real stuff tends to be a pretty good inflation hedge in the long run. I mean, real goods and services tend to be… and you could argue that stocks are to some degree just real assets. Real assets in the long run are always good inflation hedges. But you can have these acute periods, like this year or the last 12 months where things like commodities are much better inflation hedges.

Cullen Roche (00:33:37):
And for me, it’s interesting timing bringing this up, because I’m about to publish a new paper. It’s the first paper I’ve written in years, it’s called All-duration Investing. And my perspective on this basically is I’m trying to apply a concept that is similar to all-weather, but I’m doing it in very specific time horizons. And so what I’ve done is I’ve actually calculated the duration of all asset classes across the board. I’ve calculated the duration of commodities, of equities. And what I mean by that is I’m using essentially a model where I’m assuming a point of indifference. And so to me, the point of indifference for an investor, when you think of fixed income, the traditional metric of duration is how indifferent is an investor in fixed income or bonds to losses, basically. So what will an increase in interest rates cause in terms of principle losses?

Cullen Roche (00:34:35):
And when you think of that as a point of indifference, well, in the long run, a fixed income investor becomes indifferent to losses at some point, because they’re earning a higher interest rate. And at some point in the future, the higher interest rate pays off. You can do this across all instruments where you look at, for instance, if the stock market were to fall by 50%, well future expected returns should increase typically in the long run. When asset prices decline, typically the value of that asset becomes… actually, it’s kind of counterintuitive, but when asset prices fall, typically the future expected return of that asset should increase. At some point in the future, you become indifferent to the loss in that asset class.

Cullen Roche (00:35:19):
So in my model, for instance, a stock market investor is indifferent to losses, on average, over about an 18-year period. And so what I’ve done is calculated these durations for all asset classes, and then plugged this into a model across time. And to me, that’s the key aspect of good financial planning, is that you want to look at things in certain buckets essentially, where for instance, you need some cash in the short run to manage your say, whether it’s emergency funds, or your monthly liabilities, but that’s the way the financial system works, is that the financial system is structured and our financial lives are structured across these very specific time horizons. And so, you want buckets for short time horizons and medium time horizons. And let’s say maybe you want to put a down payment on a home in the next five years, but you’re not really sure where.

Cullen Roche (00:36:16):
Well, that money shouldn’t be allocated to the stock market, because the stock market in my model is this 18-year instrument. So if you need that money in the next five years, for instance, well the stock market’s not a good place to put that. It needs to go into an instrument that has an appropriate duration relative to that. And so something like cash, or even an aggregate bond fund would fit that model inside of a five-year timeframe. And commodities and inflation hedges, the way that I calculated this, it’s interesting, they’re basically 30+ year instruments, but they have a highly short term asymmetric payoff. So what I mean by that is that gold and commodities, they almost operate… I shouldn’t say almost, they do, they operate inflation insurance in a portfolio.

Cullen Roche (00:37:07):
So for instance, what is an insurance in a financial planning aspect of a portfolio? Well, if you buy a 20-year term life insurance policy, you’ve bought a long duration asset that has a highly asymmetric short term payoff. So if I buy a term life insurance policy that has a 20-year term, and let’s say I croak in two years, well that instrument, although it had a 20-year duration, that instrument had a huge, real positive asymmetric payoff in a two-year period. So I like to think of commodities and gold and inflation hedges in much the same way, where they have the potential to provide you with this almost insurance-like policy payoff in a short time horizon, even though they’re really long term instruments.

Cullen Roche (00:37:57):
So if you think of this stuff on a bell curve, I think it’s useful to think of building out your asset allocation in terms of across these durations, where the stock and bond market make up the core central aspect of the bell curve. And then on the edges, you have things that have these sort of important, real and nominal asymmetric payoffs, where cash, for instance, it’s going to lose in real terms every single year, but it provides you with absolute nominal certainty. And so on this left tail of the bell curve, you’ve got this absolute certainty in nominal terms, and on the right tail of the curve, you’ve got insurance type instruments. So gold, commodities, you could throw Bitcoin into there, things like that, life insurance fits into that for sure, things that have this really… they’re long duration instruments that have a potentially large asymmetric payoff. And depending on how personalized you need this all to be, me personally, I tend to… you’ve got to start with the stock bond core, and then you can build out all of your tangential instruments on the side.

Cullen Roche (00:39:08):
But I think in the long run, this fits into of an all-weather approach in the sense that you can build out this model and this asset allocation approach where you’re taking what I call this all-duration approach, where you own things like commodities and gold, but they’re there in a very specific allocation, where let’s say it’s like 15% of your portfolio in total, where it’s a relatively small portion, but it provides you with asymmetric certainty in environments like the one we’re going through.

Stig Brodersen (00:39:42):
Yeah, it’s such a tricky topic. I mean, you’re trying to forecast something for decades, and you’re doing that with instruments or assets that you don’t know what’s going to yield. And we depend on it, that’s what makes it even more scary. Cullen, in December 1989, the parliament in New Zealand decided on a 2% inflation target for the central bank. And this is perhaps more significant than it sounds like to our listeners, because this was the first formal target to be adopted by a central bank. And since then, many have adopted a similar 2% target, including the Fed and the ECB. And you can also argue that the lower the inflation target, the more unemployment the Fed would have to create to get there. Now let’s get to the perhaps more controversial part of it. Remember that the Fed has this dual mandate of price stability and maximum employment, which seem to be counterintuitive. Of course, no one likes unemployment. And since there is a perceived little difference between a 2% and a 3% inflation, should the central bank then increase the target?

Cullen Roche (00:40:51):
What is the right amount of inflation in the economy? And should the government even have a positive inflation target? It’s interesting. I think when you look back through history, I think part of the reason that they arrived at this sort of 2% target is because 2%, this sort of low rate of inflation, 1%, 2%, something like that, it’s still consistent with rising living standards and historical data. And so, from a basic financial system perspective, like I was saying before, you’re always going to have… you need balance sheet expansion. You need somebody… somebody has to be borrowing and creating financial assets in order for the rest of us to save. And it’s just a natural byproduct of population growth and increased productivity, is that you’re going to have more borrowing, more people. Money isn’t always equally distributed. And so, when somebody wants to buy a new home, they may not be able to find existing money. They may not have the money in their pocket right now to be able to buy that home and build it.

Cullen Roche (00:41:58):
And so, some level of borrowing is totally natural in a credit-based monetary system. The question is, does that credit growth have to coincide with inflation? And I think that’s a much, much trickier discussion. I think that if you had an economic system where the private sector was the only borrower where all money creation essentially was valued based on how productive it ultimately was, I think you would experience lower rates of inflation than we’ve seen. The interesting thing with having a system like that, where if you had a purely private based financial system, well, you’d probably have higher degrees of things like inequality, which then creates an argument for more government, which you get more government, then you get more inflation, you get more of that negative net present value spending potentially to try to equalize things.

Cullen Roche (00:43:01):
So, you get into this messy debate about what is the right size of government, really. And to me personally, I don’t think there’s… there’s not a need in a monetary system to have a positive rate of inflation. To me, it’s just the positive rate of inflation is, to a large degree, it’s a byproduct of having a primarily capitalist based system that is predominantly private sector run, that also happens to have a fairly large government attached to it in the… I think you could make an argument that 1% to 2% inflation per year… it’s the cost of having things like a public sector run court system and regulatory systems; these things aren’t free. And so to the extent that we borrow, or that they just don’t have a net present value sense, they don’t have a positive net present value in terms of a profit sense, these things can result in some marginal inflation.

Cullen Roche (00:44:08):
Is that necessarily bad in the long run? Well, history would tell us that averaging 1% to 2% inflation is not necessarily consistent with declining living standards. So I don’t know the right answer. I would like to think that you don’t need to have inflation in a monetary system, but I think that it’s hard managing that right balance of public sector versus private sector. And obviously, you don’t want really high inflation, but there doesn’t seem to be an inconsistency between a low level of inflation and rising living standards in the long run. So maybe having a court system, and a military and things like that, maybe those are just the inflationary cost of having a government in the long run. And you can get into the debate about how much bigger the government should be than that. And I think that’s a useful debate to have.

Cullen Roche (00:45:05):
But in general, I guess my answer is, I don’t really know. I don’t know what exactly is the right rate of inflation, but we certainly know that anything over 2% or so seems to be problematic. At a minimum, it’s consistent with social upheaval and bigger societal problems that do cause meaningful declines in living standards. So I think we can all agree that nobody wants a high level of inflation, but whether or not we want 0% inflation or 1% or 2%, I think is a much more reasonable debate.

Stig Brodersen (00:45:43):
As much as we could say today, well, we should probably have, say 3% because then we don’t need to bring in as much unemployment, everyone likes high employment… well, it’s a slippery slope. We also have seen that before, if we tend to think that inflation is coming and it becomes self-reinforcing. Does that mean that in the next crisis, we’ll say it’s okay with a 4% or 5%, and then what happens in the next crisis following that? So it’s really tricky and as much as the 2% is arbitrary and the Fed is on record saying that it’s arbitrary, it’s definitely on purpose that it’s in that level and it’s positive and it’s not deflation.

Cullen Roche (00:46:24):
MMT has been really popular in the last few years in terms of the social discussion. What their big policy discussion is that the government should run a job guarantee. And I’ve always been skeptical of this idea, because the basic thinking there is that you can give everybody a job, so the government guarantees everybody a job, and they argue that there would be price stability. And so that’s where you get into this very theoretical debate about, is it even possible to have a society where everybody has a job, everybody’s guaranteed a job, and you have low inflation? I don’t know. I’d like to think that that is certainly possible. It’d be great if everybody was employed and doing something productive and happy. And we also just happened to have low rates of inflation. I’m pretty skeptical of whether or not that’s possible; it’s certainly never been done.

Cullen Roche (00:47:17):
But you can also have the opposite, where you have societies and economic periods where unemployment is super high. And obviously the trade off for that is that sometimes the rate of inflation is really low as a byproduct of that, because demand is so low and is that… the Fed does not have an enviable job trying to manage the dual mandate of inflation and unemployment.

Stig Brodersen (00:47:42):
Cullen, let’s continue with this thought experiment. Let’s say that we would go into a prolonged period of not only disinflation, but for example, two decades of deflation. And I just wanted to clarify, disinflation is a lower but still positive inflation rate, whereas deflation is a negative inflation rate. So how would consumers and investors need to adjust to this prolonged deflationary period?

Cullen Roche (00:48:06):
Man, one of the most interesting charts I’ve ever seen is Japanese real estate in the last 20 to 30 years. I mean, we’re so used to, in developed world, real estate prices just always going up pretty much. That was a part of what everyone kind of knows. That was part of what caused the financial crisis to be so bad, was that in the economic models, all these investment banks assume that real estate prices just either wouldn’t go down or wouldn’t go down very much. And so when real estate prices went down 20%, 30%, obviously that caused… it threw a wrench in everything. And in Japan though, real estate prices have been going down for 20, 30 years, which is sort of unfathomable in the United States. But it’s something that… that sort of a scenario, I mean, it keeps me up at night to be honest, because again, the real estate market is such an impactful instrument in the entire US economy. You’d have very, very low rates of growth.

Cullen Roche (00:49:11):
I mean, in that sort of a scenario, if that’s something that you expected or if you thought it was a risk, counterintuitively you’d want to own a ton of bonds. So bonds in Japan were the thing that hedged people from… people talk about how the Japanese equity market has been down over this lost decade or whatever. Well, the thing that people don’t always point out is that if you owned a 60/40 portfolio denominated in yen, where you own the Nikkei for instance, and Japanese government bonds, well, you actually did okay, because the government bonds performed so well that your relative performance was okay. So diversification actually worked out in Japan, because of the bond component.

Cullen Roche (00:49:59):
But the same sort of scenario would play out in the United States, where people are worried about inflation now. And they’re worried that, oh, bonds are dead. But if you got prolonged entrenched deflation, the bonds are the things that would perform really well in that in terms of an asset allocation. So again, going back to that all-duration or all-weather sort of perspective, it’s why I always advocate, I always tell people, you always need to hold some cash and short-term bonds, and even some intermediate potentially long-term bonds. Treasury bonds, they’re sort that deflation insurance product, super long duration instrument.

Cullen Roche (00:50:37):
But yet, in terms of an economic outcome, it’s hard for me to imagine that wouldn’t be a disastrous scenario, that it wouldn’t be coinciding with something much more negative in terms of what’s occurring, just because in order to get the 20-year period of entrenched deflation, you’d have to have not just negative probably demographic growth, you’d have to have declines in productivity, and really almost like 0% GDP probably for decades, which would not be… obviously would not be great.

Cullen Roche (00:51:14):
So is that going to happen? Personally, I think that’s a low probability, just because the demographic trends, even as bad as they are in the United States and some of the developed world, they’re not necessarily going to be negative. And I think productivity will continue to be relatively strong. And it’s hard for me, united States is still such a real estate based economy that when you look at it in the long run, I mean, God, looking at it from a supply perspective, one of the problems in housing is there’s a huge shortage of housing. And so in the long run, are we going to stop building homes in the United States? Using a crude “housing is the economy” sort of model, it’s hard for me to imagine that even with the ebbs and flows in the long run, there is a lot of building to be done in the United States in terms of building out the real estate market.

Stig Brodersen (00:52:09):
Well said. Now Cullen, let’s transition into the next topic of today, which is the concept of the Fed put, which dates back to the era of Alan Greenspan, the former chair of the Fed. Starting with the stock crash of 1987, the Fed cut rates whenever share price is plunged. If you are an investor, it resembles the benefit of a put option where your downside is getting cut. Some argue that we’re now heading for a time with a Fed call, which is exactly the opposite, meaning capping the investors’ upside. We know from studies of the Wealth Effect that the wealthier people feel they are from their stock holdings, the more they spend. One study from Howard University shows 3 cents of increased spending of each dollar an increased stock wealth, plus increased employment and wages. All of this adds to inflation, which currently seems to counter the main objective of the Fed. So with all of that being said, do you think Cullen that we’re heading into a period of the Fed call?

Cullen Roche (00:53:03):
There’s a lot of different transmission mechanisms for monetary policy. And to me, interest rates are a very powerful policy lever. I do not think… people tend to think, when people talk about the Fed put, they often talk about quantitative easing and the balance sheet expansion. And I don’t think quantitative easing is as powerful as a lot of other people tend to think. And I think that drawing these correlations between the Fed’s balance sheet and the stock market, to me is just sort of silly. I mean the Bank of Japan increased their balance sheet for decades, and the Nikkei had a marginal correlation to these changes. Or ECB also, the European stock markets performed, on a relative basis, horribly compared to the US stock market, and the ECB was ramping up their balance sheet. It seems like there’s very mixed evidence on whether or not the balance sheet expansion really is the… is that the Fed put?

Cullen Roche (00:54:10):
To me, the Fed put, or what we’re seeing now, the Fed call, is really the interest rate impact. And the way that the Fed can very precisely, or I shouldn’t say precisely, I should say the Fed can very… almost like using a hammer, can sort of bludgeon the economy with interest rate changes. That’s a lot of what we’ve seen in the last six months, is this repricing of assets, because interest rates have changed so dramatically. And that’s a very, very blunt instrument. But it’s a very, very impactful instrument, especially when it’s used in a very aggressive way, which is what the Fed’s been doing. So yeah, they’ve made it very clear.

Cullen Roche (00:54:59):
Have they overreached? I think at this point, that’s the bigger question. I think that’s the question that the stock market and the broader economy is now grappling with is, has the Fed implemented this call in a short term period where they’ve raised rates so fast that they’ve sort of bludgeoned the real estate market basically? Have they snuffed out demand for real estate to an extent that yeah, it all fixed inflation because it’s going to fix the demand side of everything, but have they overreached? Are now going to find themselves going into 2023 having to backtrack a little bit, because they caused some unemployment?

Cullen Roche (00:55:41):
And that’s where you get into that dual mandate balance and what a tricky balancing act it is, because now it’s crazy, the Fed forecast of Fed funds futures, they actually forecast falling rates in 2023. So the Fed has put themselves in this position where yeah, they’ve raised rates very aggressively. It looks like they’re going to get… hopefully they’re going to get inflation under control, but are they going to do so by driving the economy into this prolonged or deep state of either negative or zero growth, where you get a jump in the unemployment rate that causes them to then have to implement the Fed put again to cause a reversal in a lot of these trends?

Cullen Roche (00:56:28):
Personally, I don’t think the Fed can afford to continue to implement this so-called Fed call in the long run in an aggressive sense that they won’t continue to raise rates really aggressively, because I think they’ll cause too much damage to the housing market. So going back to the beginning of our discussion, that risk of deflation to me is higher than the risk of inflation or prolonged high inflation going forward in large part because of the Fed’s policy response. I think they overreached a little bit. The mortgage market has started to adjust some already. We’ve seen interest rates retrench a little bit in the last month, and I’d be shocked if they continue to really put the pedal to the metal, because I think there’s a really meaningful risk now that the housing market is slowing, and that it’s slowing at an uncomfortable pace that could result in… we’re having this big debate in the United States over whether there’s a recession, and it’s kind of a silly debate, whether two quarters of negative growth… I wouldn’t be shocked if we end up having four quarters of either low or negative growth in a row.

Cullen Roche (00:57:36):
Is that going to be technically a recession? I don’t know, but it’s not good; in a big, big bind here. I don’t think they can afford to implement a long term Fed call, because I don’t think they can… I think doing so would result in pulverizing the real estate market, in essence, that would force them to re-implement the Fed put basically.

Stig Brodersen (00:57:55):
So let’s talk about the rates. We often hear in the business news that the market has priced in a hike of 50, 75, 100 basis points or whatever it might be. Where can we find that information or that website that says this is what the market has priced in? And what does that number imply for investors?

Cullen Roche (00:58:15):
The best place to always look is the two-year. The 2Y treasury, that is reflective of the future expectations of Fed policy in essence. So for instance, the two-year peaked at 3.4%, what was it a month or two ago? We’re at 2.9% right now. the Fed funds rate is only, what, it’s 2.3% or so. The effective Fed funds rate is 2.3% right now. So even though they’ve made it very clear they’re going to raise rates to probably at least 3%, the 2Y treasury has priced that in. It was more aggressively priced even just a month or two ago. So, that’s usually the place to look, is the short end of the treasury curve usually front runs the Fed and they try to get ahead of where the Fed is going to be.

Cullen Roche (00:59:07):
A lot of people, I see this on Twitter all the time where people are like, “Oh, the rate of inflation is 8%, and the Fed is only at 1%.” And it’s like, well, wait a minute, even a year ago, the 2Y treasury bill priced in way more than 1% Fed funds rates. And this is part of how Fed policy theoretically works. Well, not theoretically; this is how it really works is that they tell you… they tell the market where rates are going to go. And they’re trying to, it’s called open-mouth policy basically. They’re communicating to the market, “Hey, we are going to do this.” And there’s a lot of theory about how powerful this is, but certainly… you see it reverberate through the actual bond markets where the 2Y treasury will respond to these comments in a sort of hyperactive manner, where bond traders do reprice what the Fed does.

Cullen Roche (01:00:02):
I always like to use the analogy of the Fed curve and the interest rate structure is a lot like a man walking a dog. If you think of the, let’s say the 2Y treasury is the dog, well the Fed’s holding the leash, but the fed basically when they say they’re going to raise interest rates to 3%, well what they’re really doing is they’re letting the leash out a little bit. So they’re letting the dog run out. The dog gets ahead. The dog front runs where the Fed is going to be in the future. And so even though the man might be holding this tight leash where he’s only allowing what looks like a 2% interest rate increase, the dog is already out there at 3%. And that’s what you see in the two-year. So that’s the best place to look when you’re looking for what are the market expectations.

Cullen Roche (01:00:49):
Weirdly, it’s actually one of the worrisome things right now is that the two-year is high relative to the 10-year. And so people talk about this yield curve and the yield curve inversion. What the yield curve is basically saying right now is that the 10-year expectation of rates is lower than the two-year expectation of rates, which is consistent with what we were just talking about how the risk of this policy mistake is being priced in, that the Fed, yeah, in the short term, they’re going to go to 3%, but in the long run, are they going to end up having to retrace back to 2.5% or 2%? And that’s what the market is grappling with right now.

Stig Brodersen (01:01:30):
Cullen, as always, it’s been fantastic to speak with you about inflation, this second part here, or Inflation Masterclass. Is there anything where you feel like we skipped over it? Anything you wanted to add to the conversation?

Cullen Roche (01:01:42):
No, I feel like I’ve talked so much. I talk too much. People are probably like, “Shut up!”

Stig Brodersen (01:01:48):
Oh, I’m sure people are not like that at all Cullen. It has been absolutely amazing as always speaking with you. I already look forward to the 10th time that we’re going to bring you on. Cullen, where can the audience learn more about you, anything that you’re up to?

Cullen Roche (01:02:03):
My main website is Pragmatic Capitalism. I started a new YouTube channel recently called Three Minute Money, if people want, they’re sort of short, concise, educational mostly videos on money and finance. You can keep an eye out for my new paper, the all-duration paper. I think it’s pretty cool. It’s one of the first things I’m kind of excited about having written in a really long time. I haven’t published a paper in, I don’t know, five years, not that’s something I try to do often or am proud about necessarily. But I think it’s a cool sort of counterintuitive look at building out asset allocation models and a new framework for thinking about things across a very time-specific perspective of asset allocation. It’s very financial planning consistent. So I think it’s cool. I think that people will like it and keep an eye out for it. I’ll publish it probably on SSRN, and hopefully some journals, and certainly on Prag Cap.

Stig Brodersen (01:02:59):
Cullen as always, it’s been a pleasure. Thank you so much for making time for The Investor’s Podcast.

Cullen Roche (01:03:04):
It’s always great to talk to you guys.

Outro (01:03:07):
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