How the Fed Sees Inflation

The Fed sees inflation a bit differently than many in the markets do.  In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again.  Macroeconomists in general would not describe inflation as a well-understood problem.  Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.”  Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices.  Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive.  Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this.  And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade.  In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation.  What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI.  But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation.  What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation?  Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s.  A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd.  This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation?  The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization.  But, again, this is only for the current level of inflation.  What can we use to forecast tomorrow’s level of inflation?  For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation.  This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn?  The expectation of inflation expectations?   Nevertheless, this seems to be the best that economist have for the time being.  People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed.  The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too.  The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke.  I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored.  Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations.  A long period of actual inflation away from the target will likely eventually shift inflation expectations.  However, no one knows the parameters of such a function.  The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date.  The Fed believes that is because of temporary factors which should wash out over time.  We shall see.  The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target.  At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes?  Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later.  This calculus is all based on keeping inflation expectations well anchored.  The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation.  To that end, it seems to slow growth slightly.  The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense.  Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much.  My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now.  Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level.  I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

A Rebuttal

This week an article entitled “Should You Fear the ETF?” was written by Ari Weinberg of the WSJ. While I would prefer not to give this type of article any attention (as that seems to be the main goal), I feel like it cannot be left to exist without an industry participant’s opinion attached to it. ETFs are the primary investment vehicle for Astor’s strategies. As such, we have strong opinions on the merits of using them for investment allocations. Mr. Weinberg’s main critique of ETFs is centered on market action on August 24th. The events of this day have been thoroughly covered in many articles already, including several from the WSJ (see list at the bottom). Mr. Weinberg appears to be trying to stir up old drama by writing this several months after the fact without adding any new ideas or information to the discussion. The addition of the massive image of a demon-like face staring down a small human figure on the article page only makes me shake my head.

To ask whether someone should fear an investment product is clearly an attempt at sensationalist journalism. Fear is often caused by a lack of information or uncertainty. So often in history, new ideas are shunned solely because information does not exist. It begins a wicked cycle. Since there is fear, there is an unwillingness to obtain more information which then reduces the chance of people becoming educated which means fear continues. The better question for ETFs is “Do Investors Fully Understand ETFs and Trading?” Instead of trying to instill fear, Mr. Weinberg should use his position to disseminate information to retail investors. Mr. Weinberg’s attempts to provide education are continually steamrolled by comments and selective quotes that seem to enforce an idea of ETFs being an uncertain and risky investment product.

Now on to the trading discussion. What Mr. Weinberg only passively alludes to in the following quote (and subsequently seems to dismiss) is that there were a variety of market wide issues that day. “Critics say stock-market swings on Aug. 24 exposed the flaws in ETFs they have been warning about for years. Proponents say ETFs mostly were caught in the crossfire of marketwide trading issues that had little to do with them. One thing is for sure: It wasn’t the first time ETFs have surprised investors.” When you fully understand how ETFs and markets work, there is little surprise at the events of that day.

Bank of New York Mellon – NAV Calculation Issues

Due to an issue with an update of SunGard’s accounting system as Bank of New York Mellon, there was an issue calculating fund NAVs for several days (ETFs and mutual funds). The impact spanned nearly 1,200 funds from a variety of providers. This issue only added to the day’s woes.

Single Stock Pricing Issues

The majority of ETFs that experienced disruptions on August 24th were domestic equity ETFs due to a variety of issues with individual stocks. Due to the below issues, it was difficult to accurately price an ETF (remember ETFs are priced based upon underlying holdings).

  • A substantial segment of the stocks in the S&P 500 Index were not opened by the time the opening bell rang.
  • More than 700 stocks saw intraday moves in excess of 10%
  • A number of stocks experienced trading halts during the opening minutes and throughout the day

 Volume of Market Orders

According to the NYSE, there was an overwhelmingly larger number of market orders executed on August 24th than on a normal day (~4x). Resting stop loss orders were triggered as prices moved down the order book. Selling led to more selling as triggers were eclipsed on trading systems.

 Market Maker Responsibilities

Many people likely assume that market makers have to stand firm during volatile times and bear the brunt of risk. That’s not the case. By rule, NYSE Designated Market Makers (“DMMs”) need to only provide a quote for 10-15% of the trading day and the quote can be as wide as +/-8% of the National Best Bid and Offer (“NBBO”).  As the paper “US Equity Market Structure: Lessons from August 24” from BlackRock put it, “This is important to note because in times of extreme stress, market makers do not “support” the market. They are not buyers of last resort. Because market makers must manage their risk and maintain adequate capital, their capacity can be overwhelmed in the face of broad-based and unabated buying or selling. During periods of market-wide uncertainty, market makers can become risk averse.” APs and other providers of liquidity are not required to be active at all times. APs provide a conduit for the ETF mechanism, but those firms are also trying to stay in business and make money. Additionally, the absence of prices on underlying securities creates a large barrier to the creation/redemption process.

Two of the ETFs that experienced large price dislocation were AOK and EMQQ. Both of these ETFs typically have limited daily trading as can be seen by the 30 day average daily volume figuers below. What these numbers mean is that there is limited natural market liquidity down the order book. A single small trade could remove the entire on-screen liquidity (i.e. current bid/ask volume) at a set price and move down to the next price level where an order exists. You could sweep the book down rather quickly and end up with trades below NAV if there is no support. Liquid ETFs will have tens of thousands of shares available in the open market at each incremental price level.  You may be able to trade 200,000 shares on bid/offer or a penny down/up. Additionally, AOK is an ETF of ETFs so if any of the underlying ETFs have an issue, AOK surely will too.

iShares Core Conservative Allocation ETF (AOK) – $242M in Assets, 74K shares traded/day

Emerging Markets Internet and Ecommerce ETF (EMQQ) ~$12M in Assets, 8K shares traded/day


While these two charts look severe during the opening period, they look similar to the stock of Ford (F) a $55Bn company. Once again, there were market wide issues.

Ford (F)


A Few Statements to Clarify

“In normal markets, ETF traders who profit from zooming in and out of the ETFs and their underlying holdings keep the values in line, but investors have been startled to see that balance can be disrupted at times.” ETFs have two sources of liquidity: primary market and secondary market. The primary market consists of Authorized Participants (“APs”) who create and redeem shares of ETFs by either purchasing the underlying basket of securities and exchanging for shares of ETFs from the issuers (creation) or by exchanging shares of an ETF for the basket of securities to unload onto the market. APs seek to arbitrage any mispricing which helps to keep markets tight. If underlying securities are cheap relative to the ETF, an AP will buy the securities and exchange for shares of the ETF and vice versa. The secondary market consists of shares of ETFs held by investors and other parties being bought and sold between each other. What Mr. Weinberg fails to point out is the difficulty an AP would have in providing liquidity if the underlying holdings are not priced accurately or halted. An ETF is an investment vehicle designed to provide investor access and price discovery for groups of assets. If the players on a few sports teams decide they do not want to play hard and their teams lose, do you blame the idea of a team or do you focus on the underlying factors? Here, the blame needs to shift to the underlying securities.

 “Exchanges, as well as some fund providers, are examining how to prevent these rare trading anomalies. Meanwhile, the risk that ETFs may not always trade or price as expected is one that investors need to consider.” Mr. Weinberg is trying to make ETFs sound scary here. Should investors also shun single stocks because they can be halted, price incorrectly, or experience other issues? The bottom line is investors need to consider all investments. There is a reason so many SEC Regulations relate to disclosure. Investors need to have the proper information in order to gauge whether a particular investment makes sense. Risk is part of the game. Any security can price differently than what you expect.

 “What matters most—and what investors should focus on—is whether a fund’s underlying portfolio fits with their goals, says Rick Ferri, the founder of Portfolio Solutions and long a proponent of index investing. “Look under the hood,” he advises, because many funds that seem similar really aren’t and will produce very different results. From there, investors can assess the product’s structure and whether the costs involved in holding or trading it are a good fit for them.“ I think there needs to be a distinction here. You would be hard pressed to find a passive, broad index-based ETF perform materially different from another ETF following the same index. Active ETFs are a different story and should be treated as such. There are ETFs which may track lesser-known indices, no indices, or consist of holdings in other ETFs and funds. This statement seems to hint at a level of deception by ETFs and I think that is a misleading.

 “ETFs can be traded all day on exchanges, which usually makes it easier for investors to get into or out of positions at a market price quickly (except, of course, on days like Aug. 24).” Investors were still able to trade ETFs on August 24th, except for those that were halted. However, as listed above, a large number of single stocks were also halted. Once again, Mr. Weinberg is trying to isolate ETFs here.

“As the Dow Jones Industrial Average plunged 1,000 points, triggers went off for mandated halts in many stocks held by ETFs, as well as the ETFs themselves. Then, a number of ETFs stunned investors by trading at prices far below their NAV, highlighting concerns that ETFs might not be as easy to move in and out of at “fair” prices when markets are in disarray.” ETFs are by name “exchange-traded” which means if a buyer and a seller are willing to enter at a price, a trade will happen. If a market order is entered or a resting order is out there, a trade happens regardless of where NAV is. Mr. Weinberg seems to be saying here that it is “unfair” if a trade is executed below certain levels. Unless someone held a gun to an investors head and forced him/her to enter the trade, there is no fair/unfairness to deliberate over. Financial markets can be cruel. Take for example the recent story of Joe Campbell, a retail investor who shorted a high-risk biotech stock in his $37K E*TRADE account only to end up with a margin call of $106,000 after the stock soared on takeover news.

The Real Issue: Investor Education

To his credit, Mr. Weinberg did include a few statements which actually describe the real issue: investor education. I have highlighted a few of the most appropriate quotes below.

  • Meanwhile, it may be more advisable than ever for investors to use limit orders—orders to buy or sell a security at a specific price or better, literally putting a limit on how low the price can go.
  • “Have good trading hygiene,” says Dave Nadig, director of ETFs for FactSet. “The vast majority of ETFs deliver on their core promise to investors. But if you trade them poorly, that’s probably on you.”
  • While some advisers love that—it gives them an easy, low-cost way to provide clients with exposure to certain market segments—the concern is that some less-sophisticated investors may be buying complex, heavily marketed funds without fully understanding what they are getting.
  • If you don’t have the knowledge or time to build and manage a complex portfolio, it may be best to stick with broad-based index ETFs with significant assets and trading volume, experts say, and leave the niches to the pros.

We cannot blame an exchange-traded product for trading on exchange, even if the executed price is below NAV. Retail investors need to understand that certain periods of the day can have greater volatility and that pre-open issues can cause disruption at the opening bell. Market orders should not be used during volatile markets. Additionally, a more esoteric ETF is no different than a single stock. You have to know what you are buying and selling. Every available security requires research and analysis to determine the risks. That is Investor 101 material.


We believe in the merit of ETFs and do not believe the multi-faceted issues of August 24th point to a broken product. When prices of underlying securities were unavailable, the ETFs provided the best level of price discovery available (i.e. what a market participant was willing to buy or sell at, regardless of whether it was a resting stop loss). As soon as trading resumed in a more normalized fashion, pricing issues eased and prices came back in line. It was a temporary disruption. Going forward, there are questions to be answered. Does there need to be additional regulation to force liquidity providers to stay involved during certain periods? Do exchanges need to re-think regulations and processes to ensure we do not repeat the situation we had at the open? I believe the events of August 24th have provided a painful but necessary catalyst to open further discussion. ETFs are still a “new” idea to many investors even though they are now over 20 years old. However, the vast majority of the ETF universe has only existed since the mid-2000s or later. Due to the increased popularity and adoption by retail investors, we need to ensure as an industry that we are providing the proper education and structure for the next phase of ETF growth. The influx of ETFs in the past few years (including the so called *cringe* “smart beta” ETFs) have provided an increased need for due diligence on behalf of investors. Markets which were mostly inaccessible to the majority of investors (e.g. commodities) can now be purchased with a share of an ETF. Instead of spending several thousand dollars on initial margin for a contract of WTI Crude Oil, you can purchase a share of the United States Oil Fund LP (USO) for about $12. Maybe that is a bad example with the recent trend in energy prices, but I think you see the point.

On a related note since Mr. Weinberg brought it up, the rise of “robo-advisors” is less of a threat to the ETF industry than it is to the investment manager industry. Many of the robo-advisors primarily use ETFs in their models. ETFs are the ideal product for robo-advisors because they can provide exposure to broad asset classes with a single purchase and have advantages over mutual funds such as lower fees and intraday pricing. In fact, the robo-advisor industry might actually further the growth of ETFs rather than challenge them as a product. The example of Wealthfront’s direct indexing service is the exact reason why people use ETFs. You need $100,000 or more to buy shares in some or all of the stocks within the available indices. I am sure the required initial amount is a barrier to many investors. Speaking of barriers to entry, the robo-advisor industry is starting to become saturated. All you need is a few algorithms and you’re mostly set. Some firms, such as Schwab are cannibalizing other service channels with their robo divisions. Instead of generating fees from individual trades in client accounts, Schwab will earn its keep through the management fees on the Schwab ETFs used within its Intelligent Portfolios product. Investment managers like Astor will need to prove our worth. I would not be surprised if these robo-advisors merge with the UMA and model delivery firms of the industry. Maybe you will see sub-advised strategies on the robo platforms. The real threat is to the brick and mortar financial advisor as the world moves towards a full embrace of technology. I do not think the handshake and face-to-face will go away as human interaction is part of our existence. It will certainly be interesting to see how the rise of the robo-advisor progresses in the coming years.

A brief list of articles covering August 24th

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.  312151-341

December Economic Read

The US economy continues its pace of modest expansion. Though self-sustaining growth continues to be the most likely outcome, a few soft spots – mainly related to weak growth overseas – continue to worry. I expect the economy to adapt well to the beginning of a shallow and gradual rate hike cycle.

Our Astor Economic Index® shows growth somewhat above the ten year average, though it is lower than a month ago. The AEI is a proprietary index which evaluates selected employment and output trends to try and gauge the current pace of US economic growth.

Good news first. The broad economy continues to expand as can be seen in the steady pace of jobs growth. It may be a promising sign for the future that construction jobs continue to grow at a slightly faster rate than they have since the Great Recession. The housing sector has been weak in the recovery and improvement would be welcome.

The weakness in the manufacturing sector continues as demonstrated by a range of indicators. The latest survey from the ISM was below the line demarcating manufacturing expansion/contraction, though this level is consistent with a growing economy, not a broad recession. This is also reflected in the index of industrial production. The manufacturing sub-index has been weak all year, though not nearly as weak as the mining sub-index.

Source: Bloomberg, Bureau of Labor Statistics, Institute of Supply Management

Source: Bloomberg, Bureau of Labor Statistics, Institute of Supply Management

I see this weakness mainly as a consequence of the slower pace of growth in the Chinese economy leading to broad emerging economy weakness which, in turn, is directly reducing prices on commodities produced in the US as well as reducing overseas demand for US produced intermediate goods. As part of the financial markets reaction to this adjustment the dollar has rallied about 20% against a broad currency index over the last 18 months. The IMF estimates that the dollar movement alone has reduced US GDP growth (by reducing net exports) by about 1% in the last few years.

Will this manufacturing recession spread to the rest of the economy? I do not believe recessions can be forecasted at significant horizons, so I will not lay odds. My guess, however, is that it would take significant further deterioration in the global environment for this to happen. And whatever odds you place on them, it is also possible that the headwinds the US is facing in the external environment will begin to dissipate or at least stop deteriorating next year, a slightly optimistic vision.

The continued decent growth in the US in the face of some overseas challenges is one of the reasons why the Federal Reserve will begin raising rates shortly. They seem to be anticipating the attenuation or reversal of growth constraining factors and hope that by starting rate hikes sooner they will not need to raise them as much. Additionally, if we take the Fed at their word, they are worried about labor market slack being close to completely used up.

If I were on the FOMC I would vote against a hike as the Fed’s inflation target does not seem to be close to binding any time soon and because I would be hoping to decrease the numbers of involuntary part timers as well as try to move the labor participation rate back higher, though demography limits potential gains.

Be that as it may, the Fed is still likely to initiate a rate hike, followed by a stately pace of follow-up rate hikes. Given that the Fed has not begun to shrink its balance sheet (maintaining a substantial stimulus) and that fed funds may only be around 1% a year from now, few serious observers are anticipating that this will seriously hurt the economy.

Overall, I am still cautiously optimistic on the US economy, though less so than last month and I will be watching developments in the export sector closely.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. 312151-336