There was a great deal of excitement about today’s Employment Report. The S&P rallied 1.1%, erasing the month-to-date losses at a stroke. And for what? Nonfarm Payrolls were reported at 203k with a net +8k upward revision to the prior months, versus expectations for 185k. That’s a miss that is easily within the standard error. The 6-month average stayed at about 180k and the 12-month average at about 190k. The 3-month average reached 193k, but that is lower than it was in Q1 of this year so no great shakes there.
True, the Unemployment Rate dropped from 7.3% to 7.0%, reversing the unexpected uptick from last month as the labor force participation rate rebounded. Economists were always suspicious of that steep drop in the participation rate, and some bounce was expected (pushing the Unemployment Rate down). But so what? As the chart below (Source: Bloomberg) shows, this is just another step in a long, steady, slow improvement.
I think the reasoning must be something like this: the economy is stronger than we thought, by a little, yet this doesn’t change much about the timing of the taper. Unemployment is 7%, and core PCE is 1.1%. Neither one is close to the Evans Rule targets, so there’s plenty of time (at least, if you are a committed dove like is Yellen). They’re looking for reasons to be slow on tapering, not to accelerate it. At least, this is why equity investors were excited. Perhaps. It does not, though, change my own views in any way – the economy is moving along at roughly the pace that is now normal, adding jobs at a pace that is about what we should expect in the thick of an expansion. The expansion is still growing long in the tooth. But forecasting growth is no longer nearly as important as forecasting the Fed, and that seems fairly easy right now: mo’ money is mo’ better. Stocks are nearing an ugly disconnect, I think – but not today.
I seem to regularly take a lot of heat in the comments section of this column for several things. Some readers take me to task for covering up for The Man and his CPI Conspiracy. I won’t address that here, but on December 18th I’ll be running a combination of two old blog posts that explain why CPI isn’t a made-up number, and why most people perceive inflation as being higher than it actually is. The other major complaint is that I have been “calling for inflation forever” and that I am somehow an unrequited inflation-phobe.
I want to refute that specifically. The people who say that are sometimes confusing me with someone else, and that’s okay. But sometimes they make an assumption that since my Twitter handle is @inflation_guy, because I traded inflation derivatives on Wall Street and was the designer and market maker of the CPI futures contract that launched in 2004, and because I run a specialty investment management firm with a core focus on inflation, I must always be super bullish on inflation.
In fact, people who have followed my comments off-line and on-line for the last decade know that is very far from the truth. In fact, when I was an inflation swaps trader the dealer I worked for often got exasperated because I routinely told clients that I did not expect inflation to head higher very soon because of the huge overhang of private debt. “How can you expect us to sell inflation products,” they asked, “if you keep telling everyone there is no inflation?” My rejoinder: “If we are only selling these products when inflation goes up, we only have a business half the time, or whenever we can convince the client that inflation is going up. But these products almost always reduce risk, since almost every client has a natural exposure to inflation going up, and although they have systematically profited over the last two decades from a bet they didn’t know they were making, that cannot continue forever. That’s the reason people should buy inflation products: to reduce risk.”
So, for many years I was exactly the opposite of what I am sometimes accused nowadays of being: although I didn’t worry about deflation very much, I certainly wasn’t worried about runaway inflation.
When the facts change, I change my mind. What do you do, sir?
It was clear that the Fed’s actions in 2008 were going to change things in a big way, but it is interesting that my models anticipated that inflation would continue to decline into 2010 and bottom in Q3 or early Q4 (which is what I said here among other places). It is from that point that I began to diverge with Wall Street opinion (again – since the consensus expected inflation in the middle 2000s while I did not). I published what I think is a helpful time series of my 12-month-ahead model forecasts in early 2012, contrasting it with a chart from Goldman.
So now, let me update the model chart with a forecast for the next twelve months. Before I do, note that in the chart I have substituted Median CPI for Core CPI, for the reasons I have written about for a while now: Core CPI is being dragged down by several one-off movements, most notably in Medical Care, and so Median CPI is currently a better measure of the true central tendency of inflation.
The black line is the actual Median CPI. The red line is the average of the other two models depicted as green and blue lines. The blue line is quite similar to the model I have been using for a very long time; it uses a couple of macro variables including a role for private indebtedness. The green line is something I introduced only in the last few years; it models shelter separately from the ex-shelter components because we have a pretty decent idea of what drives shelter inflation. Frankly, I like that model better, which is why my firm’s forecast for 2014 is for core (or median) inflation to be 3%-3.6%. The model says 3%, and I believe the tails are on the high side.
But the real purpose of my presenting that chart, and the aforementioned discussion, is to defend myself against the calumny that I am a perpetual bull on inflation. Nothing could be further from the truth. From 2004-2010, if I was bullish on inflation at all it was only a “trading opinion” based on market prices. It is only since then that I have been loudly bullish on inflation. And, even then, while I will tell you why inflation could have extremely long tails on the upside, you will not find me forecasting 8%. Nor claiming that inflation really is somewhere that I said it would be, because I don’t like the numbers the BLS is reporting.
I have said in the past, and reiterate now, that one of the main reasons I write this column is mainly to hear reasoned counterarguments to my theses. I think I get sucked far too often into debates with unreasoned or unreasonable counterarguments, not to mention ad hominem attacks.
It goes with the territory of writing a public blog, I suppose. At some level it doesn’t matter much, because I wouldn’t have been on Wall Street for two decades if I bruised easily. But on the other hand, I have a right to self-defense and I have now exercised that right with respect to this particular charge!
 A quote variously attributed to Keynes, Samuelson, and others…and apropos here.
 Incidentally, note that our firm forecast may differ from the model forecast based on our discretionary reading of the model and other factors. In the last two years, the naked model has handily whupped our discretionary forecast.
I haven’t seen anything of note written about the probable effect of the implementation of the Affordable Care Act (ACA, or “Obamacare”) on Medical Care CPI. This is probably because the calculation of Medical Care inflation in the CPI is confusing to many and because the direct effects of the ACA are still speculative at this point. But this is a potentially dangerous oversight since Medical Care is 7.2% of the CPI, and is after all the part that has recently been dragging Core CPI and Core PCE lower because of its unusual weakness.
Even if one cannot fathom the details, we know that the ACA will add volatility to the measurement of medical care inflation, and with measured medical care inflation so low presently, relative to historical trends, this implies mostly upside risk to prices. The following chart (Source: Enduring Investments) shows the rolling annual increase in Medical Care CPI, along with core CPI.
The most generous interpretation of this chart is that the ACA was already having an impact on holding down medical care prices prior to its implementation, although this ignores the known effect of the sequester on medical care inflation outturns: the sequester slowed Medicare payments to providers, and this had the effect of lowering measured medical care inflation temporarily. Another cavalierly optimistic interpretation might be to suggest the possibility that the secular outperformance of medical care inflation relative to broad inflation is coming to an end.
While the actual economic effect of the ACA will only be determined over a long period of time as the actual rules and the free market response become more clear, I think that the effects of the ACA on the measurement of medical care inflation, at least for several years, will have the effect of pushing medical care inflation higher. The reasons for this are less about the question of whether disrupting the private insurance industry and price system is likely to create overall gains in efficiency in delivering health care, and hence lower prices (I doubt it), and more about the somewhat arcane way that medical care costs are accounted for in the Consumer Price Index.
Accounting for changes in the cost of medical care is a very challenging problem for a number of reasons. One of these reasons is that changes in medical care prices, like all price changes, reflect both inflation and the possible change in the quality of the delivered product. A mundane example of this problem outside of medical care is when the size of a candy bar increases 20% and the price of the bar rises 25%. Clearly, in such a case there isn’t 25% inflation in the cost of a candy bar, because the consumer is getting 20% more candy in the bargain. That is a simple quality adjustment, and the BLS regularly makes these changes (more often, of course, the candy bar shrinks so that the quality adjustment increases measured inflation rather than the other way around!). More problematic and controversial are when the quality change is more subjective, such as when a car adds chrome wheel rims or a disk drive doubles in size, or when the BLS makes changes for the aging of the housing stock. Nevertheless, the BLS has sophisticated models for making these adjustments with the least amount of subjective evaluation possible.
How, though, does one measure the improvement in the quality of medical care when the whole course of treatment for a given condition may change? The service being provided, after all, isn’t “one MRI image” but “improved leg function as the result of surgery done with the benefit of improved MRI imaging.” This is a continued challenge for the BLS and one that the Bureau has spent many resources researching over the last few years.
So one problem that the BLS faces is that the price index does not necessarily measure quality improvements well. Another problem is that the Consumer Price Index is supposed to measure costs to consumers, and few consumers pay directly for their medical care but rather for insurance; moreover, the government itself pays for much medical care through Medicare and other programs which have no direct cost (at least, in a direct financial sense as opposed to an economic sense) to the consumer of medical care. For many consumers, too, their employer picks up part of the cost of insurance.
The BLS therefore measures medical care not by looking at the cost of insurance but by looking at what insurance companies pay for the medical care on behalf of the consumers, and then separately accounting for the insurance company profit as a different consumer item. Government purchases of health care are entirely outside of the consumer price index since the government is not a “consumer!” The employer-paid portion of health care insurance is also excluded since a company is also not a consumer.
So what does this mean for the effects of the ACA on the cost of medical care? I can see several likely effects:
- Because the BLS measures the prices being paid by insurance companies to doctors, rather than insurance costs, the sharp increases in insurance costs due to the transition to the health care exchanges dictated by the ACA may not be immediately reflected in the price index for medical care. However, it is also possible that doctors and hospitals may take advantage of the confusion by changing their prices at this time and blaming the increase on the increased burdens of the ACA. Prescription drugs, too, may see price increases for this reason. The outcome of this part of the transition is probably indeterminate on medical care inflation in the short term, but it clearly increases the range of possible outcomes. If provider price increases happen quickly even though new insurance policies will only gradually be taken, then medical care inflation might increase quickly in the short run. But the opposite might also happen, so that consumers face higher insurance costs but medical care inflation does not reflect this.
- Much more problematic is a composition effect that will affect the relative health of the patients that doctors will be treating, almost immediately. Many Americans have just lost their private health insurance. Faced with this, consumers who are relatively healthy are likely to decrease their doctor visits relative to comparatively unhealthy patients because of the increased out-of-pocket cost of going to a doctor. Unhealthy patients have less of an option to decrease consumption of medical care in response to higher costs, and indeed some very unhealthy patients have seen their costs decline due to the ACA (which was, after all, the point: not affordable care for all, but affordable care for those who were finding health care very expensive partly because they needed a lot of it). Because the BLS measures health care costs at the provider level, this could increase measured health care inflation quickly because of increased utilization of more-expensive treatment options.
- The fact that the BLS only considers the employee-paid part of company health care plans also has very interesting implications under the chaotic transition to the ACA. When an employer pays less of the premium for a corporate plan, the employee pays a higher price (and feels inflation) even if the overall premium doesn’t change. But this increases the weight of Medical Care in the consumer’s consumption basket, so that the 7.2% weight in the CPI will increase, and probably substantially, over the next couple of years. Consider the previous chart, illustrating that medical care inflation has outstripped broader inflation indices for at least the last three or four decades. To the extent this continues, a higher weight of medical care implies a higher overall level of inflation.
- In general, the ACA creates uncertainty among service providers in the health care industry. A typical reaction of suppliers facing uncertainty in any industry is to raise prices in order to increase the margin for error (in much the same way that asset prices tend to be lower when investors feel less safe and thus must build a margin of safety into the bid price). While not strictly inflation since the cushion would not increase each year, it would tend to increase measured inflation over the medium term.
It is very difficult to evaluate the size and timing of each of these effects, but it is important to note that while some of the effects are indeterminate (such as #1 above), there are no effects I can discern that would tend to decrease measured inflation of medical care. Consequently, I expect that Medical Care inflation – which has been, I have previously mentioned, a key source of the weakness in core inflation compared to median inflation – is likely to rise appreciably over the next year. Note that this is likely to be the case even if the ACA actually succeeds in lowering the aggregate economic cost of healthcare (about which fact I are skeptical) because the way the BLS measures medical care inflation is likely to cause increases in this index.
Below is a summary of my post-CPI tweets. You can follow me @inflation_guy. And, given where all of this seems to be going…you ought to.
- Core inflation only up 0.122%. But housing continues to accelerate! Apparel -0.5% this month.
- Core dips slightly to 1.734% from 1.766% y/y. At odds with our forecast, due to the continued weakness in core goods.
- Still think core ends 2013 over 2%, but depends on core commodities coming up some. Our housing forecast looks good.
- Primary Rents stays at 3%, OER at 2.2%.
- Medical Care 2.4% y/y from 2.3%. And that’s with “health insurance” falling to 2.5% from 2.9%. Obviously, that’s all pre-ACA.
- Accel Major groups: Medical Care (7.2%). Decel: Apparel, Recreation, Educ/COmm (16.3%). Everything else sideways.
- This really IS mostly about the apparel decline. Bad back-to-school adjustment probably.
- I think given apparel, what we know will happen in medical care, and the housing stuff…next month may be over 0.3% on core.
This has all the signs of one of those numbers (and we’re seeing a lot of them this month) that should be averaged with next month’s number because of data collection quirks. Actually, we probably ought to average September, October, and November data together to get a “before, during, and after” average around the government shutdown. The apparel decline hit women’s apparel, men’s apparel, and girls’ apparel, but boys’ apparel inflation accelerated. Medical care prices re-accelerated slightly, as I think is destined to happen because the current run-rate is significantly due to the effect of the sequester on Medicare reimbursements, but we can already see that the “insurance” category is going to be accelerating markedly in the next few months because of the large number of cancellations and re-policying that is going on around the implementation of Obamacare. While direct consumer purchase of insurance and/or medical care is just a small part of overall inflation, a big jump will still be felt in the overall data.
The key conundrum continues to be the softness in core goods, but as I’ve argued previously the biggest part of the effect is from the very low readings from medicinal drugs and medical equipment – both of which accelerated this month. If the apparel reading really is a quirk, then core inflation is going to start heading higher with alacrity now. All of the “interesting” parts of it already are.
All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.
The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).
I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.
And all it took was a few trillions!
It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.
So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.
We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.
The data has started to arrive.
Tuesday’s Employment report (gosh, it seems strange to write that) was weaker-than-expected with Payrolls +148k versus expectations for +180k. As I wrote back at the beginning of August, something in the realm of 200k is about as good as you’re going to get, so we’re not very short of that…we’re just very far short of what the consensus seems to expect we’re eventually going to get. No doubt, 148k isn’t 200k, and the six-month average of 163k is the lowest of the year. But it is also not a calamity, on the growth front.
And yet, 10-year interest rates are 50bps below the highs of early September. (Real yields are actually down 60bps, which means inflation expectations have risen slightly during that period). Interest rates are down because everyone knows that the trajectory of policy, with Yellen as likely to be the next Chairman of the Fed, is going to be “lower for longer.” But why? This goes back to the observation that growth is not far short of the best that it is likely to get. The only point of “lower for longer” is to support asset markets – housing, equity, and the bond market whence our nation’s interest burden is determined – and it seems to be doing this quite well. The alternate theory is that the Fed still fears deflation, despite all evidence (and copious theory) that the risk arrow is pointing in the other direction. In neither case does the Federal Reserve come out looking particularly on top of things, but more and more we are expecting that from Washington whether the officials are elected or appointed.
I really thought at one point that the bond market was going to be where the profligate monetary policy was going to first come unglued, but I am now wondering if it isn’t that denizen of hair-trigger shooters, the foreign exchange markets. The dollar index is plumbing the lows of the last two years, although it remains considerably above the lows of 2008 and 2011. As the chart below shows, the dollar has actually left behind the commodity markets where, as we know, investors suffer from the delusion that growth is more important for the nominal price of commodities than is the overall price level. Weak-ish growth means that commodities are only weakly above its August lows, although the buck is quite a bit lower since then.
I don’t think we can learn much right now watching stocks, where investors are simply playing Icarus. We all know where it leads, but any words of warning are laughed off as they soar with Fed-induced wings. Of course they’ll turn away in time!
I think housing is interesting. Having gotten back barely to fair, or maybe just a smidge cheap, compared to incomes, housing is expensive once again. But it isn’t in bubble territory yet, at least in the sense that when it cracks it could cause the carnage it did once before.
Bonds are on tenuous footing. With the consensus currently in place that the Fed might keep QE in place more or less forever, there are a lot of ways to disappoint the status quo: Fed speakers might suddenly try to start sounding stern again and imply that QE might not last forever; inflation might continue to tick higher and make obvious the unsustainability of the current course; or growth numbers might surprise to the high side.
The barbarians are already overrunning the dollar, and I suspect only the fact that Japanese monetary policy is far worse is keeping the descent slow. But people plugged into the supply and demand for currency are probably most likely to understand what happens when too much is supplied (hint: it’s the same thing that happens to the price of corn when too much corn is supplied). For a while, monetary authorities have been chasing each other to see which could be the least respectable, but it now seems that Japan wins that race and the US is likely to place.
As the chart above shows, reasons for increasing exposure to broad-based commodity indices (especially those that do not overweight energy, as the GSCI does) continue to accumulate.
There is much more data to come, of course, but to me it seems the battle lines have been more or less drawn in this fashion.
I haven’t written recently because it is hard to figure out what to do here. Market action at this point seemingly has little to do with fundamentals, and isn’t even in “risk on/risk off” mode because no one seems to be sure how the government shutdown affects risk (the debt ceiling debate is another issue, which I will discuss later).
I often get comments to the effect that “political uncertainty is a fact of life,” or “the Fed always manipulates markets,” implying that we cannot simply refuse to invest because markets aren’t trading cleanly off of economic fundamentals (which don’t directly translate into market action even in the best of times anyway). This is true, but I always hearken back to the notion that uncertainty implies a smaller bet size (a long time ago I wrote an article in which I discussed the implications of the Kelly Criterion for thinking about how one invests). When the economic signals are clear but the market isn’t pricing them properly, then you have a great edge and the market is giving you good odds, and most of your chips should be on the table. When the economic signals aren’t clear, or when stochastic political events are likely to overwhelm them, then your bet should be small because your edge is lower even if you are getting good odds.
In this case, of course, no matter what market you are talking about it isn’t at all clear how the debate (perhaps calling it a “debate” is generous) about the continuing resolution to fund government operations, the ACA, and the debt ceiling will be resolved.
We can speculate about what various outcomes might mean to the markets, but even here our analysis is fraught with uncertainty. Would an extended shutdown be good for equity markets because it would imply a greater chance of lower ACA costs and a lengthier period of Fed quantitative easing? Or would it be bad because of the short-term impact on growth as government spending is delayed? Would bonds rally because there would be no incremental supply, or sell off because of the implied risk of default? A lengthy government closure might be bad for the dollar because it implies more monetary ease, but might be good because it represents “fiscal discipline” (admittedly, in this case it’s discipline in the fetishistic sense rather than in the self-control sense). The only thing I am certain about is the uncertainty, and that spells a smaller bet.
Retail investors are especially at a disadvantage, because of the huge amount of misinformation that is out there about likely scenarios and the results of various outcomes. This misinformation is often unwittingly disseminated by media outlets, but I suspect it is rarely unwittingly initiated by the original sources.
For example, a recent New York Times blog was pretty good at discussing the possible outcomes, but flunked on at least one aspect when it stated what would happen to the economy as a result of a federal default. I don’t mean to pick on the Times here, and in general it is a good article. But at one point the writer said that a default could cause a spike in Treasury yields (likely true), but then continued “The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs.”
Well, that’s wrong. It’s not offensively wrong, but it’s wrong (and I’m pointing it out partly as an example of how even simple stuff is confused right now). The interest rate on any nominal debt instrument consists of several components: the real cost of money, a premium for expected inflation, and a premium for the riskiness of the credit. Normally, with Treasuries we can say the credit spread is effectively zero, so that we refer to the spread that a corporate bond trades over Treasuries as “the” credit spread because that spread minus zero equals that spread. But there is no reason to think that spread would remain constant if the Treasury’s credit was diminished, any more than it would remain constant if the corporate’s credit was diminished. If Treasury rates spiked because the government’s perceived credit spread was no longer zero, then unless that also affected the perceived credit of, say, Caterpillar then there is no theoretical reason that CAT yields should also rise.
In any event, a federal default is not going to happen unless someone in the Administration wants it to happen. The government’s $2.9 trillion in revenues is quite a bit more than is needed to pay the $300bln or so in interest costs per year, so unless the Treasury simply decided to default (see an excellent article here by my friends at TF Market Advisors) it isn’t going to happen. The Treasury has made some mystifying statements about how they don’t have the capability to pay some expenses and not others, but in the worst case someone can sit down and manually wire the money to every holder. So that’s nonsense that is meant to scare us.
So I don’t have any decent “trading opinions” on the basis of the government shutdown. What I do believe is that this is an unmitigated positive for inflation (positive in the sense of pushing it higher), and thus for breakevens and inflation swaps. The longer the government stays shut, the longer quantitative easing will be in force as the Fed attempts to counteract the short-term contraction of economic activity (the fact that monetary policy is ineffective at affecting growth rates never seems to enter their minds); furthermore a long shutdown will more likely to push the dollar lower in my opinion – although, as I said above, I can argue the reverse position as well. On the other hand, if the Republicans cave quickly, as is likely in my view, and the ACA goes into effect, prices for consumer-purchased medical care will rise rapidly. This is less a statement about whether the ACA will push aggregate health care costs higher, although I believe that it will. It’s more an observation that controlled prices in the government-purchased sector will produce higher prices outside of the controls, and it is this latter group that will be sampled for consumer prices (since the price the government purchases at is not a “consumer” price). Since it is the Medical Care subgroup of CPI that has been pressing core CPI to be lower than median CPI, any rebound in Medical Care inflation will push aggregate core inflation higher.
Was that said in a confusing-enough manner?
TIPS should do well while the government is shut, because there is ongoing growth in demand for TIPS while the supply will be drying up. Unlike with the nominal Treasury market, there is no corporate inflation-linked bond sector that can replace the inflation exposure (although there should be) demanded by investors, so TIPS will tend to outperform nominal bonds in the event that both sets of auctions are canceled.
 There are other costs, such as the discount to the interest rate that the Treasury pays as a result of the status of Treasuries as superior collateral in repo and similar exchanges, but they are not relevant to this point.
 There may be a practical argument that there might be a substitution effect, but that’s also saying that investors would bet the selloff in Treasuries makes them a better risk-adjusted bet than CAT bonds. However, if the Treasury’s credit spread moved permanently higher, it would not affect the equilibrium bond yield of a corporate bond.
Now, now, children! Stop fighting! This is unbecoming!
It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.
Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.
On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?
The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.
It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?
To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?
And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.
I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.
One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.
I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.
Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.
It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!
Here is a summary of my tweets after the CPI release this morning. You can follow me @inflation_guy.
- CPI +0.1%/+0.1% core, y/y core to 1.8%. Core only slightly weaker than expected as it rounded down to 0.1% rather than up to 0.2%.
- Housing CPI was weak, second month in a row. Rents will eventually catch up w/ housing prices…but not yet.
- Apparel CPI was weak after a couple of strong up months. I’ll have the whole breakdown in a bit.
- Core was actually only 0.13%, suggesting last August’s 0.06% and this August’s number might merely be bad seasonals.
- Market was only looking for 0.17% or so, so it’s not a HUGE miss. Still disappointing to my forecasts as upturn in rents remains overdue.
- Core CPI now 1.766% y/y. More difficult comparison next month although still <0.2%.
- Accelerating major grps: Apparel, Medical Care, Educ/Comm, Other (20.9%); decel: Food/Bev, Housing(!), Transp (73.1%), unch: Recreation
- Housing deceleration actually isn’t worrisome. Primary rents were 3.0% y/y vs 2.8% last. OER was 2.23% vs 2.19% last.
- Housing subcomponent drag was from lodging away from home, household energy, other minor pieces. So housing inflation story still intact.
- Core services inflation unch at 2.4% y/y; core goods inflation up to 0% from -0.2%. Source of uptick: mean reversion in core goods.
- So OER still reaches a new cycle high at 2.23%…it’s just not accelerating yet as fast as I expect it to. Lags are hard!
The initial reading of this number, as the tweet timeline above shows, was negative. The figure was weaker-than-expected, and Housing CPI decelerated from 2.26% to 2.17%. This seemed to be a painful blow to my thesis, which is that rising home prices will pass through into housing inflation (expressed in rents) and push core inflation much higher than economists currently expect.
Housing CPI is one of eight major subgroups of CPI, the other seven being Food and Beverages, Medical Care, Transportation, Apparel, Recreation, Education and Communication, and Other. Housing receives the most weight, at 41% of the consumption basket and an even heavier weight in core inflation. So, a deceleration in Housing makes it very hard for core inflation to increase, and vice-versa. If you can get the direction of Housing CPI right, then you’ll have a leg up in your medium-term inflation forecast (although it isn’t very helpful in terms of projecting month-to-month numbers, which are mostly noise). Thus, the deceleration in Housing seemed discouraging.
But on closer inspection, the main portions of Housing CPI are doing about what I expected them to do. Primary Rents (aka “Rent of primary residence”) is now above 3%, in sharp contrast to the expectations of those economists and observers who thought that active investor interest in buying vacant homes would drive up the price of housing but drive down the price of rents. Though I never thought that was likely…the substitution effect is very strong…it was a plausible enough story that it was worth considering and watching out for. But in the event, primary rents are clearly rising, and accelerating, and Owners’ Equivalent Rent is also rising although less-obviously accelerating (see Chart, source BLS).
So, it is much less clear upon further review that this is a terribly encouraging CPI figure. It is running behind my expectations for the pace of the acceleration, but it is clearly meeting my expectations for what should be driving inflation higher. As I say above, econometric lags are hard – they are tendencies only, and in this case the lags have been slightly longer, or the acceleration somewhat muted, from what would typically have been expected from the behavior of home prices. Some of that may be from the “investors producing too many rental units” effect, or it might simply be chance. In any event, the ultimate picture hasn’t changed. Core inflation will continue to rise for some time, and will be well above 2% and probably 3% before the Fed’s actions have any meaningful effect on slowing the increase.
I will resist the temptation, succumbed to by many others, to offer a pithy title turning on some pun involving Larry Summers’ name. For example, I will not title this article:
- Summers’ Not Lovin’
- Summers of Our Discontent
- Summer Happy, Summer Not So Happy
- Cruel Summers
- School’s Out For Summers, or
- Lazy-Hazy-Crazy Days of Summers
Such tomfoolery is occasioned by the news yesterday that Larry Summers has withdrawn his name for consideration to be the next Fed Chairman, succeeding Bernanke. The markets reacted with similar tomfoolery. Although the equity markets hadn’t exactly plunged as Summers became the odds-on candidate (at a conference I went to last week, all six of the panelists during one segment said Summers would be the selection), stocks rocketed higher today as this supposedly makes a dovish Chairman more likely. Bonds rallied as well, and the dollar fell – all of these for the same reason. Strangely (but not so strangely if you have been watching commodities for the last couple of years), commodities fell on the potential for a more-dovish Chairman.
The odds-on favorite just became Janet Yellen, with Donald Kohn the runner-up. Both of these are considered to be more-dovish than Summers, which is odd because it is generally acknowledged that Summers had virtually no track record expressing his opinions on matters of monetary policy, and was essentially a policy unknown.
In any event, markets for the nonce are enjoying the notion that a Chairman Yellen or Kohn would bring “continuity” to the Federal Reserve and make the adjustment from the Bernanke years seamless. You can be a short seller of that idea. Volcker to Greenspan, Greenspan to Bernanke…neither of those transitions was expected to make a dramatic difference in monetary policy, but of course ultimately they did. Going back further, Volcker was chosen partly as an antidote for G. William Miller, so it is not surprising that things changed under Volcker – but we were looking for change). You probably have to go back to the Arthur Burns/G William Miller transition in the late 1970s to find a transition that truly didn’t matter very much, although that was mostly because Burns had made such a mess of things and triggered such an ugly inflation by adding too much liquidity to the system in order to cure the recession that the only thing Miller thought he could do was to continue on…
Oh. I see the parallel now.
In any event, a Chairman Kohn or Chairman Yellen is very likely to turn out to be something different from what we think we are getting, or from what the President thinks he is getting (not necessarily the same thing). It is much like appointing a Supreme Court justice: after donning the robes, physically or metaphorically, a justice might vote in a way very different from the way his nominator expected him or her to. Just ask G.H.W. Bush. So, regardless of whether the next Chairman is Yellen, Kohn, or some as-yet-unknown candidate, the bottom line is that investors should expect surprises. If your investment strategy is reliant on there not being any surprises, then I advise you to reconsider that strategy!
Speaking of surprises, Tuesday brings the CPI report. The market consensus is for +0.2% on headline and +0.2% on core inflation, with the y/y core inflation reading rising to 1.8% from 1.7%. However, since last year’s CPI print was a mere +0.06%, forecasting a rise is very easy. If the monthly figure is only 0.105%, y/y core inflation will still tick up to 1.8% (rounded). Indeed, the risk here is that it only takes a +0.21% to produce a 1.9%, which would make for some panicky portfolio adjustments even though it would not be an extreme outlier.
In my view we are probably overdue for a +0.25% print on core inflation. The current rise of core CPI back towards median CPI, which has been either 2.1% or 2.2% for a year and a half, is happening because some of the unusual effects that pushed core CPI later are waning. Moreover, as I have written about expansively previously, housing inflation appears to have turned up but a more-substantial move higher is due (or perhaps overdue).
The CPI report and the adjustment to the market’s expectations about the next Fed Chairman are somewhat related. There is a notion out there – which I think is foolish – that the removal of Summers from consideration as the next Chairman, coupled with slightly weak recent data, lessens the chance that the “taper” will be announced this week. I do not think that either event bears on the probability that a taper will be announced. While I originally expected the taper to come later in the year than this, the voluminous statements of Fed Governors and Fed Presidents seems to indicate that it will begin imminently. The likelihood that a dove will take the Chairman’s seat does not change that. However, to the extent that the stock and bond markets rallied because they think a taper is less likely, a CPI print that takes core to 1.9% on the year will extinguish that frail hope. I think today’s stock market rally is subject to a near-term disappointment if this happens, and this is likely the case, although less so, for the bond market as well.