Here is a summary of my post-CPI tweets. You can follow me @inflation_guy:
- Well, that was boring. CPI exactly as expected. Although frankly, most big shops expected +0.2% on core (me too).
- Weird month where higher fuel prices seem to have taken edge off Shelter, but lower gasoline prices pushed Transp down!
- Apparel down, and New cars & trucks down despite rising in PPI. So much for new PPI. Medical care commodities up though…
- Medical Care as a whole +0.3%. Only 7.6% of the whole CPI, but reverses a recent trend caused by last year’s sequester.
- Core services remained at 2.3% y/y, core goods declined to -0.3%. My proxy, though, is rising so this latter won’t continue.
- Striking – core less shelter now at +0.933% y/y, the lowest since the real deflation crisis in 2004.
- accelerating CPI categories: Housing, Med Care, Other (52.4%), Decel: Apparel, Educ/Comm (10.5%). Unch: 37.1%
- Primary rents +2.88% y/y, virtually unch from +2.87%. But Owners’ Equiv Rent +2.517% from +2.488%.
- New & Used cars and trucks under tremendous pressure, +0.3% y/y, and that’s 7.5% of core CPI. And Apparel (another 4%) has flatlined.
The reason that most big shops – and me too – expected +0.2% or even +0.3% on core, as opposed to the +0.13% that we got, boils down to three things: second, the housing part of core CPI, which is huge, is clearly accelerating and continues to do so. Second, core goods, which represents most of the rest, has been flat or deflating for a while, and normally that part of inflation is more mean-reverting.
The housing part of that view is working out. The Shelter subcomponent of Housing (which is ¾ of it, after extracting utilities and household furnishings and operations) is now rising at 2.58%, the fastest rate since 2008. Owners’ Equivalent Rent, the largest single component of the CPI, is at 2.52% y/y, and as I’ve illustrated often – here comes that chart again – there is every reason to expect this to continue. OER should be in the 3.3%-3.5% range by year-end.
Core Goods, on the other hand, remains stuck in the mud. There was some reason to expect a rise in that index this month, as the Passenger Cars component of PPI rose +0.5% (but new vehicles in the CPI rose only 0.08% m/m), and the pharmaceuticals part of PPI was +2.7% (but only +0.9% in the CPI). In all likelihood, this suggests that core goods will move higher in the months ahead.
However, the weakness in Apparel and in vehicles has a commonality – those are sectors that are either sourced from non-US manufacturers or (in the case of vehicles) receive heavy competition from non-US manufacturers, and especially Japanese manufacturers in the case of autos. The recent strength of the USD with respect to the Yen and Yuan is not irrelevant here. Although early 2014 has seem some reversal in that trend with respect to the Yen, it’s not likely to have a serious reversal for a while – the Yen is going to keep getting weaker, and that will keep pressure on goods prices in the US.
Indeed, by one measure price dynamics in the US are closer to deflation than they have been since 2004. And it’s not a measure which should be taken lightly: core inflation, ex-shelter, is only 0.9% y/y, as the chart below (source: Enduring Investments) shows.
In the mid-2000s, the Fed flirted much more with deflation than they thought they were, because the housing bubble hid the underlying dynamic. Conversely, in 2010 we weren’t really very close to deflation, but the fact that housing was collapsing made it appear that we were. You can see both of these episodes on the chart. It is possible that the 2004-type stealth deflation could be happening again, but I don’t think so for one big reason: in 2004, money growth was in the 4-5% range as the economy was recovering, which created disinflationary tendencies. But now, we’re coming off a period of 8-10% money growth, and it’s still at 6%. It’s much harder to get deflation in such a circumstance.
And, with rents rising smartly, there is almost no chance that core inflation ends 2014 lower than it currently is. I continued to expect core inflation to move towards 3% over the course of this year (and median CPI to reach that level).
Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week’s events. [Note to editors at sites where this comment is syndicated. Feel free to split this article into separate articles if you wish.]
Follow the Bouncing Market
In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday’s sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday’s weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed’s taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong – but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher’s observation that the Fed’s adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with “beer goggles.” It’s not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!
The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn’t seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn’t necessarily imply that today’s equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) – the ones you can see by eyeballing a chart, by the date the drawdown ended.
I mentioned last week that in equities I’d like to sell weakness. We now have some specificity to that desire: a break of this week’s lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.
There is nothing about this week’s price action, in short, that is remotely soothing to me.
A Couple of Further Thoughts on Thursday’s CPI Data
I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation – the deceleration in medical care CPI – which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).
Moreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners’ Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.
Sorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%…in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.
For the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.
Famous Last Words?
So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the “Buddha of Banking,” as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.
“The problem with Q.E.,” he said, with more than a hint of a smile, “is that it works in practice, but it doesn’t work in theory.” “I don’t think that’s a concern and those who’ve been saying for the last five years that we’re just on the brink of hyperinflation I would point them to this morning’s C.P.I. number.” (“Reflections by America’s Buddha of Banking“, NY Times)
Smug superiority and trashing of straw men aside, no one rational ever said we were on the “brink of hyperinflation,” and in fact a fair number of economists these days say we’re on the brink of deflation – certainly, far more than say that we’re about to experience hyperinflation.
“He noted the Labor Department’s report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.
“Such readings, he said, ‘suggest that inflation is just not really a significant risk of this policy.’“ (“Bernanke Turns Focus to Financial Bubbles, Instability”, Wall Street Journal )
And that’s simply idiotic. It’s simply ignorant to claim that the policy was a complete success when you haven’t completed the round-trip on policy yet by unwinding what you have done. It’s almost as stupid as saying you’re “100 percent” confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.
I will also note that if QE doesn’t have anything to do with inflation, then why would it be deployed to stop deflation…which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman (“Deflation: Making Sure “It” Doesn’t Happen Here”, 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn’t that mean you think it causes inflation?
On inflation, Bernanke said, “I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed’s) balance sheet stays where it is or gets bigger.” (“Bernanke downplays cost of economic stimulus”, USA Today)
No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke’s watch, although it has wussied out by saying it wasn’t tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.
It’s not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It’s no fun going the other way, and I don’t think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.
The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke – which is good, because otherwise you’d really wonder why they want to retreat from a policy that only has salutatory effects.
“Bernanke said the only genuine risk of the Fed’s bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets ‘seem to be within historical ranges.’” (Ibid.)
I suppose this is technically true. If you include prior bubble periods, then today’s equity market valuation is “within the historical range.” However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won’t re-prosecute that case here.
So, this is perhaps Bernanke’s last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.
The following is a summary of my tweets following the CPI release today. You can follow me @inflation_guy. I am about to get on a plane to visit a reinsurance company to talk about inflation, so forgive me if I don’t add much color to the original tweets (as I usually do).
- CPI +0.3%, +0.1% ex-food-and-energy. About as-expected but core a little soft in that range. 1.71% is y/y core.
- Another 0.0% for Medical Care CPI. It’s hard to get core goods rising when Medical Care remains flaccid. That will change.
- Core #inflation ex-housing is down to only 1.1%! Core goods still in deflation dragging it all down…-0.1% vs +2.3% for core services.
- Owner’s Equiv Rent to 2.49% y/y. Clearly accelerating and a big risk to core going forward.
- Accel Major Grps: Housing, Apparel, Transp, Other (64.8%) decel: Food/Bev, Med Care, Recreation (28.4%). Educ/Comm unch.
- Med Care CPI only +2.01% y/y. That’s very unlikely to continue.
Big risk to core remains housing, which accelerated a heady +0.1% y/y, which is a big move for a ponderous group like Housing. Not surprising – I’ve been forecasting it for a long time, and it’s happening.
Note: The following blog post originally appeared on June 14, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?
The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:
“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”
But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.
That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.
A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:
That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).
That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.
So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.
Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.
I do not expect core inflation to begin to fall any time soon. [Editor's Note: While core inflation in fact began to decelerate in the months after this post, median inflation has basically been flat from 2.2% to just above 2.0% since then. The reason for the stark difference, I have noted in more-recent commentaries, involves large changes in some fairly small segments of CPI, most notably Medical Care, and so the median is a better measure of the central tendency of price changes. Or, put another way, a bet in June 2012 that core inflation was about to decline from 2.3% to 1.6% only won because Medical Care inflation unexpectedly plunged, while broader inflation did not. So, while I was wrong in suggesting that core inflation would not begin to fall any time soon, I wasn't as wrong as it looks like if you focus only on core inflation!]
 The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.
Note: The following blog post originally appeared on February 3, 2011 (with an additional reference that was referred to in a February 17, 2012 post) and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
Rising energy prices, if they rise for demand-related reasons, needn’t be a major concern. Such a price rise acts as one of the “automatic stabilizers” and, while it pushes up consumer prices, it also acts to slow the economy. This helps reduce the need for the monetary authority to meddle (not that anything has stopped them any time recently). It doesn’t need to respond to higher (demand-induced) energy prices, because those higher prices are serving the usual rationing function of higher prices vis a vis scarce resources.
But when energy prices (or, to a lesser extent, food prices) rise because of supply-side constraints – say, reduced traffic through the Suez Canal, or fewer oil workers manning the pumps in a major oil exporting region – then that’s extremely difficult for the central bank to deal with. More-costly energy will slow the economy inordinately, and higher prices also translate into higher inflation readings so that if the central bank responds to the economic slowdown they risk adding to the inflationary pressures.
One of the ways that we can restrain ourselves from getting too excited, too soon, about the upturn in employment is to reflect on the fact that surveys still indicate considerable uncertainty and pessimism among the people who are vying for those jobs (or clinging to the ones they have, hoping they don’t have to compete for those scarce openings). This is illustrated by the apparent puzzle that Unit Labor Costs (reported yesterday) remain under serious pressure and Productivity continues to rise at the same time that profit margins are already extremely fat. Rising productivity is normal early in an expansion, but the bullish economists tell us that the expansion started a year and a half ago. We’re about halfway through the duration of the average economic expansion (if you believe the bulls). And fat profit margins are not as normal early in an expansion.
Now, we don’t measure Productivity and Unit Labor Costs very well at all. Former Fed Chairman Greenspan used to say that we need 5 years of data before we can spot a change in trend, and he may be low. But it seems plausible that there remains downward pressure on wages. Call it the “industrial reserve army of the unemployed” effect. While job prospects are improving, they are apparently not improving enough yet for employed people to start pressing their corporate overlords to spread more of the profits around to the proletariat.
Fear not, however, that this restrains inflation. The evidence that wage pressures lead to price pressures (and conversely, the absence of wage pressures suggest an absence of price pressures) is basically non-existent. Let me present two quick charts that make the point simply.
The chart above (Source for data: Bloomberg) shows the relationship between the Unemployment Rate and the (contemporaneous) year-on-year rise in Average Hourly Earnings. I have divided the chart into four phases: 1975-1982 (a period which runs from roughly the end of wage-and-price controls in mid-1974 until the abandoning of the monetarist experiment near the end of 1982), a “transition period” of 1983-1984, the period of 1985-2007 (the “modern pre-crisis experience”), and a rump period of the crisis until now. Several interesting results obtain.
First of all, there should be no surprise that that the supply curve for labor has the shape it does: when the pool of available labor is low, the price of that labor rises more rapidly; when the pool of available labor is high, the price of that labor rises more slowly. Labor is like any other good or service; it gets cheaper if there’s more of it for sale! What is interesting as well is that abstracting from the “transition period,” the slopes of these two regressions are very similar: in each case, a 1% decline in the Unemployment Rate increases wage gains by about ½% per annum. Including the rump period changes the slope of the relationship slightly, but not the sign. This may well be another “transition” period leading to a permanent shift in the tradeoff of Unemployment versus wage inflation.
But clearly, then, when Unemployment is high we can safely conclude that since there are no wage pressures there should be no price pressures, right?
The second chart puts paid to that myth. It shows the same periods, but plots changes in core CPI, rather than Hourly Earnings, as a function of the Unemployment Rate. This is the famous “Phillips Curve” that postulates an inverse relationship between unemployment and inflation. The problem with this elegant and intuitive theory is that the facts, inconveniently, refuse to provide much support. [Note: the above chart is very similar to one appearing in this excellent article by economist John Cochrane, which appeared in the Fall of 2011.]
Why does it make sense that wages can be closely related to unemployment, but inflation is not? Well, labor is just one factor of production, and retail prices are not typically set on a labor-cost-plus basis but rather reflect (a) the cost of labor, (b) the cost of capital, (c) the proportion of labor to capital, and importantly (d) the rate of substitution between labor and capital. This last point is crucial, and it is important to realize that the rate of labor/capital substitution is not constant (nor even particularly stable). When capital behaves more like a substitute for labor, a plant owner can keep customer prices in check and sustain margins at the same time by deepening capital. This shows up as increased productivity, and causes the relationship between wages and end product prices to decouple. Indeed, in the second chart above the R2s for both periods is…zero!
This isn’t some discovery that no one has stumbled upon before. In a wonderful paper published in 2000, Gregory Hess and Mark Schweitzer at the Cleveland Fed wrote that
It turns out that the vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation. In fact, it is more often found that price inflation causes wage inflation. Our recent research, which updates and expands on the current literature, also provides little support for the view that wage gains cause inflation. Moreover, wage inflation does a very poor job of predicting price inflation throughout the 1990s, while money growth and productivity growth sometimes do a better job. The policy conclusion to be drawn is that wage inflation, whether measured using labor compensation, wages, or unit-labor-costs growth, is not a reliable predictor of inflationary pressures. Inflation can strike unexpectedly without any evidence from the labor market.
The real mystery is why million-dollar economists, who have access to the exact same data, continue to propagate the myth that wage-push inflation exists. If it does, there is no evidence of it.
You can follow me @inflation_guy, or subscribe to receive these articles by email here.
Note: The following blog post originally appeared on January 11th, 2011 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
…Looking over the Atlantic, ECB President Trichet offered what some observers saw as a threat that the ECB would raise interest rates to combat inflation if energy-price increases pass through to broad price increases. The German bond market, and others, sold off on his “conditional warning”:
“We see evidence of short-term upward pressure on overall inflation, mainly owing to energy prices, but this has not so far affected our assessment that price developments will remain in line…Very close monitoring of price developments is warranted.”
This is an empty threat. There is no chance that the ECB will raise rates to combat inflation while they are simultaneously buying every bond in sight to try and lower borrowing costs for member nations (and especially the periphery countries). The ECB may be slightly more politically independent than the Fed, but tightening while member nations are trying feverishly to balance their budgets – with their only chance being either a strong resurgent economy or a cheapening of their nominal liabilities through inflation – is highly unlikely.
Trichet has more credibility, though, than our own domestic monetary policymakers. I have to take some time here to mention Fed Vice-Chair Janet Yellen’s speech from last weekend, since I have been meaning to for several days. It is important because the speech was an important defense of the Large Scale Asset Purchase (LSAP) program that the Fed has been conducting, and in that context we should be very afraid of what comes next. Because if this is the best thinking they have to share on the subject, then we are in a situation not unlike the baby who finds Daddy’s firearm in an unlocked position. Tragedy is likely to ensue.
In a nutshell, Dr. Yellen’s argument boils down to this:
- The LSAP program is not affecting the dollar.
- The LSAP program is not triggering “significant excesses or imbalances in the United States.”
- The LSAP program does not risk markedly higher inflation because there is slack in the economy.
- However, the LSAP program has had an enormous effect on jobs, adding about 3 million jobs to the economy.
So, the program has been hugely successful in the ways they needed it to be, without any side effects and no chance of anything going wrong. Does it make me a bad person that I am naturally suspicious of a drug that will make me immensely strong, lengthen my life, improve my love life, and cure hangovers but has no negative side effects? How about if that drug worked as intended the first time it was tested?
Incidentally, the claim that the LSAP program has created about 3 million jobs is interesting because the Administration claimed 2 million jobs were saved or created through fiscal stimulus. Each is not claiming that their policy in conjunction with other policies not under their control created jobs, so these must be additive. Fiscal policy, plus monetary policy, saved or created some 5 million jobs. Right now, the Civilian Labor Force is 153,690,000 and unemployment is 14,485,000 (9.4%), so these actions have prevented an Unemployment Rate of about 12.7%. This is interesting because no one was forecasting a 12.7% Unemployment Rate before these programs were put into place, so the people who are now telling us that the drug is working perfectly are the same people who had previously told us that no drug would be needed.
These results – the 2 million, 3 million jobs – are coming from time series regressions that are conducted with high mathematics and great rigor. But there are lots of reasons that econometric analysis should not be expected to work well in this case:
- The distributions you are trying to analyze are not static, which is a precondition for most time series analysis, nor normal. Indeed, you are actually trying to change the distributions with your policy.
- It is pretty plain that the model is not completely specified. That is, the people who were examining whether fiscal policy was effective didn’t include the separate effect of monetary policy, and vice-versa, so they both think it was their policy which worked. The fact that both of these policies are pushing in the same direction at roughly the same time also creates a problem of multicollinearity, a technical condition that basically means that with two people pulling on the same rope at the same time it is hard to tell who is pulling how much.
- The noise in the relationships far outweigh the signal, which means that all conclusions will (or should) have massive error bars on them.
- The analyst is analyzing the result of a single experiment. It is like trying to divine the laws of motion after hitting a cue ball a single time on the break of a game of billiards, except that the balls aren’t round, you can’t measure anything directly, and you have dirt in your eye. But in this case, the implications of reaching incorrect conclusions are far greater than if you were lining up your next shot in a game of pool.
Econometricians ought to be more guarded about conclusions such as this. Indeed, any reasonable experience with financial data sets tends to produce the realization that it is often hard to get any conclusive information out of them, although it is very easy to generate suggestive relationships that can’t be rejected simply because the error bars are too large to reject any particular hypothesis. It may be that the econometricians within the Fed who are actually doing the dirty work are providing the policymakers with all of the proper caveats, and warnings about the usefulness of the data, and that they policymakers are simply ignoring it. Or it may be that econometricians at the Fed feel pressure knowing that while 90% of the time there is nothing conclusive to say, it is hard to support your case for continued employment when your results most of the time are indistinguishable from not working.
The Fed continues to be especially cavalier about the end game. Yellen says the Fed remains “unwaveringly committed” to price stability, but says:
“I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes. The FOMC will be able to increase short-term rates by raising the interest rate that we pay on excess reserves–currently 1/4 percent. That ability will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.”
Oh really? And you’ll be able to do that, politically, with unemployment at 9%? And you’re so sure that the effect will be immediate, perfectly calibrated, and won’t have any unanticipated side effects? She also suggests that they can withdraw stimulus by offering deposits to member institutions through a Term Deposit Facility, and also by selling portions of their holdings. The notion that you can have a huge effect by implementing a policy, but that reversing the policy will have little effect, is an offense against common sense. No, it’s an offense against financial physics. Yellen isn’t the first Fed official to make statements like this, and won’t be the last. And then, we’ll have several years of apologies when it doesn’t work out the way they said it would.
You can follow me @inflation_guy, or subscribe to receive these articles by email here.
Note: The following blog post originally appeared as two blogs on February 16, 2010 (“Oh, (Yeah!) Canada!”) and August 17, 2010 (“The ‘Real-Feel’ Inflation Rate”). I have combined them because they speak to the same topic, and given the resulting dual-article a more representative name. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original posts here and here.
RE-BLOG of “Oh, (Yeah!) Canada!”:
On Friday the BLS will release the Consumer Price Index, which is a very important release and one of the most maligned even though CPI is one of the more carefully-designed and researched numbers in the entire list of government releases. This is partly because so much is riding on it, between securities linked to non-seasonally-adjusted CPI (such as TIPS) and contracts such as Social Security and others. To some people, this just opens the door for more government shenanigans, since arguably the government stands to gain the most from monkeying with CPI.
But if people with lots of money on CPI didn’t fundamentally believe in the veracity of the number, then the $500billion-plus TIPS market would be in real trouble. Indeed, in some countries where there is better reason to doubt the government’s accountability on such matters, there are private as well as public inflation indices and there are securities are linked to each index. (Brazil is one example.)
That doesn’t mean that these investors are right, of course, but you can believe that they’ve looked pretty hard at the number. Sure, investors have also looked very hard at equities and concluded that they are entitled to a very lofty multiple right now, so we can’t just rely on that. I will tell you, though, why inflation cannot possibly be as high as some folks believe it is, and why you very likely feel that inflation is higher than is being reported by the government.
What follows is an enumeration of some of the cognitive errors that people make with respect to CPI. The list isn’t complete, but I think I’ve hit on the biggest of them.
As a first point: CPI does what it is supposed to do very well, but that might not be what you want it to do. CPI is a cost-of-living index, which means that if your standard of living improves then the price you pay for that standard of living should also increase (that is, your outlays should increase faster than general inflation); if your standard of living is static then your outlays should increase with inflation. CPI measures, in other words, the cost of an unchanged standard of living.
This important point gives rise to the concept of hedonic adjustments, which adjust the price recorded by the BLS for a particular good to account for changes in the quality of those goods. This is a crucial adjustment for certain goods that change significantly in quality, such as cars, computers, and medical care. But this is one source of complaints of people who don’t bother to understand the CPI: people don’t mentally record hedonic adjustments; people measure cash out of their pockets. So when you buy a new computer and it’s lots better than the last one but costs the same, you experienced deflation in the sense that the cost of your old lifestyle…which you no longer have…costs less. Since you spent the same amount, it doesn’t feel like deflation to you, but since your standard of living improved while the costs were unchanged, that’s deflation in a cost-of-living-index sense.
Second, your consumption basket may vary. For most people, the broad CPI index is a reasonable measure, but each person’s consumption is different. Some people spend more on Apparel and less on Recreation; others are the opposite. CPI is supposed to measure the average experience, and no one is exactly average.
Third, CPI excludes taxes that don’t have anything to do with consumption, since CPI is only supposed to measure changes in the costs of things you consume. But taxes definitely affect our standard of living, so if income taxes rise and that causes a decline in your standard of living, that sucks but it’s not inflation. Don’t blame CPI – blame the dudes who are taxing you!
Fourth, people tend to remember price changes of small, frequently-purchased goods rather than large, infrequently-purchased goods even though the latter are more important to your cost of living. For example, your house is typically no more than a once-a-year negotiation (if you rent) or even less frequent if you own. But it is a huge part of your cost of living. When milk doubles in price, or gasoline spikes, you notice it a lot but it’s a much smaller portion of your consumption and matters less.
Fifth, you may be the victim of classic attribution bias. When you go to the store and you come home with a bunch of stuff at higher prices, you say it’s inflation; when you come back with a bunch of stuff at lower prices, it’s “good shopping.” Combined with the prior effect, the rapid oscillations in food and energy prices seem to us to be lots of inflation interspersed with lots of good shopping.
These are the predominant cognitive and comprehension errors that most people make when they think about inflation. But some complaints about CPI go way beyond these innocent and entirely normal perceptual biases.
Some complaints of CPI are just silly. Shadow Government Statistics, which has made quite a great business catering bad data to conspiracy theorists – and I won’t link to the site; if you need to find it for some reason I am sure you can – has a chart of what inflation would be if the BLS used 1980 methods, with the implication being that the guvmint is trying to hide the 9% rate of inflation (the site says inflation is understated by about 7%). The choice of 1980 is very adept, since it was in 1982 that the BLS changed the method of computing the cost of housing to remove investment-value-of-the-home considerations (such as the mortgage rate) and focus on the consumption-value-of-the-home (which is best represented by what it would cost to rent). This was done after much research, many public papers and debate, and is absolutely the right way to measure inflation in the cost of housing consumption as distinct from changes in the value of the home as an asset. There are lots of other improvements that have been made to CPI, and they really are improvements. Not everything from 1980 is better than the 2010 version. Computers, cars, medicine. I’ll concede music.
But we can rely on a very simple argument to prove that true inflation cannot be at 9% (but it involves math). I presume that most readers can recall what they were paid ten years ago, or at least can very easily figure out what their income was back then. Government statistics say that the average increase in wages and salaries (in the Employment Cost Index) has been about 36% over 1998-2008 (for some reason I am having trouble finding 2009 data, perhaps because it is subject to revision). I assume that we don’t think the government is exaggerating that number on the low side for some sinister reason. Now, if inflation is really running at the 9% or so that Shadow Government Statistics says it has for the last decade, then while your wages have grown 36%, cost of living has risen 136% (the government says inflation has been more like 29%).
More concretely: suppose you made $60,000 in 1998, took home $40,000 after tax and were just breaking even with your cost of living at $40,000. According to the government, you ought to be making about $81,500, and if taxes were the same your take home pay of $54,333 would leave you about $3,000 better off, with your cost of living about $51,500. If, however, inflation was really at 9%, then your cost of living is now $94,700, and you declared bankruptcy several years ago. You don’t have to be able to track your receipts to see that 9% is not the right rate of inflation – you just need to look at the compounded outcome.
Consider a longer period of time for a more-poignant comparison. The person making $30,000 and taking home $20,000 in 1980 is now making $89,000 and the $59,300 take-home pay (2/3, assuming improbably that taxes were unchanged) has improved his/her standard of living somewhat as the old standard of living now costs $52,800 using CPI. Using a 7% higher rate of inflation, the same standard of living this person enjoyed in 1980 for $20,000 now costs $353,000.
That is nonsense. And by the way, it also means that housing over the last decade not only wasn’t in a bubble, it didn’t even come close to keeping up with inflation, and neither did any other asset in the world. That’s worse than nonsense; it is an offensive ignorance of mathematics.
CPI is not a perfect number, and moreover it may not be a perfect number for what you want it to do. But it does what it is supposed to do, and it does it very well. I am certainly no apologist for the government and the way it is run, but on the occasions that the bureaucrats get something basically right, I think it’s okay to say so.
RE-BLOG of “The Real-Feel” Inflation Rate:
In today’s comment, I would like to talk about inflation as it is measured, inflation as it is perceived, the difference between the two, and the implications of that difference. First, I want to thank the readers of this column for helping me by taking the poll on my website; the poll supported certain hypotheses of mine (or, more technically, it failed to reject them) that I will discuss here. Read on for poll results!
But first, let me discuss CPI (inflation as it is measured). The vitriolic rants that occur against this measure were one of the motivations for my research. As an inflation trader, I have had to become intimately familiar with the CPI and its quirks, and also have had to explain it many times. Since I believe that CPI does what it is supposed to do very well, I have occasionally become a target of the ranter and called a government stooge, conspirator, or worse. And so I have always wanted to figure out the difference between inflation as it is calculated and inflation as it is perceived, since it is this difference that leads to the vitriol.
Let me get this out of the way: yes, I think CPI accomplishes its mission. But its mission may not be what the ranter thinks its mission should be. It is not supposed to measure (nor could it ever measure) the change in prices that any individual faces. It is an aggregate, meant to reflect the average experience of consumers. You are not average. And you are not an average consumer. And so your experience may vary.
Moreover, it is not supposed to measure the average change of prices in the economy. It is closer to a cost-of-living index, which means that it is meant to answer the question “what is the cost of achieving today the standard of living actually achieved in the base period?” This is a difficult goal, since your “standard of living” must necessarily incorporate your preferences about how different goods and services are better or worse than others and we can’t directly test your preferences. All that the Bureau of Labor Statistics can do is to survey prices and quantities consumed, to draw inferences about consumption patterns, and to calculate the change in prices of the consumption basket that keeps the average consumer’s standard of living approximately unchanged. That’s difficult, and they do it remarkably well at that. The fact that they do it pretty well is evidenced by the observation that, if the BLS were appreciably wrong about the rise in prices for a given standard of living, over long periods of time we would see a substantial difference in standards of living compared to what we expect. The difference between 2% and 5%, compounded over 40 years, is huge. If prices rise 2% over 40 years, the same standard of living now costs 2.2 times what it did back then. If the compounding rate is 5%, the same standard of living costs 7 times as much. So while it is reasonable to ask whether the BLS is off 0.2% or 0.5% here or there, it is very unlikely to be meaningfully biased over long periods of time.
It is a very separate question, though, what inflation feels like. Moreover, it is very relevant. Modern monetary policy considers inflation expectations a metric of signal importance in the formulation of monetary policy. While the Taylor Rule provides a well-known heuristic for monetary policymakers that relies on actual, not expected inflation, policy discussions rely very heavily on the question of whether inflation expectations are, and will continue to be, “contained.” Current Federal Reserve Chairman Ben Bernanke himself described the importance and significance of inflation expectations in a speech in 2007 by saying “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”
So how does the Fed measure inflation expectations? Generally, with surveys – including the Livingston survey, the Survey of Professional Forecasters (SPF), and the Michigan Survey of Consumer Attitudes and Behavior. Some of these measure the expectations of economists about CPI, which isn’t really helpful – the Fed already has their staff economist forecasts, so checking a survey essentially of the people they hang out at the club with would give a false sense of security.
The Michigan survey asks consumers for their views about “the expected change in prices.” But here’s the problem, as illustrated by the survey I took on my website recently: normal humans are not capable of conducting in their heads the monumental tasks of cataloging all of the year’s purchases and calculating the differences from the same basket from the year before. Price changes are not homogeneous, and this leads to seat-of-the-pants adjustments. Consider this very thorough explanation from one person who answered my survey and then wrote to explain her vote:
“My personal experience has been that big ticket items have gone down, but small ticket items have gone up (example fast food ice tea prices or Frontline for my dog). It is crazy that I spend almost $2 for a glass of ice tea that is just water and a tea bag with some ice. But the cost has gone up around 20 cents at most places in the past two years. Conversely, grocery store prices are very mixed with some real bargains, but I do see vast differences between the same good at Wal-Mart and at Krogers. Sometimes Kroger prices are 25% higher for the identical item. I stopped drinking Coke over six years ago. A bargain then was three cases for $10. I saw a display at Wal-Mart the other day of one case for $5.25. It may have had 18 cans instead of the 12 of old. It looked bigger, if so, that would indicate not much price pressure. I recently bought a fan to replace one that died. The new one was by the same company and almost identical, but cost the same after 3-4 years. Of course I bought the first one at a department store and the second one at Wal-Mart. (FYI Walmart is about the only store less than an hour and fifteen minutes from my house other than dollar stores or local hardware stores. Did you know that each Wal-Mart sets its own pricing? There can be noticable price differences sometimes on the same item at my two nearest Wal-Marts. The slightly closer one has less competition and they told me that lets them price some goods higher than the other store.) But, TVs and computers are a lot cheaper, so much so that it has induced me to buy. My telephone and cable bills haven’t changed in years. These conflicting observations made it very hard for me to answer your question.”
Clearly, the FOMC would like to sample the perceptions of the people who are involved in price-setting and wage-setting behavior. But consumer surveys are not ideal instruments for at least two reasons. First, as some researchers have pointed out, taking the “median” expectation obscures a lot of information and it isn’t exactly clear what role the variation in expectations should play. Second, and more importantly, surveys of inflation don’t work well because consumers do not discern inflation properly. Perceptions of inflation are muddied by a myriad of practical problems (such as those described so clearly by my correspondent above!) and behavioral biases that tend to impair accurate assessment of price changes. For example:
- Quality change and substitution adjustments are not recognized viscerally by consumers, although they are a necessary part of a cost-of-living index. It might also be the case that people notice downward quality adjustments (“my insurance coverage is shrinking”) more than upward quality adjustments.
- Consumers have an asymmetric perception of inflation as a whole, as well, so that they tend to notice goods that are inflating faster than the overall market basket, but to notice less the goods that are not inflating as fast. This sense is enhanced by classic attribution bias: higher prices is inflation, lower prices are “good shopping.”
- Items whose prices are volatile tend to draw more attention, and give more opportunities for these asymmetries to compound, so they tend to factor more heavily into our sensation of inflation.
- People notice price changes of small, frequently-purchased items more than they notice large, infrequently-purchased items even though the latter are a bigger part of consumption basket. Gasoline is hugely important even though it’s not a huge part of the basket because (a) it is purchased frequently and (b) it is volatile, which means attribution bias acts constantly.
- Consumers do not viscerally record imputed costs, such as owners’-equivalent rent as distinct from what they see as their costs (principal plus interest, taxes, and insurance). Even though the former is better for CPI, the latter (which is the pre-1983 method, basically) affects perception more directly.
- People perceive increased changes in income taxes as inflation.
So what is the result of this complex problem? Well, here are the results from the poll I conducted. The question was “Consider your personal experience of inflation over the last year. Would you say that the prices you pay have generally (choose the best answer):” There were 355 votes, 22 of which (6%) were “I don’t know.” Here are the percentages of respondents who perceived different price increases.
Two immediate observations, both of which support my general contention: first, the average response (coarsely, if we take the first category mid to be 0.50%, the second to be 2.5%, the third to be 4.5%, and the fourth to be 6.5%) is 3.45%, obviously much higher than the official CPI (1.2%). Clearly, consumers perceive higher inflation than what is calculated, which is the direction in which I would expect the behavioral biases to operate. Second, there is no general agreement about whether inflation is low or high, much less how low or high it is. A small plurality prefers the “4-5%” answer. The sample size is small, but not that small…we should have expected, if humans were coldly rational calculating machines who have generally similar consumption baskets, to see at least something of a bell curve developing. The difference in experienced price increases is probably not this wide; at least some of this is because while consumption baskets are in fact more similar than you might think, we have wildly different heuristics and biases that we use when answering this question.
In my paper, I attempt to correct for a few of these biases. If we can model inflation perceptions this way then we might not only be able to identify changes in inflation perceptions but to also understand the drivers of those changes in any particular episode. The monetary policy prescription might vary if, for example, elevated perceptions of inflation were driven because of an increase in taxes than because of an increase in the volatility of price changes in the consumption basket.
I don’t attempt to correct for every bias here, but for some of the more important ones. I correct for the misperception of quality and substitution effects (specifically, I remove all of the quality adjustments that tend to decrease CPI while retaining all of those that tend to increase it), for the asymmetric perception of price changes, and for the perception of volatility (big changes in prices) as inflation. You probably don’t want to see the math, and if you do then you should wait for the paper itself, but as an example here is the adjustment I make for the perception of volatility as inflation:
where lambda is a coefficient of loss aversion per Kahneman and Tversky; w is the weight of an item in the CPI basket; and σ is the standard deviation of the item’s price over the past year. This adjustment is derived from a result that tells us the expected future value of a one-period, at-the-money option.
The details, as I say, are probably not of much interest to most readers of this column. But the charts will be. The tricky part is calibrating the lambdas, and this can and should be done more diligently in a behavioral economics laboratory. But with the choice of lambda that I thought to be “about right,” here is the aggregate upward adjustment that should be made to CPI to get to perceived inflation.
And, combining this with year-on-year CPI, the chart below shows the difference between the official CPI and the perceived CPI, incorporating my adjustments.
This chart suggests that one reason that 6%+ may have been so prevalent as a poll answer is that until a few months ago, that is how it actually felt. The most-recent point, incidentally, is 3.4%, so thanks again to everyone who took the poll – I couldn’t have hoped for a nicer match!
Let me return one more time to the reason for this exercise, this time with a simple analogy. There is clearly a reason that we need to measure the CPI with as much exacting, mechanical precision as we can muster. Knowing how prices are actually changing in the economy is important for consumers, wage-earners, and investors. Similarly, it is very important to have a good thermometer that can tell you just how cold it actually is outside in Chicago in January. But before venturing outside in Chicago in January, you ought to also consider the “wind chill” or “real feel” temperature, because it has great relevance for your real-life behaviors. The “true” temperature is given by the thermometer, but in many situations the wind chill is what actually matters (it is connected more directly, in this case, to your survival chances if you under-dress).
In the same way, policymakers need to know not only what prices are actually doing, but what the “real feel” inflation rate is, because it is relevant for many consumer decisions. My research here is a first step, I hope, to developing such a tool.
[Editor's Note: The paper referred to here was eventually published in the journal Business Economics; you can find a link to the full published article here.]
You can follow me @inflation_guy, or subscribe to receive these articles by email here.
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.