Summary of My Post-CPI Tweets

Writing from the Netherlands after visiting future clients this week; here is a summary of my post-CPI tweets (Follow me @inflation_guy) :

• very surprising core inflation, barely rounded up to 0.1% month/month. Waiting for breakdown, but Shelter was still +0.1% so something odd.
• Core CPI ex-shelter only 1.39%, not terribly far from the 2010 lows.
• …part of the answer is that core commodities decelerated further, -0.1% y/y. But core services, most of which is housing, ALSO decel.
• Major groups; Accel: Food/Bev (15.3%); Decel: Apparel, Transp, Medical Care, Educ/Comm (34.3%). Balance unch on y/y rate rounded to tenths.
• Housing actually accelerated slightly. So decline in core was apparel, Medical Care, Education, and non-fuel transportation. Hmmm.
• …If you believe core is going to keep falling, you DON’T want to bet on it being led lower by Medical Care and Education.
• We expect this to be the low print on core. Our forecast remains 2.6%-3.0% for 2013, but only 0.6% has been realized so far
• It wd probably be prudent to lower our 4cast range; we will if there is another miss lower in May. But not by much: housing still the driver

I think the sixth bullet is the key point: core inflation is drooping because of Medical Care and Education & Communication decelerating. This is terrific news, but there’s about forty years of history that should lead one to be skeptical that these are the categories that will lead inflation lower.

Our forecast for 2.6%-3.0% is based on an expected acceleration in rents, based on the recent rise in home prices. We’re not changing that forecast yet because our model didn’t expect the acceleration to happen yet. However, it should begin to happen in the next 1-3 months.

If primary and Owners’ Equivalent rents don’t begin to accelerate in the next month or two, we will lower our 2013 forecast simply because it will be difficult to see a sufficient acceleration to reach our goal with only a half year or so to go. But the reason we don’t lower our forecast much is that the primary driver here is still rents, and there is no question which way rent inflation is headed. Only if we conclude that for some strange reason there is going to be a permanent shift in the capitalization rate of owner-occupied housing (that is, if there is a permanent shift in the ratio of rents to prices from what it has historically been) would we reconsider the direction of our forecast, and then only if home prices stopped launching higher.

Meanwhile, weak growth numbers, soft inflation numbers, and the seeming success of the Abe program in Japan as growth there has abruptly surprised higher (although it cannot be attributable to the BOJ monetization, since that program hasn’t been around long enough to affect the real economy even if there is money illusion at work) ought to cause any silly talk about the “taper” of the Fed’s buying program. That was always due for enormous skepticism, but with all of the arrows pointing the wrong way there is almost no chance that the FOMC will elect to taper purchases in the next few months. Indeed, I would expect the “hints” of such action to cease in short order. The only reason to talk about it is to (a) convince the world that Fed policy is credible, but a ruling on that credibility won’t be made until the episode is over, based on results, not at this time and based on what they say; or (b) because there is little cost of doing so, since the markets won’t panic if there’s no chance of near-term implementation.

Why the Fed Doesn’t Fear Inflation, But You Do

The core PCE deflator for March recorded a near-record 1.1%. Should we worry that deflation is taking hold?

Well, first of all you should recognize that the PCE, unlike the CPI, is frequently revised and by significant amounts. As the chart below shows, this is only a near-record because there was a massive revision that raised the 2010 low from 0.7% or so to 1.1%. We should be wary, in my opinion, to draw any strong conclusions from (and certainly wary of implementing policy based on) a data series that can have the rate of change revised by 60%.

But still, core PCE is near its lows while core CPI is not. Should we be concerned about deflation? Should the Fed?

There are a number of reasons for the difference. A persistent difference of about 0.25%-0.5% is consistent with differences in the type of formula used and other “normal” differences. The Fed favors the PCE because it has a broader representation of the economy – in that it doesn’t focus “just” on consumers – and because it adjusts more quickly as the composition of spending changes. However, if you are looking at how the costs to you the consumer change, the CPI is the index that you should be looking at.

The main reason that core PCE is currently so much lower than core CPI is that PCE has a much lower weight on housing. And, thanks to the Fed’s loose money policy, it is housing that is driving the CPI higher. The difference in housing weights currently adds 0.31% to CPI compared to PCE. The PCE makes up for this low weight in housing by having a much higher weight on medical care (about three times the CPI weight). Why the huge difference in the medical care weight?

The CPI and PCE metrics are meant to measure different things – the PCE is broader, but the CPI measures specifically expenditures by consumers. Consequently, the difference in medical care weights occurs because the CPI measures spending by consumers, while the PCE includes spending by Medicare, Medicaid, other government entities, the employer portion of health insurance, and other non-consumer payers. Which do you think is more relevant for consumers? And which do you think is a better representation of what a typical consumer spends: 42% on housing and 6% on medical care, or 26% on housing and 22% on medical care? In simple terms, do you spend more for your house, or do you spend about equal amounts on both? I suspect that for most Americans, especially those who are employed and those who are currently receiving Medicare, spending on housing is vastly higher than direct spending on medical care.

Isn’t it convenient for the Fed that right now, they can focus on a metric that is pointedly underweighting the category of expenditure that is most directly being affected by quantitative easing? This is one reason that I do not expect QE to stop any time this year.

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can follow me @inflation_guy.

• Sigh.Not this month!Core #inflation +0.1%, waiting 4 data to see rounding. Big fall in apparel, & housing uptick not happening yet.
• Apparel decline most since April 2001. That will reverse.
• Core with rounding looks like 0.106%, 1.89% y/y. definitely weak. Will look at breakdown to see where.
• This is the most that y/y has been below our forecast track since January 2009!
• Core services fell from +2.6% y/y to +2.5%, but core goods fell to flat from +0.3%. Our thesis is that these will converge up, not down.
• Core goods is inherently harder to forecast. Core services is largely housing.
• Accelerating subgroups: Educ/Comm (6.8% of basket). Decel: Apparel, Transp, Food & Bev, Recreation (41.7%). Unch: Housing, Med Care, Other
• CPI drooping appears to be seasonal maladjustment. The Apparel burp itself is worth 0.04%.
• Housing – we’re still waiting for the upturn. This month primary rents rose to 2.81% from 2.74% y/y, Lodging Away from Home rose too.
• Owners’ Equivalent Rent (24% of CPI) fell to 2.083% vs 2.144%. Since Primaries are rising, probably just a lag issue. 1 or 2 more months.
• Apparel saw broad-based huge declines. Again, likely seasonal. Core decelerated 0.11%, and 0.06% of that was Apparel.
• Our forecast for full-year CPI doesn’t change as a result of this number. We’re still at 2.6%-3.0% on core for 2013.

I don’t want to overplay the Apparel card here. March is a big month for seasonal adjustment for Apparel, but it is possible that this marks the end of the two-year spike in Apparel prices. If it does, then it resolves one speculation I’ve had: that the rise in Apparel, after twenty years of flat-to-declining prices, indicated that in some areas the globalization dividend on inflation may have ended. It is far too early to say that speculation is wrong, especially with big seasonal adjustments in March. Prior to 1992, there were certainly setbacks in Apparel on a regular basis due to the difficulty in seasonal adjustment. So it’s too early to say this is wrong, but not too early to say it’s surprising. And, after all, there’s always the possibility that the screwy numbers were the last twenty-three of them, and not this one. But these are still the highest seasonally-adjusted Apparel prices we’ve had in March since 2001 (see chart, source BLS, below).

The small blip down in Housing is much less of a concern. Primary rents are still rising, and OER didn’t exactly decline aggressively. We’ve been waiting out a “flat part” in the lag structure – this just means we have to wait another month or two. The chart below is updated (multiple sources) through this morning.

None of this will help the commodities guys, nor the TIPS guys, in the short run. But it doesn’t change the big picture for inflation. It’s coming. We just have to wait another month or two for the evidence!

 

Big Trade, Little Door

In ordinary times, the terrorist attack at the finish line of the Boston Marathon (officials are being careful not to call it “terrorism,” but I’m not an official so I can operate in the reality sphere) would absolutely trump anything that happened in the markets today and, in fact, would likely have been the cause of any market movement that actually occurred. That’s because most of the time markets echo the framework of the rest of reality: most of the universe is space, and most market activity is just empty noise.

This is the reason that traders who are continuously transacting in the markets are called “noise traders.”

But on Monday, there was plenty of market action and it had nothing to do with Boston, nor with the slightly-earlier ultimatum from North Korea to South Korea, which stated that military action would “start immediately.” (N.b.: There were many losers today, but one of them surely must be reckoned as Kim Jong-un. A tin-pot dictator makes a threat, and is almost immediately knocked off the front page of the New York Times by events in Boston. That must really annoy him.)

Before the attack in Boston, however, there was already plenty of financial pain. The carnage in the precious metals pits came right on cue after the negative sell-side reports of late last week had a chance to work on the psyches of investors. Gold fell 10%, and silver nearly 14%. This represents the worst two-day fall in gold in thirty years. And, while yesterday I pointed out that the commodity “super-cycle” certainly doesn’t look like one, I can understand how the picture of gold in real terms looks like it may be completing something big (see chart of gold expressed in December 2012 dollars using CPI, source Bloomberg).

There is considerable concern tonight that these losses may provoke selling in related markets as investors raise funds to meet margin calls. This is possible, although significant thumpings in the past in precious metals (it isn’t like this is the first time we’ve seen volatility in a commodity) didn’t provoke dramatic related-market action. To be sure, the avalanche is much more loaded now than it has been in the past, with equity markets sharply overvalued and investors already reaching a level of disgust with commodities. But I don’t think it goes too far. (Those may be my famous last words!)

What happened in gold and silver is a function of the big trade/little door syndrome, more than anything else. News outlets blamed the weak data yesterday in the U.S. and the small miss in Chinese GDP (7.7% versus 8.0% expected, but keep in mind that we all know these are made-up numbers) for setting off the wave of selling, but that’s just the latest straw. The break of technical levels on Friday, combined with the suddenly-burning desire of hedgies to not be the last one through the little door, is what led to such a dramatic move today. It may well continue until everyone who wants to get through the little door has done so. Or, it may not – but I would admonish an investor who wants to buy gold here to think like a trader rather than a playground monitor: don’t try to break up the fight. If the hedgies want to eat each other in a fight to get to the door, let them.

And, incidentally, remember that the big trade/little door syndrome is not limited to gold and silver. Think about equity exposures too. If you’re long by policy, fine. But if you’re long stocks and feeling uncomfortable about it, then “sell down to the sleeping point” at least.

The irony of the timing of the gold rout is potentially juicy, with CPI tomorrow. The decline in precious metals is happening partly because so many investors are abruptly convinced that inflation has truly been defeated. It is incredible to me that this belief is so widespread, but perhaps this is the sine qua non for the next washout in financial markets and the setup for the long-awaited up-move in commodities (for, although the “super-cycle” is evidently just now ending according to some observers, commodities prices have been in general decline for the last two years).

Growth is falling short of expectations, but that doesn’t have any implications for inflation. Tomorrow’s CPI is forecast to be flat and +0.2% on core, holding core inflation constant at 2.0%. Sentiment appears to be favoring a shortfall in those figures, but it is my belief that we are on the cusp of the next sustained move higher in core inflation, to be led by housing. Remember that the last two CPI figures haven’t exactly been soothing. Two months ago, core inflation was +0.3% when the market was expecting +0.2%. Last month, all eight major subgroups of CPI accelerated on a year-on-year basis, the first time that has ever happened since the current 8 subgroups have been in existence. I am loathe to pick the month where we’re going to see Owners’ Equivalent Rent finally break higher, because econometric lags are not written in stone. But it ought to be soon.

When it happens, expect sell-side economists and pundits of all stripes, to say nothing of the Federal Reserve, to downplay the significance of it. I wouldn’t expect a sudden rally in commodities or a rebound in breakevens (10-year breakevens are at the lows of the year, mainly because rates on the whole are declining – 10y TIPS yields are also within 3bps of the year’s low), but it might help stop the bleeding.

Why Inflation Futures Matter

The Chicago Mercantile Exchange (CME) is currently having discussions with market participants and is considering launching in 2013 two new futures contracts related to inflation: a Consumer Price Index (CPI) futures contract and a deliverable TIPS futures contract. My company has been an advocate for these contracts and involved in their construction. We expect to be involved in making markets in them. Our interest is therefore no doubt obvious. But are these contracts important, in a larger sense, for the market? The answer is yes, and here is why.

It is a fact of financial life that most mature markets enjoy three legs of a liquidity ecosystem: cash markets, over-the-counter (OTC) derivatives, and exchange-traded derivatives. For example, in the nominal interest rates market Treasuries provide a deep and liquid cash market, there is a large and well-functioning market for LIBOR swaps, and there is efficient and transparent pricing in the futures markets as represented by Bond, Note, 5-year Note, 2-year Note, UltraBond, and Eurodollar contracts.

The presence of three legs, rather than only one or two, in this ecosystem is important. With two legs, there are only two directions of liquidity transmission: A to B and B to A. But with three legs, there are six ways that liquidity can be transferred: A to B, A to C, B to A, B to C, C to A and C to B. By adding the third leg, the avenues of liquidity transmission aren’t increased 50%, but threefold.

This richer liquidity ecosystem matters the most in crisis situations, such as during the credit crisis of 2008. Consider that during the crisis, credit and inflation markets became quite illiquid at times while equities, nominal rates, and commodities remained (comparatively) liquid. The main difference between these two sets is that the latter three markets all have cash, OTC, and exchange-traded instruments while the former two have only two (in both cases, cash and OTC derivatives).

Accordingly, while the inflation-linked bond market has become truly huge (see chart below, source Barclays Capital) and the inflation-linked swap market has enjoyed an almost uninterrupted rise in volumes since 2006, investors need the third component of the ecosystem: exchange-traded futures contracts on inflation and/or real rates. It is interesting to note that one analysis of the original CPI futures contract traded on the CSCE (many years ago) suggested that a prime cause of the contract’s failing was that “…the CPI futures market, unlike other futures markets, has no underlying asset which is storable or traded on an active spot market, which reduces the opportunities for arbitrageurs and speculators to participate in the market.” (Horrigan, B. R., “The CPI Futures Market: The Inflation Hedge That Won’t Grow”, Federal Reserve Bank of Philadelphia Business Review , May/June 1987, 3-14).

Adding these products will likely increase the volumes and the liquidity of all inflation products, including (perhaps especially) the liquidity of off-the-run TIPS. This liquidity will also remove the main lingering concern among those investors who have not yet made meaningful investments in the market.

Inflation-related futures are not a new idea. Since at least the 1970s, economists have anticipated that these instruments would one day be available. Several previous attempts, dating back to as early as the mid-1980s, have failed for various reasons – too early, too different, bad structure. But futures that present a different method of investing in, trading, or hedging inflation and real rate exposures are needed, not only because they create opportunities to make different sorts of trades or to trade more efficiently but also for the good of the market itself. Healthy markets in CPI futures and TIPS futures will create a better liquidity ecosystem for the entire inflation market, including for off-the-run TIPS bonds and seasoned inflation swaps.

Unfortunately, at the moment the CME appears to be afraid of launching new products that might not immediately work. It wasn’t always that way – once, a CME official told me that since it cost them virtually nothing to list a contract, they favored launching lots of them and seeing what the market took to. This has changed, and the pendulum has swung in the opposite direction. Now, although many market participants are asking for these futures and there are market-makers willing to make markets, the CME is deferring a decision on them until later in the year. I remain hopeful that they will launch, because they are sorely needed.

Summary of My Post-CPI Tweets

Here’s a summary of my post-CPI tweets:

• #CPI +0.7%/+0.2% ex food & energy. Y/Y core back up over 2% at 2.004%. And going higher.
• Gasoline prices +9.1%, so there you go for everyone who thought Jan’s number was low.
• Economists had been looking for a “soft” 0.2% on core core, and got it at +0.17% rounding up to +0.2%.
• y/y rise in Owner’s Equivalent Rent rose to 2.14%, a new post-2008 high. That’s on the way to 3% or 4% over the next 1-2 years, at least.
• Accelerating Major groups: whoa…EVERY major group accelerated y/y. All 8 of them. I’ve never seen that.
• Food & Bev: 1.625% from 1.558%. Housing 1.929% from 1.805%. Apparel 2.426% from 2.115%. Transp 2.361% from 0.712%.
• Recreation 0.890% vs 0.554%. Educ/Comm 1.740% from 1.622%. Other 1.803% from 1.574%. Only close one: Medical 3.107% from 3.095%
• #CPI didn’t surprise on the upside, but there is just nothing weak about this number. Anywhere.
• Well, core goods I guess. +0.3% from +0.4%. But core services went to 2.6%, mainly on housing strength. If core goods ever recover…

The mainstream media and many economists will yawn at this number and miss the big picture. There is just nothing important here that is weak. In particular, every major group accelerated on a year-on-year basis. That’s amazing. It’s not unprecedented, I am sure, but I don’t remember seeing it happen before. Usually some are accelerating, some are decelerating, even when inflation overall is accelerating or decelerating.

In particular, housing continues to quietly accelerate, as we’ve been predicting. It is going significantly higher.

Core inflation is going to accelerate further, although the next several months have solid year-earlier comparisons of +0.22%, +0.22%, +0.20%, and +0.21%. But we think we’ll see core inflation nevertheless accelerate over that time frame, and then there are six easy comparisons in a row with nothing above 0.17%. By year-end, we still think we will see core of 2.6%-3.0%.

You can follow me @inflation_guy!

A Bad Day At The Federal Reserve

There will be many more days ahead for the Fed, and many of them will have plenty of good news. It is a mistake to trya and read too much into one day’s economic releases. With that said, here is my attempt to do exactly that.

I tweeted the following real-time reactions (@inflation_guy) following the CPI release this morning:

• Ready for an exciting day…CPI, Claims, Philly Fed, a 30-year TIPS auction, wild commodity swings, 3 Fed Presidents…buckle up!
• Hello! Core inflation +0.3%, higher-than-expected. Look out above.
• Apparel +0.8%. Some will pooh-pooh the number on that basis, but Apparel has been trending higher for more than a year.
• To be fair, core inflation BARELY rounded up to +0.3%. But the market was looking for +0.16% or +0.17%.
• Core Services remains at +2.5% y/y, but core goods ticks up to +0.4%. The recovery of core goods has been something we’re looking for.
• Somewhat surprisingly, the +0.251% rise in core inflation did so without having a rise in Owners’ Equiv Rent. Went from 2.1% y/y to 2.08%
• Accel Inflation: Housing, Apparel, Educ/Commun, Other (54.7% of basket); Decel: Food/Bev, Transp, Med Care, Rec (45.3% of basket)
• In Transp, the drag was almost all fuel. New/used Cars, maintenance, insurance, airline fares, inter- and intracity transp all up.
• What’s amazing in the CPI today is how much it did with how little from the main driver of housing. That uptick is yet to come.
• …and, next month, headline will get upward pressure from the steep rise in gasoline, which also dampens discretionary spending.

The primary takeaway from the CPI release is this: yes, core inflation surprised a little bit on the high side. But it did so without the support of the main factor that I think will push core inflation almost certainly higher going forward: housing. Rents (both primary and OER) neither accelerated nor decelerated this month from the prior year-on-year pace. And yet, there is really no temporary factor that pushed inflation higher this month. It was fairly broad-based. Apparel stood out on the month-to-month change perspective, but here is the chart (source Bloomberg) on Apparel:

This month doesn’t appear to me as too much of a true outlier. The underlying dynamic there has simply changed.

So this month core inflation stayed at 1.9%; next month it is very likely to return to 2.0% as we are dropping off the weak February change from last year. And all of that, before the housing inflation hits the data.

Speaking of housing inflation, there is no sign yet of that abating. In today’s Existing Home Sales report, the year-on-year change in Median Existing Home Sales Prices rose to 12.61%, another post-2005 record, and the highest real price increase ever, outside of 2005. This is happening because the inventory of new homes has dropped to almost a record low – really! Sure, the chart below (source Bloomberg) ignores “shadow inventory,” but it is starting to look more like the inventory of new homes now.

Some of that is seasonal, but there’s no doubt that lower inventories are now helping the home pricing dynamic. And, as I’ve shown previously, the inventory of existing homes actually has a nice relationship with shelter inflation 1-2 years later (Source: Enduring Investments):

The current level of inventories translates into a 3.6% expected rise in CPI-Shelter over the course of 2014. So you see, we’re not only firing inflationary rounds but we’re also continuing to feed more ammunition into the gun for next year. Our model of housing inflation projects Owners’ Equivalent Rent no lower than 3% by year-end 2013. And if that happens, there is no way that overall core inflation is going to be at 2%.

Now, in addition to the bad news on prices and the news on home prices that are probably seen at the Fed as a guarded positive (after all, it means the mortgage crisis is essentially over as more borrowers will be ‘above water’ again every month hereafter), there was also a mild surprise on the high side from Initial Claims (362k versus 355k) and a bad miss on the Philly Fed index for February. This latter was expected at +1.0 after -5.8 last month; instead it dropped to -12.5. Philadelphia-area manufacturers have reported softening business conditions in three of the last four months, suggesting that December’s pop to +4.6 was the outlier. Now, there were similar one-month dips in August of 2011 and June of 2012, so we’ll have to see if it is sustained…but it is consistent with the report out of Wal-Mart and the worsening of business conditions in Europe.

Higher prices (and more coming, on the headline side, as retail gasoline prices have now risen in 35 consecutive days) and lower business activity. This is exactly the opposite of what the Fed wants. It has been a bad day at the Fed.

However, it is exactly what traditional monetarism expects: accommodative monetary policy leads to higher prices (check), and has no effect on real activity in the absence of money illusion (check). So score one point for Friedman today.

And so, what else would you expect after such a day? Bond yields are declining, inflation breakevens are narrowing, and industrial commodities (metals and energy) are sliding. As with so much else these days, that makes no sense, unless you just don’t know what’s going on. When we encounter these bouts with irrationality (or, more fairly, thick-headedness), the market can be frustrating for a long time – and the ultimate denouement can sometimes be jarring. As I said earlier in this post: buckle up!

 

Fun With The CPI

As the markets gyrate, trying to decide on just what the next move is going to look like, I thought I’d answer a question a friend posed to me recently. He asked “what does the consumption basket look like today, compared with 25 years ago?”

The question was something of a challenge to me (well, more precisely to the BLS, who puts together the CPI) because my friend – like so many others – had heard that the BLS assumes that when the price of steak goes up, you eat more chicken, and that the CPI doesn’t capture what may be construed as a decline in consumer welfare due to this effect.

The BLS doesn’t in fact make such determinations. In 1999, the BLS started using a geometric mean formula that captures the fact that consumers in fact tend to switch their consumption patterns towards items that have fallen in relative price. But that only affects items in the same very low-level “basic” category (the example the BLS gives is “different types of ground beef in Chicago”), and not at the higher levels like chicken-for-beef.

Moreover, an important point is that consumers will buy more of the item whose price relative to other goods has declined (say, chicken) even if the consumer is compensated for that change. Suppose a consumer pays $10 per week for soda, $5 each for Coke and Pepsi (which he considers interchangeable). Now suppose the price of Pepsi doubles, but the American Society for the Promotion of Cola Products sends the consumer $5. With the additional $5 he could continue to buy equal amounts of Coke and Pepsi, but will he? Of course not; the consumer will spend his $10 all on the cheaper brand and keep the extra $5, or buy more total cola by spending the entire $15—but all on the cheaper brand. The consumer’s utility/dollar is now much higher with one (formerly interchangeable) brand.

It is important that the BLS attempt to get the consumption basket to look as much like the average consumer’s consumption basket as possible, in order that the price index resembles as closely as possible a true cost of living index. So it doesn’t spend a lot of time guessing. Every few years, the BLS conducts a “Consumer Expenditure Survey” to collect information about spending habits from around 60,000 quarterly interviews and 28,000 detailed weekly purchase diaries gathered over a two year period. From these, the base weights are determined for about 200 item categories in dozens of cities and regions. These are then aggregated up into successively larger groups up to the eight “major groups” (Food & Beverages, Housing, Apparel, Transportation, Medical Care, Other, Recreation, and Education & Communication) and the overall CPI-U.

In short, the BLS does everything possible to avoid making value judgments about what is being spent. That being said, studies have assessed the aggregate effect of substitution adjustments to be around 0.3% per year.[1]

So with that all said, how much have our spending patterns shifted in the CPI? Are we spending money dramatically differently than we did 25 years ago?

You can find the CPI weights for 1988 here, and compare them to current weights found on p. 11 of the monthly CPI report, for example here. Be aware that the categories sometimes change over time, so that for example in 1988 there was not an “Education and Communication” major category. But here are some comparisons:

Category	1988 weight	2012 weight
Food and beverages	17.72%	14.96%
Food at Home	9.98%	8.47%
Alcoholic Beverages	1.545%	0.93%
Housing	42.30%	40.21%
Primary Rents	7.85%	6.36%
Owners’ Equivalent Rent	19.33%	23.49%
Apparel	6.35%	3.49%
Transportation	17.21%	16.54%
Medical care	5.97%	6.92%
Tobacco and Smoking Products	1.35%	0.79%
Energy	7.33%	9.49%
College Tuition	1.17%	1.66%
Beef and veal	1.05%	0.54%
Poultry	0.48%	0.33%
Pork	0.57%	0.37%
Fish and Seafood	0.39%	0.30%
“Other meats”	0.41%	0.27%
All Items Less Food & Energy	76.50%	76.49%

In summary? Surprisingly, while we get a lot less for our money than we used to, our patterns of expenditure haven’t changed much, in aggregate. Sure, some of us are spending less on education while others spend more, simply because our patterns change as we go through life (and the BLS has some age-related indices as well). We spend, not surprisingly, less of our money today on clothes, food, alcohol, cigarettes, housing, and transportation – even with higher energy prices. Overall, though, we spend more on energy itself, on medical care, and on tuition. You can see the effect of the ‘home ownership movement’ in the greater basket weight of “Owner’s Equivalent Rent” compared to “Primary Rents”. But overall, the spending patterns are evolutionary, not revolutionary.

Oh, and we do spend less, as a portion of our total expenditure, on beef and veal! But we also spend less on chicken, pork, fish, and “other meats” (shudder).

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[1] I won’t talk here about quality adjustments, including so-called “hedonic” adjustments, except to say that the aggregate effect of quality adjustments is so small as to be hardly worth considering. Hedonic adjustment lowers the CPI for a number of categories whose weight total to around 0.7% of the index, but increases the CPI for Rent, Owners’ Equivalent Rent, and Apparel, plus some smaller categories, totaling about 32% of the index. So large downward adjustments on lightweight categories are balanced by very small upward adjustments on large categories. The net effect is thought to be less than 0.01% per year (see Johnson, Reed, and Stewart, “Price Measurement in the United States: a Decade after the Boskin Report”, 2006).

Greed Over Fear?

Desperation is unattractive, and desperate greed – needing to have a big return, quickly – is dangerous when it comes to investing. But investors appear to be getting increasingly desperate to swing for home runs rather than to try for singles and doubles, if the increased stampeding of retail investors’ monies into equities is any indication. Again today, stocks rallied steadily for most of the day. As the S&P reaches a new 5-year high with every advance, and is not terribly far away from an all-time (not inflation-adjusted) high, investors are increasingly throwing caution to the wind and plunging back in to stocks. Blackrock’s CEO, Larry Fink, observed today that “…the move back into equities is one of the mega trends we witnessed in the fourth quarter, and that has continued into the first 15, 16 days of the year.”

According to Fink, investors are doing this because of disdain for bond returns, not because of a desire to go “risk on.” And yet, risk-on they are going. They are going risk-on with corporate margins at post-WWII highs and following a Q4 that will be exaggerated by the tax-related movement of income from Q1 into Q4 (for example, via the payment of special dividends), and a Q1 that will end up looking weaker than the underlying fundamentals really are. Are these desperate investors ready to see a few months of weak data when they’re buying in at the highs?

Today’s data offered both the good and the bad. The good was the December Housing Starts number, which achieved the highest level since 2008 (see chart, source Bloomberg). To be sure, building activity is nowhere near the levels that were common in the 1980s, 90s, and 00s, but it is recovering. This should continue, as the inventory of new homes is at a very low level. The bad was the January Philly Fed index, which was expected to rise but which instead declined. The index of current conditions (at -5.8%) is the worst for a January since 2009.

Much was made of the sharp decline in the Initial Claims figure, which was expected at 369k but instead came in at 335k. My advice is to ignore any Claims figure in the second half of December until late January, as the seasonal adjustment factors are actually much larger than the net number – that is, the report should have a huge error bar around the weekly number, which is a seasonally-adjusted figure. If this is why stocks rocketed higher, then the desperation is even more disturbing. No one ought to ever invest on the basis of a weekly economic number.

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After yesterday’s CPI report, I expected to see a number of denunciations of “inflation-phobes,” and I was not disappointed. David Wessel’s column in the Wall Street Journal was one example. Although Wessel came to the wrong conclusion (he agreed with Bernanke that there isn’t “much evidence” that the monetary policy of the last several years is going to be inflationary), at least he did undertake to “weigh…arguments on the other side.”

But he almost lost me straightaway, when he said that “the link between the money supply and the inflation rate is hard to discern in data…” Take a look at the chart below (source: Enduring Investments) and tell me if it’s really hard to discern the link in the data.

Oh, and on a longer-term basis there is this, which I wrote about in this great article.

What is hard to discern in the data is any link between inflation and growth, other than the spurious one that comes from the fact that the 2008 crisis was caused by an implosion of housing prices, which then impacted core inflation with a lag. (See chart, source Bloomberg)

Or, more consonant with the NAIRU theory, any link between the unemployment rate and core inflation (see chart, source Bloomberg).

This last chart is fun. If you run core CPI as a function of the unemployment rate from 2000-2012, you get a good correlation that looks like the right thing. But again, it’s spurious: if you look at the same relationship from 1990-2000, you also get a good correlation…but exactly the opposite slope to the relationship (that is, implying that lower unemployment causes lower inflation). Showing them both together makes the point that…you can’t see much in this data.

These latter two relationships are absolutely accepted without question in large swaths of the economics profession, such as when Wessel argues that “it would be difficult to spark and sustain inflation with so many unemployed workers, empty stores and offices and underused factories.” Where does he see that in the data?

I shouldn’t be so hard on Mr. Wessel, because he does make a reasonable effort to give some arguments about why people fear that the Fed will either intentionally or unintentionally make a mistake. But I think his best argument is one that he doesn’t make on purpose: policymakers and many economists just don’t understand what inflation is and how it works, and that creates a very high likelihood of error in the future. Moreover, they not only don’t understand, but they greatly overestimate their degree of understanding. I recognize, as an investor, trader, and economist, that there is some chance that my forecasts are wrong. Furthermore, since I understand that overconfidence is a very common cognitive error, I even recognize that I am most likely underestimating the chances that I am wrong. As a consequence, I am very conservative with my approach to investment when the consequences of an error are very high. Most good investors are very wary of overconfidence.

No such wariness afflicts the economic profession, unfortunately, especially at one particular address on Constitution Avenue Northwest in Washington, DC.

It Pays To Be Contrary

At one time, I think most of us assumed that the stock market would have a hard time rallying without its largest component, Apple (AAPL).

Pretty soon, Apple will solve that problem, since it won’t be too long before it is smaller than Exxon-Mobil (XOM) again. It is actually fairly remarkable that the S&P has managed to rally 3.2% this year even though AAPL is -8.7%.

This phenomenon is amazingly timely, considering that in the November/December issue of the Journal of Indexes there was an article by Rob Arnott and Lillian Wu called “The Winner’s Curse” in which the authors noted that “For investors, top dog status – the No. 1 company, by market capitalization, in each sector or market – is dismayingly unattractive.” Later, they note that “the U.S. national top dog underperforms the average company in the U.S. stock market by an average of 5 percent per year, over the subsequent decade.”

Nice call.

That observation follows naturally from Arnott’s work that led to fundamental indexing – his observation, simply, is that by definition if you are capitalization weighting you will always have “too high” a weight in stocks that are overvalued relative to their true prospects and “too low” a weight in stocks that are undervalued relative to their true prospects. There is no way to know if Apple is one of those – it’s a great company, and there’s no reason that the top-capitalization company is necessarily overvalued – but the authors of that article note that when you’re the top dog, more people are taking potshots at you. It suggests an interesting strategy, of buying the market except for the top firm in each industry.

This is why contrarians tend to do well. If you buy what everyone else is selling, and sell what everyone else is buying, there’s no reason to think you’ll be right on any given trade but you are much more likely to be buying something that is being sold “stupidly” and to sell something that is being bought “stupidly.”

Which brings me back to commodities, which are unchanged over the last 9 years (DJUBS Index) while the basic price level has risen 24% and M2 is +72%. But I know you knew that’s where I was going.

Below is a picture of the worst two asset classes of the last nine years (I picked 9 years because that’s the period over which both of them are roughly unchanged). The white line is the S&P-Case Shiller index, while the yellow line is the DJ-UBS Commodity Index.

One of these two lines is currently generating much excitement among economists and investors, including institutional investors, who are pouring money into real estate. The other line is generating indifference at best, loathing at worst, and plenty of ink about how bad global growth is and how that means commodities can’t rally.

One of these lines is also associated with an asset class that has historically produced +0.5% real returns over long periods of time, and consequently isn’t an asset class that one would naturally expect to have great real returns. The other is associated with an asset class that has historically produced +5-6% real returns, comparable with equity returns, over long periods of time. Care to guess which is which?[1]

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Tomorrow, the BLS will release the Consumer Price Index for December. The consensus for core inflation is for a “soft” +0.2%, and a year-on-year core inflation increase for 2012 of +1.9%.

Now, last December’s core inflation number was +0.146%, and last month’s year-on-year core CPI was +1.94%. What that means is that it will be quite difficult to get both +0.2% on the monthly core figure and +1.9% on the y/y change. If get +0.17% on core, then we should round up to +2.0% unless something odd happens with the seasonal adjustments.

In other words, I think it’s very likely that core inflation will pop back up to 2.0%. As a reminder, the Cleveland Fed’s Median CPI is still higher, at 2.2%, so it should not be surprising at all that core inflation has a better chance of going up than going down from here.

The two major subindices to look for are Owner’s Equivalent Rent, which last month was at 2.14% y/y, and Rent of Primary Residence, which was 2.73% y/y. Those two, combined, represent 30% of the consumption basket, and it was the flattening out of those series that caused core CPI to flatten around 2.0%. (Six months ago, the trailing y/y change in OER was 2.1%; the y/y change was 2.7%). Accordingly, watch closely for an uptick in those indicators. We believe that they are going to accelerate further, likely sometime in the next 3 months.

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[1] Hint: the one that has historically provided great returns is one that few investors have very much of. The one that has historically provided bad returns is the one that represents most of a typical investor’s wealth.