While we wait for our Employment Report tomorrow, there is plenty of excitement overseas.
The dollar continued to strengthen today, with the dollar index reaching the highest level since the middle of last year (see chart, source Bloomberg).
As with the rest of the dollar’s strengthening move, it was really not any of our own doing. The dollar is simply, and I suspect very temporarily, the best house in a bad neighborhood right now. In the UK, the Scots are about to vote for independence, or not, but it will be a close vote regardless. In Japan, the Yen is weakening again as the Bank of Japan continues to ease and Kuroda continues to jawbone against his currency.
In Europe this morning, the ECB surprised many observers by cutting its benchmark rate to the low, low rate of just 5 basis points (0.05%), and lowered the deposit rate to -0.2%…meaning that if a bank wants to leave money sitting at the ECB, it is forced to pay the ECB to hold it. A negative deposit rate is akin to the Fed setting interest on excess reserves at a negative figure, something that makes great sense if the point of quantitative easing is to get money into the economy. In the Fed’s case, it turns out that the real point was to de-lever the banks forcibly, so it didn’t care that the reserves were sitting inert, but in the ECB’s case they would really like to see inflation higher (core inflation for the whole Eurozone is under 1%) so it is important that any increase in the balance sheet of the central bank is reflected in actual currency in circulation.
Right now, the negative deposit rate isn’t so important since the ECB holds negligible deposits. But the negative deposit rate was step one; step two is to gin up the quantitative easing again. ECB President Draghi had promised several months ago to do so with ‘targeted LTRO’, and today he delivered by saying that the ECB has decided to begin TLTRO in October. The ECB will “purchase a broad portfolio of simple and transparent securities” even though some observers have noted that there aren’t a lot of asset-backed securities in the market to buy (but trust Wall Street on this: if there is a buyer of a few hundred billion Euros’ worth of such securities, those securities will be issued. Wall Street isn’t good at everything, but they’re darn good at finding ways to satisfy a motivated, huge buyer. (See “subprime MBS”).
This is significant, as I said it was when Draghi first mentioned this back in June. It is significant if they follow through, and at least at this point it appears they mean to do so. Now, Europe still needs to fight against the dampening effect on money velocity that lower interest rates are having, but at least they recognize the need to get M2 money growth above the 2.7% y/y rate it is at presently (which is, itself, above the 1.9% rate of the year ended April). Money growth in Europe is currently the lowest in the world, and – surprise! – deflation is the biggest threat in Europe. Go figure.
How does this affect inflation in the US?
Changes in the global money supply contributes to a global inflation process that underpins inflation rates around the world. The best way to think about the fluctuations in exchange rates, with respect to inflation, is that they allocate global inflation between countries (or, alternatively, you can think of inflation as being “global” plus “idiosyncratic”, where a country’s idiosyncratic inflationary or disinflationary policies affect the domestic inflation rate and the exchange rate with other countries). So, the ECB’s aggressive easing (when it happens) will have two main effects. First, it will tend to push up average inflation globally compared to what it would otherwise have been. Second, it will tend to weaken the Euro and strengthen the dollar so that inflation in Europe should rise relative to US inflation – all else being equal, which of course it is not.
With respect to this latter effect, I need to take pains to point out that it is a small effect, or rather than the relative movements in the currency need to be a lot bigger to be worth worrying about. A stronger dollar, in short, is not going to put much pressure on US inflation to be lower. The chart below (source: Enduring Investments) shows a proxy we use for core commodities inflation, ex-medical, against the broad trade-weighted dollar lagged 9 months.
You can see that core commodities respond broadly to the dollar’s strength or weakness. A 5% rise (decline) in the dollar causes, nine months later, a 1% decline (rise) in core commodities inflation, ex-medical care commodities. Core ex-medical care commodities represents about 18% of the consumption basket, and the dollar’s effect outside of that part of the basket is indeterminate at best, so we can say that a 5% rise in the dollar causes inflation to decline about 0.18%.
In short, don’t waste a lot of time worrying that the 4% rise in the dollar this year will lead to deflation any time soon. Against that 18% of the consumption basket, we have 57% of the basket (core services) inflating at 2.6%, and over half of that consists of primary and owners’ equivalent rents, which are rising at 3.3% and 2.7% respectively and have a lot of upward momentum. Unless the dollar shoots dramatically higher, it should not affect overall prices very much.
So, the Fed’s tightening is almost done.
Chairman Yellen informed Congress that a “high degree” of easing is needed given the slack in the labor market. This is in keeping with the Fed’s ongoing thematic presentation of “tapering is not tightening,” but of course tapering is indeed tightening. Call it “easing less” if you like, but going from “providing lots of liquidity” to “providing less liquidity” to “providing no added liquidity” is tightening.
I would argue that providing no added liquidity – which is where the Fed is headed, with the taper due to be completed in the autumn – is neutral policy, not an easy policy. But the Fed, like many observers, confuses the level of interest rates with the degree of accommodation. That is confusing a price (the interest rate) with a flow, but it seems not to bother them very much. (I explain the distinction, which is crucial to monetary policymaking, in this article.)
Now, whatever the Chairman thinks she’s saying, what she means is that the Fed isn’t going to be raising interest rates soon. This is partly because the main tool they had been planning to use, the reverse repo facility, isn’t as simple a solution as they believed at first. This isn’t terribly surprising; as I (and others) have been pointing out in presentations and articles for a while it isn’t trivially easy to drain $2 trillion in reverse repo transactions, even if you can do $2 billion with ease. The pattern is familiar, and should be mildly discomfiting:
- At first, the Fed thought to unwind the massive purchases of Treasuries by simply selling them. The original argument was that the Fed pushed rates lower by buying Treasuries, but selling them wouldn’t raise interest rates. This sort of perpetual motion machine never made much sense, and at some point it became clear that if the Treasury started to unwind the SOMA portfolio securities and rates rose, it would likely not be sufficient to drain all of the excess reserves, since the average selling price would most likely be lower than the average purchase price.
- The Fed then thought to just let the securities in the SOMA roll off. Then someone noticed that because of the TWIST program, the Fed doesn’t own many short-dated Treasuries, so that letting QE gradually drain itself would take more than a decade.
- No problem; we’ll just conduct massive reverse repo operations to drain a couple trillion dollars from the system. The link above shows that the Fed’s newly discovered skepticism on that matter; the website Sober Look recently had a good article on the topic as well.
None of this is surprising to people who actually have market experience; unfortunately, over the last decade or so the level of actual market expertise at the Federal Reserve has dropped significantly so they are re-discovering these things the hard way. Now, the focus is on interest on excess reserves (IOER) as the main tool for raising rates eventually.
All of this confusion is one reason that the Fed will move only slowly to ‘normalize’ interest rates. They’re simply not sure how they’ll do it. The problem with IOER is that we have no idea how sensitive the level of reserves it to the amount of interest paid on reserves…since we have never done this before. But to the Fed, that’s no problem because they don’t seem to care about reserves – they only care about the level of interest rates, which at the end of the day don’t matter nearly as much as the growth rate of the money supply.
And so US and UK money supply growth rates are both in the 6-7% range, and interestingly median inflation in the US recently accelerated to 2.3% while core inflation in the UK surprised everyone today by rising to 1.9% (as of April). Commercial bank credit growth in the US over the last 13 weeks has risen at a 10.4% pace, the highest rate since early 2008 (see chart, source Federal Reserve).
Slowing QE has not, evidently, slowed money supply growth, and this is one reason the Fed insists that tapering is not tightening. Unfortunately, this doesn’t mean that the Fed is right, but that they are wrong twice: first, tapering is tightening. Second, changing the pace of addition to reserves does not matter for growth in the money supply (and, hence, inflation) when there are enormous piles of inert reserves already. Picture a huge urn filled with coffee. The spigot at the bottom controls the pace at which coffee leaves the urn, and adding more coffee to the top of the urn has essentially no effect.
So money supply growth, and corporate loan growth, is currently not under control of the Fed in any way. Interest rates are under their control, but interest rates don’t cause changes in the money supply but rather the other way around. Here is another analogy: a robust harvest of corn pushes corn prices lower, but if the government officially sets the price of corn very low it does not cause a robust harvest of corn. This is exactly what the Fed is trying to do if they attempt to control the money supply by changing interest rates.
It actually is worse than this. Raising interest rates will tend to increase money velocity, a relationship which has held very well for the last two decades. I have written about this quite a bit in the past (see for one example this article from last September), but I – like many monetary economists – have often struggled with the fact that there was a regime shift in the early 1990s which messes up the beauty of this fit (see chart, source Enduring Investments).
We have recently resolved much of this problem in our own modeling. The following chart uses three (unstated here, but included in our quarterly inflation outlook to clients) inputs to model M2 velocity, and the regime shift is largely absent. Suffice to say that with a model that makes sense and fits a much wider range of history, we are even more confident now that any Fed move to hike interest rates, rather than to drain reserves, would be a mistake.
The bottom line is that it is good news that Yellen is not planning to hike interest rates soon. It is bad news that she is not planning to drain reserves any time soon. But the Fed is perilously close to making its big policy error of this cycle. Stay tuned.
As we wait to see whether the Fed slants its statement ever-so-slightly to the hawkish side or ever-so-slightly to the dovish side (not to mention whether Chairman Yellen repeats her blunt performance in the presser), it is probably worth a few moments to think about what the Fed ought to do.
Yesterday’s inflation figures, viewed in isolation, might be perceived as a one-off bad figure. I pointed out yesterday some reasons that this would be an unfortunate error. Keep in mind that anything the Fed does to address monetary policy will take some time to impact an economic process with momentum. That is to say that even if the Fed tightened today, core inflation over 3% is probably still going to happen. The real question is how high inflation goes, and how long it stays there. There is no longer any question about whether inflation is rising. (This has actually been true for a while, but people who were focused on core rather than median and didn’t look at the particulars of inflation, as well as those who focus on the “output gap” as preventing any possibility of inflation, have been able to ignore the signs for a while).
As an aside, the “output gap” crowd – who expected deflation in 2009-10, and didn’t get it, and now expect disinflation, but aren’t getting it – aren’t defeated yet. They’ll simply re-define the gap to fit the data, I am sure. When you get to choose your own observations and change the model to fit the observations, science is easy.
What concerns me about the Fed’s next steps here, and the state of the debate, is that the Federal Reserve seems overly focused on the level of interest rates, and how to adjust them, and not on the level of reserves or controlling the transactional money supply. For example, recently the IMF published a paper arguing that central banks should raise the long-term inflation target from 2% to 4% because with a 2% target it is too easy to get deflation and have interest rates pinned at zero, leaving the central bank powerless to stop deflation. It seems not to matter to the author that Japan only recently proved that it is money, and not interest rates, that matter when they were able to get out of deflation with an aggressive QE. And, after all, “Helicopter” Ben made the point years ago that deflation is easy to prevent if only the Fed prints money.
So the cult of interest rate manipulation concerns me. Another, and more influential, example (because after all, no one really believes the central bank will start targeting 4% inflation) is in the publication recently of “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve,” co-authored by Brian Sack and Joseph Gagnon. Dr. Sack used to be head of the Fed’s Open Markets Desk, so his opinions have some weight in the institution. In this policy brief, he and his co-author suggest ways that the Fed could raise rates even without reducing the amount of excess reserves in the system. Their approach would, indeed, succeed in moving interest rates. But the proposal, in the authors’ words, “appropriately ignores the quantity of money.”
Considering that it is the quantity of money, not its price, that impacts inflation – as hundreds of years of monetary history have proven beyond any educated doubt – this is a frightening view. We are always looking for where the next policy error will come from; this is certainly a strong candidate.
There is a crucial misunderstanding here, and it is unfortunately a fundamental tenet of the interest rate cult. Interest rates are not the cause of money supply changes, but the result of them. The way the Fed operates tends to cause this confusion, because the Fed seems to adjust interest rates. But that is not in fact what happens. The Desk actually adjusts the level of reserves in the system, and reads the interest rate as an indication of whether reserves are at the right level (or at least, this was the way it used to be done, before the “environment of abundant liquidity”). The confusion has gradually developed, and the institution has contributed to the confusion by gradually altering its policy statements to obfuscate what is actually going on. The domestic policy directive of February 1989 said in part:
“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions…somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 2 and 3½ percent, respectively.”
Notice that the main focus here is how pressure on reserves leads to money supply growth. By 1994, the Fed was drawing the line to interest rates more explicitly. The press release following the February 4th, 1994 meeting said in part:
“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”
The Federal Reserve eventually stopped talking about “reserve positions,” although that continued to be how interest rates were managed in fact. Here is what the Fed was saying in January 2007:
“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”
Now, of course, the Fed not only sets the current level of interest rates but also gives us an expected path.
But again, even when the Fed was talking about the interest rate target, the Fed actually managed interest rates by managing reserves. By doing large system repos or matched sales, the supply of reserves was managed with respect to what the Fed thought the demand for reserves (which is unobservable in real time) was. If the resulting interest rate was too low or too high, then they added or subtracted to the supply reserves. And thus we get to the point that is crucial for understanding how monetary policy is conducted: the interest rate is a measurement of the pressure on reserves.
Interest rates, in other words, are like a thermometer that measures the temperature in the body. The doctor plies his trade on a feverish patient with an eye on the thermometer. He can’t see the microbes and antibodies, but the thermometer tells him (her) if he (she) is winning. In exactly the same way, the level of short-term interest rates tells the Fed if they have too many reserves or too few. But suppose the doctor lost sight of the real purpose of treatment? Suppose the doctor said “wow, this would be so much easier if I just put a little dial on the thermometer so that I could control the reading directly! Then I could just set it to the right temperature and I would be done.” We would all recognize that doctor as a quack, and the patient would probably die.
This approach, though, is what the Sack/Gagnon paper proposes. We want to control the temperature, so let’s introduce a thermometer that allows us to control the temperature! But this is wrong, because it is the reserve position that is critical to control; it is that which is out of control at the moment due to the presence of copious excess reserves; and the fact that the Fed can simply set the interest rate is irrelevant. (Why do we need a Fed? Why not have Congress set the legal interest rate at the “appropriate level” so that the Fed doesn’t even need to do open market operations?)
The Sack/Gagnon plan will clearly permit the movement of interest rates to wherever the Fed wants them to be. But it will not solve the root problem, which is that the level of required reserves is essentially out of the Fed’s control – which means the size of the money supply is out of its control as well. Excess reserves will continue to leak into transactional money, and inflation will continue to rise. Here is your error. The Fed is about to score an “own goal.”
We all have our hot button issues. It will not surprise you, probably, to learn that mine involves inflation. For the rant which follows, I apologize.
Reasonable people, smart people, learned people, can disagree on how precisely the Consumer Price Index captures the inflation in consumer prices. And indeed, over the one hundred years that the CPI has been published such disagreements have been played out among academics, politicians, labor leaders, and others. The debates have raged and many changes – some large, some small; some politically-driven, most not – have occurred in how prices have been collected and the index calculated. If you are interested, really interested, in the century-long history of the CPI, you can read a couple of histories here and here.
If someone is not interested in how CPI is calculated, in how and why changes were made in the methodological approach to calculating price change, then that’s fine. But if a person can’t spend the time to learn the very basics of this hundred-year debate, during which changes were made in the CPI with much public input, not in a smoky back room somewhere, then I wonder why such a person would spend time spewing conspiracy theories on the internet about how the CPI doesn’t include food and energy (um…it does), about how the CPI underestimates prices because it doesn’t account for changes in quality and quantity (um…it does), or about how sneaky methodological changes have caused the CPI to be understated by 7% per year for thirty years.
Recently, the CFA Institute’s monthly magazine for CFA Charterholders was duped into accepting an article that brings together some of the dumbest theories into one place. At some level, the article asks the “interesting” question about whether a consumer price index should include asset prices. Interesting, perhaps, but asked-and-answered: assets are not consumer goods but stores of value. If you are not consuming something, then why would you ever expect it to be included in a consumer price index? You might argue that we should include asset prices into some other sort of index that measures price increases. But we already do. They are called asset price indices, and you know them by names like the S&P 500, the NCREIF, and so on.
Worse, the magazine gives a great big stage to the person who has singlehandedly done more to confuse and anger people, to poison the well of knowledge about inflation, and to stir up the conspiracy theorists about inflation, than anyone else in the world – and all because he is selling an ‘analysis’ product to those people. I won’t mention his name here because I don’t want to advertise his product, but he claims that the CPI is understated by “about 7 percentage points each year.”
That this is being published in a magazine of the CFA Institute is almost enough for me to renounce my membership. It is offensively idiotic to claim that the CPI may be understated by 7% per year, and simple math (which CFA Charterholders were once required to be able to perform) can prove that. If inflation has risen at a pace of around 2.5% per year over the last 30 years, it implies the price level has risen about 110% (1.025^30-1). This seems more or less right. But if inflation had really been 9.5% per year, as claimed, then the cost of the average consumption basket would have risen about 1422% (1.095^30-1).
Can that be right? Well, Real Median Household Income, using the CPI to deflate nominal household income, has risen about 13% over the last 30 years. http://en.wikipedia.org/wiki/File:Median_US_household_income.png But if we use the 9.5%-per-year CPI number, then real median household income has actually fallen 84%. If this was true, we would be living in absolute Third-World squalor compared to how things were in the salad days of 1984. You don’t have to be an economist to know the difference between a slightly-better standard of living and one in which you can afford 1/6th of what you could previously afford. You just need a brain.
Any person who does even rudimentary research on the CPI – say, visiting http://www.inflationinfo.com and reading some of the hundreds of papers gathered there, or perusing the BLS website, or speaking with an actual inflation expert – cannot possibly think that this guy is anything other than a nut or a shill. It is a tragedy that the CFA Institute would publish such trash, and it tarnishes the CFA Institute brand. Let’s hope they publish an apologetic retraction in the next issue.
I also like to point out, when I am in rant mode over this (and, as an aside, let me thank the tolerant reader for allowing me to rant – this allows me to forever point people to this link when they bring up this guy), that if the CPI=9.5% number is right then you must also believe a bunch of other ridiculous things:
First: MIT is in on the conspiracy. The Billion Prices Project, which uses very different methodology from the BLS, figures inflation to be about the same as the BLS does. (Digressing for a bit, I think it’s also interesting that the BPP index has tracked Median CPI much better than headline CPI over the last year, when headline CPI has been dragged lower by one-off changes in medical care prices).
Second: Consumers consistently underestimate inflation, or else are serially optimistic about how it is likely to decline from 9.5% to something much lower. The University of Michigan survey of year-ahead inflation expectations – and every other consumer survey of inflation expectations – is much closer to reported inflation than to the shill’s numbers (see chart below, source Bloomberg). I’ve written elsewhere about why consumers might perceive slightly higher inflation than really occurs, but I cannot come up with a theory that explains why consumers would always say it’s much lower than what they are in fact seeing. Maybe we’re all stupid except for this guy with the website.
Third, and related to the prior point: Investors who pour money into inflation-indexed bonds must be complete morons, because they are locking up money for ten years at what is “really” -9% real yields (meaning that they are surrendering 62% of the real purchasing power of their wealth, rather than spending it immediately). We don’t see this behavior in countries where it is known that the official index is manipulated. For example, we know that in Argentina the inflation data really is rigged, and in September of last year long-dated inflation-linked bonds in Argentina were showing real yields of more than 20%. In recent months, the government of Argentina has begun to release figures that are much more realistic and real yields have plunged to around 10% as investors are giving the data more credibility. The upshot is that we have bona fide evidence that investors will base their demanded real yields on the difference between the inflation index they are being paid on and the inflation they think they are actually seeing. The fact that we don’t see TIPS real yields around 6% or 7% is evidence that investors are either really stupid, or they believe the CPI is at least approximately right.
Fourth, and related to that point: if inflation has really being running at 9.5%, then every asset is a losing proposition. There is no way to protect yourself against inflation. You’re not really getting wealthy as you ride stocks higher; you’re only losing more slowly. Since there is no asset class that has returned 10% over a long period of time, we are all doomed. The money is all going away. Especially housing, and real goods like hard commodities – there is nothing you can do that is much worse than holding real stuff, which is only going up in price a couple of percent per year over time while inflation is (apparently) ravaging everything we know and love. There is no winning strategy. Of course, the good news is that it turns out that the U.S. government is being extremely fiscally responsible, with the real deficit falling by 5% or more every year. Right.
I really should not let this bother me. It is good for me, as an investor with a brain, when mindless zombie minions follow this guy and do dumb things in the market. But I can’t help it. The Internet could be a tool for great good, allowing people access to accurate, timely information and the opportunity to learn things that they couldn’t otherwise. It allows this author to come into your mailbox, or onto your screen, to try to educate or illuminate or amuse you. But there is also so much detritus, so much rubbish, so much terribly erroneous information out there that does real harm to those who consume it. And perhaps this is why I get so exercised about this issue: I absolutely believe that people have a right to say and to believe whatever they want, no matter how stupid or dangerous. I am simply aghast, and deeply saddened, that so many people are so credulous that they believe what they read, without critical thought of their own. Everyone has a right to his/her opinion, but they are not all equally valid. There is no FDA for the Internet, so snake-oil salesmen run rampant among their eager marks.
I want my readers to think. If you all agree with me, then I know you’re not all thinking! Look, it is perfectly reasonable to suggest that some minor improvements can be made to CPI. The number has been tweaked and improved for a hundred years, and it will be tweaked and improved some more in the future. It is in my opinion not reasonable to suppose that the number is completely made up and/or drastically incorrect. And that’s my opinion.
I haven’t written in a couple of weeks – a combination of quiet markets, and a lack of intersection between stuff that’s interesting to write about and my having time to write – but I thought I would “global cc” everyone on something I just wrote in a private email about some common misconceptions regarding the CPI:
A friend and longtime reader (name withheld) writes:
I thought you might find these interesting….
My response is below:
Thanks. Unfortunately Stockman doesn’t understand what he’s talking about. He understands better than most, but then he starts saying how the BLS asks homeowners what their homes would rent for…which they do, but only to determine weights, every couple of years, not to determine OER. It says this very clear in a paper on the BLS website called “Treatment of Owner-Occupied Housing in the CPI:“
“To obtain the expenditure weights for the market basket…Homeowners are asked the often-cited question:
If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?
This is the only place where the answers to this question is used; in determining the share of the market basket. We do not use this question in measuring the change in the price of shelter services.”
For that purpose – calculating inflation itself – a survey of actual rents is used. I can understand how the casual observer doesn’t ‘get’ this, but there’s no excuse for Stockman not to know, especially if he is railing about the CPI…he should take some time to understand its main piece.
In short, Stockman writes a good populist screed, but he avoids the main questions:
1. Is headline inflation a better predictor of future inflation than core inflation? Answer: No, even if we can now realize that the rise in energy prices was a permanent feature of the decade ended in 2010, it tells us exactly nothing about whether those are likely to persist. The Fed uses core CPI not because they don’t think people use cars (whenever a columnist uses that silly argument, I know they’re just writing to please a certain audience), but because core CPI is persistent statistically in a way that headline is not. In fact, some Fed statisticians prefer median, or trimmed-mean, neither of which proscribes any particular category. So whining about how the Fed doesn’t include the particular brand of inflation that concerns you misunderstands how and why policymakers actually use measures of inflation in policymaking.
2. Suppose the CPI represents a miserable mis-estimation of actual inflation. Then, pray tell, why does a trillion-dollar market based on that index get priced as if it is accurate? In Argentina, where the inflation numbers are made up, the inflation-linked bonds trade very cheap because they will pay off in a number that is assumed to be too low. And the bond yields are too high by roughly the amount that inflation is assumed to be understated in the future. Markets are efficient, especially big markets. How did the Fed manage to convince at least $1T in private money to misprice the bond market?
3. If the CPI is so wrong, so manipulated, then why to measures of inflation that the government has nothing to do with, like the Billion Prices Project, come up with the same number?
It’s nice that Stockman has a following. And he’s gotten the following partly by ranting about a number people love to hate. That gets him read, but it doesn’t make him right.
On Tuesday, the Bureau of Labor Statistics will report the CPI index (along with endless other data) for March. Currently, the consensus estimate calls for +0.1%, and +0.1% ex-food-and-energy. This release will generate the usual irritation among conspiracy theorists who believe the government is monkeying with the inflation numbers for their own nefarious ends. I have previously explained why it is that inflation tends to feel faster than it actually is, and I have regularly debunked the claim by certain conspiracy-minded individuals that inflation has been running about 5% faster than the “official” mark since the early 1980s. However, today I want to point out another reason that right now we will have a tendency to recognize that inflation is not rising at 0.1% per month, and that involves the issue of seasonal adjustment.
The point of seasonal adjustment is to remove regular, cyclical influences so that we can see if the underlying trend is doing anything interesting. Consider temperature. Is it particularly helpful for you as a meteorologist to know that the average temperature in April has been higher than the average temperature in January? Of course not, because we know that April is always warmer than January. Hence, with temperature we ask whether April was warmer than a typical April.
Closer to the point, consider gasoline. The national average gasoline price has risen in 61 of the last 66 days, as the chart below (Source: Bloomberg) illustrates.
Yes, if you’re noticing that gasoline prices have been rising you are not alone, and it is not an illusion! But should we worry about this rapid acceleration in gasoline? Does this necessarily presage spiraling inflation? Bloomberg offers an easy way to look at the seasonality question (we formerly had to do this by hand). The following chart shows the change in gasoline prices (in cents) since December 31st for each of the last four years, for the 5-year average (the heavy, yellow line) and for this year (the white line).
You can see that the rise from late January into April is not only normal, but the scale of the increase is just about the same this year as for the prior four years – what was unusual was that prices didn’t start rising until February.
Now, this particular seasonal pattern is important to inflation-watchers and TIPS traders because the volatility of gasoline prices is an important part of volatility in the overall price dynamic. In fact, it is important enough that if I take the average line from the gasoline chart above and overlay it with the official CPI seasonal adjustment factors from the BLS, you can see the ghost of the former in the latter (see chart, source Enduring Investments).
Now, the seasonal adjustment factors for the CPI as a whole are less dramatic (closer to 1, in the chart above, if you look at the right-hand scale compared to the left-hand scale) than are the factors for gasoline, but that makes sense since gasoline is only a small part – albeit a really important part – of the consumption basket of the average consumer. And the BLS methodology is a lot more sophisticated than the simple average-of-the-last-x-years approach I have taken here. But this should be good enough for you to grasp the intuition.
What this means is that when the BLS reports tomorrow that gasoline prices didn’t add anything to overall inflation in March, you should recognize that that does not mean that gasoline prices didn’t rise in March. It means that they didn’t rise significantly more or less than the average factor the BLS is assuming. Most of all, it doesn’t mean that the BLS is monkeying with the data to make it seem lower. The product of the seasonal adjustment factors is (approximately) 1.0, which means that what the BLS takes away in the springtime, to report inflation numbers lower than would be anticipated given a raw sampling of store prices, they will give back in the late fall and winter, and report inflation numbers higher than would be anticipated given a cursory glance of store shelves. What is left, hopefully, is a more-unbiased view of what is happening with the price level generally.
Where you can see this effect most clearly is in the difference between the seasonally-adjusted number that is reported and the rise in the NSA figure that is used to adjust inflation-indexed bonds like TIPS. While the consensus calls for a +0.1% rise in headline CPI, the forecasts expect the NSA CPI (the price level) to rise from 234.781 to 236.017, which is a rise of +0.5%. So yes – if it feels like inflation is suddenly rising at a 6% annualized pace, that is because it is. But fear not, because that will slow down later in the year. Probably.
 The summary of that argument: we know that wages have increased roughly 142% since the early 1980s – average hourly earnings was $8.45 in April 1984 and is $20.47 now, and this “feels about right” to most people. Against this, the CPI has risen 128%, meaning that our standard of living “should” have improved a little bit since then, but not much (although any individual may be doing somewhat better or worse). But if prices instead of rising at 2.8%/year had risen at 7.8%/year, prices in aggregate would have risen 851% versus a 142% increase in wages, and we would all be living in absolute squalor compared to our parents. This is offensively and obviously wrong.
In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.
Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.
But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).
There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).
Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.
It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.
Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.
But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.
It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?