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Summary (and Extension) of My Post-CPI Tweets

July 22, 2014 2 comments

Below is a summary (and extension) of my post-CPI tweets today. You can follow me @inflation_guy.

  • CPI +0.3%/+0.1% with y/y core figure dropping to 1.9%. That will be only by a couple hundredths on rounding, but it’s still a decline.
  • Looks like core was 0.129% rounded to 3 decimal places. y/y went from 1.956% to 1.933% so a marginal decline.
  • RT of Bloomberg Markets @themoneygame: Consumer Price Changes By Item http://read.bi/1nx0sUf 
  • Core goods still -0.2%, core services still +2.7%, unchanged from last month. [ed note: I reversed these initially; corrected here]
  • All of this a mild miss for the Street, which was looking for +0.19% or so, but I though the Street was more likely low.
  • Major groups accel: Apparel, Recreation, Educ/Comm, Other (19.7%). Decel: Food/Bev, Transp, Med Care (38.9%), Housing flat.
  • There’s your real story. Recent drivers: medical care, which is a base effect and oddly reversed. That’s temporary. Also>>
  • >>big fall in non-rental/OER parts of housing: insurance, lodging away from home, appliances. Those are not as persistent as rents.
  • Primary rents went to 3.153% from 3.058%; OER unch at 2.640% from 2.638%. The rest will mean-revert.
  • College tuition and fes at 4.142% from 4.001%.
  • 60.5% of all low-level categories accelerating (down from 70.5%). Still broad but not as broad.
  • Actually looks like Median CPI could downtick today.

This is why I try very hard to resist the urge to forecast the monthly CPI, and admonish investors (and even traders) to resist trading on the data. Chairman Yellen is right about this: the data are noisy, so one month can be almost anywhere. This month, there was a reversal in the recent rise in y/y medical care inflation. But that rise was due to base effects, which aren’t going away, so forecasting medical care inflation to continue to accelerate is more a statement of mathematical likelihood than it is an economic forecast. And it’s all the more surprising then when it reverses.

This month’s figure makes it a fair bit harder for my forecast of near-3% for 2014 on core or median inflation to come to pass, although it bears noting that median inflation (even though it may downtick later today) is still within striking distance. Since median is currently the better measure, and will be for much of this year, I won’t back off my forecast yet. Another weak month, though, would cause me to ratchet down the target simply because it becomes harder to hit as time becomes shorter.

However, I expect several months this year will exceed +0.3% on core inflation. And it is worth remembering that core inflation faces easy year-ago comparisons for the rest of the year. In July of last year, the seasonally-adjusted m/m core inflation figure was +0.167%; in August it was +0.138%; in September it was 0.132%; in October +0.124%; in November +0.175%; and in December +0.101%. So, even if core inflation only averages +0.2% for the rest of the year, core will still be at 2.3% by year-end. If core inflation averages what it has been for the last four months, we’ll be at 2.4%. What that means is that (a) my forecast of something near 3% doesn’t represent a massive acceleration, although we only have half a year to get there, and (b) anyone forecasting less than 2.3% by year-end is actually forecasting a deceleration in inflation from recent trends.

The breadth indicators also took a mild breather this month, with the proportion of the CPI that is accelerating (looking at low-level categories) dropping to around 60% from around 70% in May. As with the other analysis, however, we should be careful not to read too much into one month since this figure also jumps around a lot. Interestingly, the proportion of categories where the year-on-year change is at least 2 standard deviations above zero – so that we can reject the ‘deflation’ meme for these categories – is basically unchanged from last month at 24%. As the chart below shows, we last saw a level this high in 2006, which is also the last time that core CPI ran at 3%.

twosd

Housing inflation is now back below my model’s projections, inflation breadth is still high, and the persistent parts of CPI are maintaining their levels or advancing while a few of the skittish parts are retreating (or at least not yet converging to the mean). There is nothing here to indicate that the three months of accelerating core CPI were the aberration; in fact to me it appears that the June figure was the aberration. That question will be answered over the balance of the year. In the meantime, inflation markets remain priced at levels so low that even if you’re wrong in betting on higher inflation, you don’t lose much but if you’re right, you do very well. In my view (although admittedly I may be biased), most investors remain significantly underweight protection against this particular risk.

Categories: CPI Tags: ,

Dog Bites Man: Markets Still Not Making Sense

July 7, 2014 5 comments

The Employment number these days is sometimes less interesting than the response of the markets to the number over the ensuing few days. That may or may not be the case here. Thursday’s Employment report was stronger than expected, although right in line with the sorts of numbers we have had, and should expect to have, in the middle of an expansion.

12mpayrolls

As the chart illustrates, we have been running at about the rate of 200k per month for the last several years, averaged over a full year. I first pointed out last year that this is about the maximum pace our economy is likely to be able to sustain, although in the bubble-fueled expansion of the late 1990s the average got up to around 280k. So Thursday’s 288k is likely to be either revised lower, or followed by some weaker figures going forward, but is fairly unlikely to be followed by stronger numbers.

This is why the lament about the weak job growth is so interesting. It isn’t really very weak at all, historically. It’s merely that people (that is, economists and politicians) were anticipating that the horrible recession would be followed by an awe-inspiring expansion.

The fact that it has not been is itself informative, although you are unlikely to see economists drawing the interesting conclusion here. That’s because they don’t really understand the question, which is “is U.S. growth unit root?” To remember why this really matters, look back at my article from 2010: “The Root of the Problem.” Quoting from that article:

“what is important to understand is this: if economic output is not unit root but is rather trend-stationary, then over time the economy will tend to return to the trend level of output. If economic output is unit root, then a shock to the economy such as we have experienced will not naturally be followed by a return to the prior level of output.”

In other words, if growth is unit root, then we should expect that expansions should be roughly as robust when they follow economic collapses as when they follow mild downturns. And that is exactly what we are seeing in the steady but uninspiring job growth, and the steady if not-unusual return to normalcy in the Unemployment Rate (once we adjust for the participation rate). So, the data seem to suggest that growth is approximately unit root, which matters because among other things it makes any Keynesian prescriptions problematic – if there is no such thing as “trend growth” then the whole notion of an output gap gets weird. A gap? A gap to what?

Now, it is still interesting to look at how markets reacted. Bonds initially sold off, as would be expected if the Fed cared about the Unemployment Rate or the output gap being closed, but then rallied as (presumably) investors discounted the idea that the Federal Reserve is going to move pre-emptively to restrain inflation in this cycle. Equities, on the other hand, had a knee-jerk selloff on that idea (less Fed accommodation) but then rallied the rest of the day on Thursday before retracing a good part of that gain today. It is unclear to me just what news can actually be better than what is already impounded in stock prices. If the answer is “not very darn much,” then the natural reaction should be for the market to tend to react negatively to news even if it continues to drift higher in the absence of news. But that is counterfactual to what happened on Thursday/Monday. I don’t like to read too much into any day’s trading, but that is interesting.

Commodities were roughly unchanged on Thursday, but fell back strongly today. Well, a 1.2% decline in the Bloomberg Commodity Index (formerly the DJ-UBS Commodity Index) isn’t exactly a rout, but since commodities have been slowly rallying for a while this represents the worst selloff since March. The 5-day selloff in commodities, a lusty 2.4%, is the worst since January. Yes, commodities have been rallying, and yet the year-to-date change in the Bloomberg Commodity Index is only 2% more than the rise in M2 over the same period (5.5% versus 3.5%), which means the terribly oversold condition of commodities – especially when compared to other real assets – has only barely begun to be corrected.

I do not really understand why the mild concern over inflation that developed recently after three alarming CPI reports in a row has vanished so suddenly. We can see it in the commodity decline, and the recent rise in implied core inflation that I have documented recently (see “Awareness of Inflation, But No Fear Yet”) has largely reversed: currently, implied 1 year core inflation is only 2.15%, which is lower than current median inflation – implying that the central tendency of inflation will actually decline from current levels.

I don’t see any reason for such sanguinity. Money supply growth remains around 7%, and y/y credit growth is back around 5%. I am not a Keynesian, and I believe that growth doesn’t matter (much) for inflation, but the recent tightening of labor markets should make a Keynesian believe that inflation is closer, not further away! If one is inclined to give credit in advance to the Federal Reserve, and assume that the Committee will move pre-emptively to restrain inflation – and if you are assuming that core inflation will be lower in a year from where it (or median inflation, which is currently a better measure of “core” inflation) is now, you must be assuming preemption – then I suppose you might think that 2.15% core is roughly the right level.

But even there, one would have to assume that policy could affect inflation instantly. Inflation has momentum, and it takes time for policy – even once implemented, of which there is no sign yet – to have an effect on the trajectory of inflation. Maybe there can be an argument that 2-year forward or 3-year forward core inflation might be restrained by a pre-emptive Fed. But I can’t see that argument for year-ahead inflation.

Of course, markets don’t always have to make sense. We have certainly learned this in spades over the last decade! I suppose that saying markets aren’t making a lot of sense right now is merely a headline of the “dog bites man” variety. The real shocker, the “man bites dog” headline, would be if they started making sense again.

Awareness of Inflation, But No Fear Yet

June 24, 2014 1 comment

Suddenly, there is a bunch of talk about inflation. From analysts like Grant Williams to media outlets like MarketWatch  and the Wall Street Journal (to be sure, the financial media still tell us not to worry about inflation and keep on buying ‘dem stocks, such as Barron’s argues here), and even Wall Street economists like those from Soc Gen and Deutsche Bank…just two name two of many Johnny-come-latelys.

It is a little surprising how rapidly the articles about possibly higher inflation started showing up in the media after we had a bottoming in the core measures. Sure, it was easy to project the bottoming in those core measures if you were paying attention to the base effects and noticing that the measures of central tendency that are more immune to those base effects never decelerated much (see median CPI), but still somehow a lot of people were taken by surprise if the uptick in media stories is any indication.

I actually have an offbeat read of that phenomenon, though. I think that many of these analysts, media outlets, and economists just want to have some record of being on the inflation story at a time they consider early. Interestingly enough, while there is no doubt that the volume of inflation coverage is up in the days since the CPI report, there is still no general alarm. The chart below from Google Trends shows the relative trend in the search term “rising inflation.” It has shown absolutely nothing since the early days of extraordinary central bank intervention.

risinginflationsearch

Now, I don’t really care very much when the fear of inflation broadens. It is the phenomenon of inflation, not the fear of it, which causes the most damage to society. However, there is no doubt that the fear of inflation definitely could cause damage to markets much sooner than inflation itself can. The concern has been rising in narrow pockets of the markets where inflation itself is actually traded, but because we trade headline inflation the information has been obscured. The chart below (source: Enduring Investments) shows the 1-year headline inflation swap, in black, which has risen from about 1.4% to 2.2% since November. But the green line shows the implied core inflation extracted from those swap quotes, and that line has risen from 1.2% in December to 2.6% or so now. That is far more significant – 2.6% core inflation over the next year would mean core PCE would exceed 2% by next spring. This is a very reasonable expectation, but as I said it is still only a narrow part of the market that is willing to bet that way.

coresincedec

If I was long equities – which I am not, as our four-asset-class model currently has only a 7.4% weight in stocks – then I would keep an eye on the search terms and for other anecdotal evidence that inflation fears are starting to actually rise among investors, rather than just being the probably-cynical musings of people who don’t want to be seen as having missed the signs (even if they don’t really believe it).

Deflation, Indeed!

May 15, 2014 2 comments

Today’s post-CPI update is later than usual (normally, on CPI day I ‘tweet’ my impressions as I have them). A prospect meeting got in the way – yes, isn’t it interesting that there is demand for creative inflation-linked solutions?

Probably, after today, this will be a trifle less surprising. Core inflation surprised on the high side. Consensus had been for the month-over-month figure to be +0.1%; instead it printed +0.236%. This pushed the year-on-year core inflation rate to 1.826%, the highest it has been in a year…and yet still the lowest it is likely to be for a very long time.

So, with the wonderful perfection of timing that is only possible from elite policymakers, the Fed has begun to chirp about deflation fears at just exactly the time that core inflation is turning higher. Do recall that core inflation never got below 1.6% – very far from “deflation” – and was only that low because of well-known effects stemming from the impact of the sequester last year on Medicare payments. Median inflation, which eliminates the influence of small outlier decreases (and increases) on the number, scraped as low as 2.0%, and now sits at 2.2%. It has not been higher than that since mid-2012. Median inflation hasn’t been higher than 2.3% since 2009, so it is fair to say that inflation is much closer to the highs of the last five years than to the lows. Deflation, indeed.

A closer view of the subcomponents do not give any less cause for concern. Of the eight major subcomponents, six (Food & Beverages, Apparel, Transportation, Medical Care, Recreation, and Education & Communication) accelerated on a year-over-year basis while only two (Housing and “Other”) decelerated.

At first glance, that sounds promising. Housing inflation dropped to 2.5% from 2.8%, and those people who are worried about another housing bust right now will be quick to seize on that deceleration. Housing inflation, which is 41% of the total consumption basket, has been a primary driver of core inflation’s recovery in recent months so a deceleration would be welcome. But a closer look suggests that the number for Housing overstates the ‘deceleration’ case considerably. “Fuels and utilities,” which is 5.2% of the entire consumption basket and about 1/8th of Housing, dropped from 6.8% y/y to 4.2%. That was the entire source of the deceleration in housing. The larger pieces, which are also much more persistent, were higher: Primary rents rose from 2.88% y/y to 3.05% y/y, while Owners’ Equivalent Rent was roughly flat at 2.62% compared to 2.61%. So it is perhaps too early to panic about deflation, since the rise in OER and Primary rents is right on schedule as we have been marking it for some time (see chart below, source Enduring Investments).

updatedOER

Outside of housing, core inflation accelerated as well. Core ex-Shelter rose to 1.16% from 0.90%. The inflation is still significantly in services, as core commodities are still only -0.3% year/year. But that will rise soon, probably starting as soon as next month, based on our proxy measure.

As has been well advertised, the temporary depression in Medical Care inflation growth has officially ended. Now that April 2013 is out of the year/year data, the Medical Care major group saw prices rise 2.42% over the last year compared with 2.17% y/y a month ago. Medicinal drugs are at +1.70% compared with +1.44%. Medical equipment and supplies -1.39% vs -1.53%. Hospital and related services +5.55% vs 4.69%. I don’t see the deflation, do you?

This rise in CPI was broad and deep, with nearly 80% of the lower-level indices seeing increases in the y/y rate. It is hard to find any major component about which I would have to express concern, if I was a Federal Reserve official worried about deflation. The breadth of increase is itself a signal. When some prices go up, it is a change in relative prices and will be considered inflation by some people (those who are sensitive to those prices) and not so much by others. But “inflation” is really about a general rise in prices, in which most goods and services participate. As I mentioned above, not all goods prices are participating but in general most prices are rising and, if this month is any gauge, accelerating.

We should hesitate to read too much into any one month’s inflation number. There is a lot of noise in any economic data, so that it can be hard to discern the signal. I believe that there is enough underlying strength here that this is in fact more signal than noise, though, and so I continue to expect core inflation to accelerate for the balance of the year.

I have no idea how long Fed officials will continue to fret about deflation, nor how long it will take the concern to shift to inflation. I suspect it will take a long time, although the stock market today seems less certain on that point with the S&P at this writing down -1.3%. Curiously bonds, which are clearly overvalued if inflation is not contained, rallied today (although breakevens predictably widened). But I think all markets are safe for some time from the risk that central bankers will develop a concern about inflation that is acute enough to spur them to action. (Not to mention that it isn’t at all clear to me what action they could take that would have an effect on the inflation dynamic in any reasonable time frame given that excess reserves must be drained first before any tightening has teeth). This does not mean that I am sanguine about the prospects for nominal asset classes such as stocks and nominal bonds – but at some point, they won’t need the Fed’s cudgel to persuade them to re-price. When inflation is obvious enough to all, that will be sufficient.

Summary of My Post-CPI Tweets

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

  • Core CPI +0.12%, a bit lower than expected.
  • Core 1.56% y/y
  • Both core services and core goods decelerated, to 2.2% y/y and -0.4% y/y. This is highly surprising and at odds with leading indicators.
  • Accelerating groups: Food/Bev, Housing, Med Care (63.9%). Decel: Apparel, Transp,Recreation, Educ/Comm (32.7%). “Other” unch
  • Primary rents fell to 2.82% y/y from 2.88%, OER 2.51% from 2.52%.
  • Primary rents probably fell mainly because of the rise in gas prices, which implies the non-energy rent portion is lower.
  • …but that obviously won’t persist. It’s significantly a function of the cold winter. Primary rents will be well into the 3s soon.
  • Household energy was 0.7% y/y at this time last year; now it’s 5.5%. Again, that slows the increase in primary rents
  • Medical Care moved higher again, slowly reversing the sequester-induced decline from last yr. Drugs +1.86% y/y from 0.91% last month.
  • Core ex-housing leaked lower again, to only 0.84% y/y. Lowest since 2004. If you want to worry about deflation, go ahead. I don’t.
  • The Enduring Inflation Angst Index rose to -0.51%, highest since Nov 2011 (but still really low).

I must admit to some mild frustration. Our call for higher primary rents and owners’ equivalent rents has finally been shown to be correct, as these two large components of consumption have been heading higher over the last few months (the lag was 3-4 months longer than is typical). But core inflation, despite this, has stubbornly refused to rise, as a smattering of small-but-important categories – largely in the core goods part of CPI – are weighing on the overall number.

It is also almost comically frustrating that some of the drag on core CPI is happening because of the recent rise in Natural Gas prices, which has increased the imputed energy component of primary rents. As a reminder, the BLS takes a survey of actual rents, but since utilities are often included in rental agreements the BLS subtracts out the changing value of that benefit that the renter gets. So, if your rent last December was $1,000, and your utilities were $100, and your rent this month is still $1,000 but utilities are $125, then the BLS recognizes that you are really paying $25 less for rent. Obviously, this only changes where price increases show up – in this example, overall housing inflation would be zero, but the BLS would show an increase in “Household Energy” of 25% and a decline in “Rent of Primary Residence” of 2.78% (which is -$25/$900). But “Household Energy” is a non-core component, while “Rent of Primary Residence” is a core component…suggesting that core inflation declined.

There isn’t much we can do about this. It’s clearly the right way to do the accounting, but because utility costs vary much more than rental costs it induces extra volatility into the rental series. However, eventually what will happen is either (a) household energy prices will decline again, causing primary rents to recover the drag, or (b) landlords will increase rents to capture what they see as a permanent increase in utilities prices. So, in the long run, this doesn’t impact the case for higher rents and OER – but in the short run, it’s frustrating because it’s hard to explain!

Now, core inflation outside of housing is also stagnant, and that’s surprising to me. Apparel prices have flatlined after increasing robustly in 2011 and 2012 and maintaining some momentum into mid-2013. Ditto for new cars. Both of those series I have expected to re-accelerate, and they have not. They, along with medical care commodities, are the biggest chunks of core goods in the CPI, which is why that series continues to droop. However, medical care commodities – which was driven lower in 2013 due to the effect of the sequester on Medicare payments – is starting to return to its prior level as that effect drops out (see chart, source BLS).

medcarecomm

We will see in a few hours what happens to median inflation. My back of the envelope calculation on the median suggests median CPI might actually rise this month in reverse of last month.

Summary of My Post-CPI Tweets

February 20, 2014 Leave a comment

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.

morehousing

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.

exhousing

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).

Categories: CPI, Tweet Summary Tags: , ,

Catching Up on the Week

January 17, 2014 4 comments

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.

6/24/2013

5.80%

8/27/2013

4.60%

10/8/2013

4.10%

12/13/2013

1.80%

1/13/2014

1.60%

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).

median and coreMoreover, 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.

whoopsOERSorry 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.

sorryfolksFor 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.

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