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Posts Tagged ‘headline inflation’

Deserving It

September 5, 2012 4 comments

Does Chad “Ochocinco” Johnson deserve another chance?

That’s a question I saw several times bandied about today on the NFL Network. (It is, after all, kickoff night of the NFL and so you will perhaps forgive the digression.) But no one seemed to ask the question that I find much more interesting, and more relevant in other familiar contexts as well:

Does any other team deserve to be saddled with Ochocinco for another season?

Because really, it isn’t just a question of whether he deserves another chance. That would imply there is some objective standard by which his ‘deservedness’ should be measured. It seems to me that this begs the question. Shouldn’t the arbiters of whether he deserves another chance be the people who actually have to be saddled with the consequences of giving him another chance?

I’m just saying…

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There is a very interesting development in inflation land: Deutsche Bank, which along with Credit Suisse distanced themselves from less-innovative firms earlier this year when they issued ETN/ETF structures that allow an investor to invest in a long-breakeven position, has created a tradeable index that proxies core inflation.

Now, it isn’t any mystery that you can create core inflation by taking headline inflation and stripping out energy (and, if you feel like torturing yourself with tiny futures positions, food) – for example, I presented a chart of ‘implied core inflation’ in the article linked here -  so the DB product doesn’t break any new theoretical ground. But it is a huge leap forward in that it allows more market participants to trade in a direct way something that acts like core inflation.

Why would an investor care about core inflation? Is it because he “doesn’t care about buying gasoline and food”? No, an investor may wish to buy a core-inflation-linked bond for the same reason that a Fed governor wants to focus on core even though all prices matter: core inflation moves around less in the short run, but in the long run core and headline inflation move together. The chart below (Source: Bloomberg) shows the core CPI price index, and the headline CPI price index, normalized so that they were both 100 on December 31, 1979. Since then, prices have tripled, whether you are looking at headline or core. The difference in the compounded inflation rate? Core inflation has risen at a 3.471% inflation rate, while headline inflation has grown at 3.415%.

This is why central bankers want to focus on core – headline provides lots of noise but almost no signal. And it’s the same reason that investors should prefer bonds linked to core inflation: you get virtually all of the long-term protection against inflation that you do with headline-inflation-linked bonds (like TIPS), but with much lower short-term volatility.

Now, Deutsche’s index isn’t truly core inflation, but a proxy thereof. It appears to be a decent proxy, but it is still a proxy (and we have some more theoretical/quantitative critiques that are beyond the scope of this column). And their product is a swap, not a bond (although it would not surprise me to see bonds linked to this index in the very near future). So it isn’t perfect – but it is a huge step forward, and Deutsche Bank (and Allan Levin, the guy there who has the vision) deserves praise for actually innovating. Innovation tends to happen on the buy side, and with smaller firms, not with big sell-side institutions, and we should cheer it when we see it.

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Now, back to actual markets: tomorrow, the ECB is expected to announce a new program of buying periphery bonds when necessary. Actually, it is a bit more than expectation, since the plan was leaked today. Supposedly, the ECB will announce that they are going to do “unlimited, sterilized bond buying” of securities three years and less in maturity.

The Euro was somewhat buoyed by this news. The idea is that big bond purchases will bring down sovereign yields, but sterilization of the purchases will mean that it isn’t truly monetization and therefore not inflationary.

This seems ridiculous to me. I am not surprised at the idea that the ECB would conduct large purchases of bonds that no one else seems to want; they did quite a bit of that with Greece, after all. But I’ve lost track – are they still sterilizing the billions in bonds that they’ve already bought, as well as the two LTRO operations which they claimed to sterilize, but never explicitly did except through the expedient of paying interest on reserves to sop up the liquidity?

How are they going to sterilize more purchases? There are basically three straightforward ways for a central bank to remove liquidity from the market. We used to think that there were only two, because the only ways the central bank ever did it was to (a) conduct large reverse-repurchase operations in which the central bank lent bonds and borrowed cash, taking the cash temporarily out of the economy and (b) to sell bonds outright, to make a permanent reduction in reserves. Now we recognize a third option, although we’re not sure how efficacious it is: (c) raising the interest rate on deposits of excess reserves at the central bank, so as to discourage the multiplication of those reserves.

But for the ECB’s purchases to be effective in terms of their size, they will be far too large to use reverse-repos as a sterilization method; and it doesn’t seem to make much sense to be selling bonds when they’re buying other bonds, unless they want to try and push up the yields of countries like the Netherlands and Germany (which might not be politically too astute) at the same time that they’re lowering the yields of Spain and Portugal. And they just cut the deposit rate to zero in July…are they going to raise it again?

I can understand the political cleverness of such an announcement, if the ECB makes it: make the bond buys “unlimited” to suggest that they can’t be outmuscled, but also sterilized so it’s not printing. But these can’t both be true – because there is not unlimited capacity for sterilization.

That plan can only work if, in fact, the ECB doesn’t actually buy many bonds. In the past, they’ve tried to trick the market into rallying with “bazooka-like” comments so that they didn’t actually have to do anything. To date, it has never worked. I doubt this will, either.

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Back in the U.S., the wave of Employment data is about to hit. Tomorrow morning, Initial Claims (Consensus: 370k) will be released; about Claims the only thing I want to note is that while it is down considerably from the peak of the most-recent recession, it is only slightly below where it was at the peak of the last recession. Over the last 52 weeks, Claims have averaged 381k; in May of 2002 that average reached 419k. Also due out tomorrow is the ADP report (Consensus: 140k), which is expected to weaken slightly from last month’s figure. On Friday, of course, the Payrolls report is expected to show a rise of 127k new jobs with the Unemployment Rate steady at 8.3%.

Some observers have made a lot of the fact that the Citigroup Economic Surprise index has risen from -65 or so in July to nearly flat now. But this is not a sign of improving economic conditions; it is a sign of improving economic forecasts. Remember that this index doesn’t capture absolute levels, but the degree to which economists are missing. The current level is near flat because economists adapted their forecasts to the weak data, not because the data improved to catch up with the over-optimistic forecasts. I wouldn’t draw much relief from that indicator.

Now, with the ECB and the Fed on the calendar over the next week, markets may well get some relief. But the economy, not so much, even if we do deserve it.

Inflation: As ‘Contained’ As An Arrow From A Bow

February 17, 2012 5 comments

Is 15 months in a row of rising core inflation ‘contained?’

Year-on-year core CPI has now risen for 15 consecutive months. At some point, it will seem reasonable to let it have a month off, but until now it hasn’t needed it. Fifteen months in a row. That’s impressive. It’s so impressive, in fact, that it hasn’t happened since 1973-1974, when prices were catching up from the failed experiment of price controls imposed by President Nixon in 1971-73. Core inflation has never, in the history of the data (which exists since 1957), accelerated for 16 consecutive months. So, next month we have a chance for a record!

Headline inflation was softer-than-expected by 0.1%, even as the NSA CPI index itself came in higher-than-expected. As I pointed out yesterday,  that was a semi-predictable consequence of the change to new seasonal adjustment factors. Core inflation was 0.218% month-on-month, however, which actually generated a rise in the rounded year-on-year index to 2.3% (2.277% to three decimal places). The table below shows the evolution of the year-on-year changes for the eight major subgroups from 6 months ago to 3 months ago to last month, to now.

Weights y/y change prev y/y change 3m y/y chg 6m y/y chg
 All items

100.0%

2.925%

2.962%

3.525%

3.629%

  Food and beverages

15.0%

4.212%

4.452%

4.470%

4.001%

  Housing

40.2%

1.876%

1.874%

1.869%

1.453%

  Apparel

3.5%

4.664%

4.573%

4.194%

3.056%

  Transportation

16.5%

4.961%

5.197%

9.185%

11.980%

  Medical care

6.9%

3.605%

3.491%

3.116%

3.199%

  Recreation

5.9%

1.372%

1.027%

0.253%

-0.173%

  Education and communication

6.7%

1.838%

1.670%

1.371%

0.982%

  Other goods and services

5.3%

1.740%

1.701%

1.660%

0.847%

Compared to last month, Apparel, Medical Care, Recreation, and Education/Communication accelerated, groups which total 23% of the consumption basket. Transportation and Food & Beverages both decelerated, and they total 31.5% of the basket. Now, notice that Transportation and Food & Beverages are the two groups that are most affected by direct commodity costs – energy and food, respectively. So…don’t get too excited by the deceleration there, although new and used motor vehicles and other components of Transportation also decelerated and that doesn’t have much to do with energy prices. In Food & Beverages, “Food at home” is decelerating (about 57% of the Food & beverages category) while “Food away from home” and “Alcoholic beverages” (the balance of the category) are accelerating.

Yes, you can get eyestrain looking too closely at these figures, but doing so does help.

For example, one theme I think the Fed is counting on is that the “Housing” component of CPI is expected to decelerate due to the still-high inventory of unsold homes and the fact that foreclosure sales can now proceed. It has been a conundrum why rents have been rising while home prices stagnate (actually, not much of a conundrum: there is an underlying inflation dynamic that in the case of the housing-asset market is being overwhelmed by a decline in multiples. But this is a conundrum to the Fed, and to be fair I also expected Housing inflation to be lower than it has been recently). And in this month’s data, you can see that the year-on-year increase in Housing CPI flattened out. But, as the table below shows, the Shelter component wasn’t what flattened out. Housing only went sideways because the “Fuels and Utilities” component declined – again, a commodity effect.

Weights y/y change prev y/y change 3m y/y chg 6m y/y chg
  Housing

40.2%

1.876%

1.874%

1.869%

1.453%

   Shelter

30.92%

1.983%

1.905%

1.792%

1.399%

   Fuels and utilities

5.27%

1.941%

2.432%

3.483%

3.201%

   Household furnishings and operations

4.03%

1.035%

1.000%

0.561%

-0.224%

I still expect Housing inflation to level out and probably to decline, but so far those expectations have been dashed. It will be uncomfortable for the Fed if it remains this way; a significant part of their expectations for a visually-contained core inflation number is (mathematically) due to the expectation that housing inflation isn’t going to keep rising. As you can see in the chart below (Source: Enduring Investments http://www.enduringinvestments.com), the rest of core inflation outside of Shelter is continuing to rise. Inflation is not ‘contained’, except maybe for housing. Maybe.

I am fairly confident, though, that if Housing inflation does not decelerate as expected, then the Fed will find some other reason to ignore the very clear acceleration in inflation. The economists at the FRB are for the most part true believers in the notion that the output gap constrains any possible acceleration in inflation, despite ample evidence that output gaps don’t matter (or, anyway, matter far less than monetary variables). For another view of this proposition, see the Chart below, taken from this article by economist John Cochrane.

Fed economists also feel strongly that “well-anchored inflation expectations” means that they can ignore 15-month trends in core inflation, despite the fact that by Chairman Bernanke’s own admission we aren’t really very good at measuring inflation expectations (to be kind).

They have time. The Fed has recently begun to treat 2% (on core PCE, not core CPI) as more of a floor than a target, so it will be some months, even if core inflation doesn’t pause for a month or two pretty soon, before the Committee starts getting at all warm under the collar about inflation. Even then, they are extremely unlikely to take steps to reduce liquidity while Unemployment remains high. The Fed is in a political bind, and the only easy path for them is to “see no evil” on inflation while hoping that Unemployment drops swiftly enough for them to act before prices really get out of hand. We will see.

The Inflation Trend Is Not Yet “Tamed”

December 16, 2011 11 comments

Inflation Unlikely to Be a Cause for Concern,”  expressed the Wall Street Journal today. “The cost of oil, metals, and grains would have to jump another 20% to 30% in coming months [my note: actually, just oil] to trigger a repeat run-up in consumer prices next year. Absent that, headline inflation rates are poised to weaken.”

U.S. Consumer Prices Stagnate as Fuel Costs Show Inflation Tamed”  said the headline on Bloomberg.

Why the sudden emphasis on headline inflation, now that it’s converging back to core? Why are pundits abruptly myopically focused on fuel, which is 9.1% of the consumption basket (although a good part of its volatility)? I would suggest that this spin on the headline derives from the fact that economic prognosticators have been saying for some time that the slow global growth will keep inflation contained, and so they are beginning to obsess about the parts of the price index that appear contained even if they are not the important parts of the index.

Meanwhile, core inflation rose +0.173%, bumping the year/year rise in core inflation to 2.153%. Both were above expectations. Look at the chart of core inflation, below, and objectively try and decide if that looks like a “tamed” inflation trend. To me, it looks like a trending trend.

Tame? Only if you're already assuming the trend stops.

The last time year/year core inflation was 2.2% was in October 2008. It took exactly 2 years to decelerate to a low of 0.6% in October 2010. It took 13 months to return to the level. And as the chart makes clear, it has been a straight shot. Year-on-year core inflation has not fallen in a single month since October 2008.

It isn’t as if this rise is being caused by wages, or by medical care, or by fuel. While the second story below takes pains to blame it on “higher medical care and clothing costs”, in fact most of the basket is accelerating. The table below shows the eight major subgroups.

Weights y/y change prev y/y change 1y ago y/y change
 All items

100.0%

3.394%

3.525%

1.143%

  Food and beverages

14.8%

4.373%

4.470%

1.496%

  Housing

41.5%

1.918%

1.869%

0.010%

  Apparel

3.6%

4.763%

4.194%

-0.790%

  Transportation

17.3%

8.024%

9.185%

3.750%

  Medical care

6.6%

3.370%

3.116%

3.184%

  Recreation

6.3%

0.348%

0.253%

-0.862%

  Education and communication

6.4%

1.418%

1.371%

1.590%

  Other goods and services

3.5%

1.858%

1.660%

1.840%

 

From last month, acceleration in the year-on-year rate happened in Housing, Apparel, Medical Care, Recreation, Education & Communication, and Other, totaling 67.9% of the basket, while Food & Beverages and Transportation (mostly due to energy), 32.1% of the basket combined, decelerated. And, from 6 months ago (shown below), every major group has accelerated its year-on-year trend except Transportation (again, because of energy prices) even though the headline inflation rate itself has fallen.

Weights y/y change 6m ago y/y chg
 All items

100.0%

3.394%

3.569%

  Food and beverages

14.8%

4.373%

3.363%

  Housing

41.5%

1.918%

1.159%

  Apparel

3.6%

4.763%

1.045%

  Transportation

17.3%

8.024%

13.098%

  Medical care

6.6%

3.370%

2.995%

  Recreation

6.3%

0.348%

-0.022%

  Education and communication

6.4%

1.418%

1.029%

  Other goods and services

3.5%

1.858%

1.517%

This bears repeating. There has been a 5% fall in the year-on-year rate of inflation in 17.3% of the basket. That causes an 0.88% drag on the headline number. But the headline number only dropped from 3.569% to 3.394%, because every other major group accelerated.

You can call that “tamed” if you want to. I will say that it is surprising our models, which a year ago only expected core inflation to be in the 1.6%-1.8% at year-end 2011. Housing inflation in particular has remained surprisingly high despite inventories which should be pressuring rents and home prices. And yet, prices are rising. There is just no sign of deceleration in core inflation at this point, although core inflation ex-housing rose only to 2.37% and will probably only be around 2.6% by year-end, a trifle lower than we were expecting two months ago.

This is not a growth story. While economic data on Thursday was better-than-expected, with another eyebrow-raising decline in Initial Claims and better-than-expected readings from Empire Manufacturing and Philly Fed, recovery today (such as it is) doesn’t affect inflation today. Inflation, if it responds to growth at all, is supposed to respond with a lag. So that’s not what is happening here.

The best candidate continues to be money and lending. M2 on Thursday night bounded ahead again, pushing the 52-week change up to +9.6%, and the 52-week rise in Commercial Bank Credit reached 2.5% for the first time since November 2008. The chart below shows both the rise in Commercial Bank Credit and the contemporaneous rise in CPI for the last few years. CPI seems to respond to changes in credit with a 6-12-month lag.

Commercial Bank Credit vs Core CPI - related, or at least both related to a third thing.

Well, I am not saying these things are necessarily causally related because if we trace this back to the early 1980s the fit is less persuasive, but I suspect there is a causal link which becomes more apparent when other factors are muted. It certainly fits with theory that money and lending should impact prices.

Assessing all of the data, I cannot see how a neutral observer can look at current price trends as being “tame” or “stagnated,” and I can easily see how inflation might become a cause for concern…even if it isn’t already.

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