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A Bad Day At The Federal Reserve

February 21, 2013 9 comments

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

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

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

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

apparel

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

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

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

numafs

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

sheltervsinvent

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

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

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

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

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

 

Taking the Market’s Temperature

Forget for a moment, if you can, the European drama – the falling of the Dutch government, the possible imminent failure of the French one, and the ongoing heated argument about whether Europe can stand austerity (and whether that means austerity for all, or just for the periphery). If you want to take the temperature of the U.S. market, we have other tests worth considering.

It was revealed yesterday that Wal-Mart is the subject of a U.S. criminal corruption probe by the U.S. Justice Department, resulting from allegations of bribery in its Mexican unit Wal-Mart de Mexico. The company had already announced an internal investigation, but a criminal inquiry is another matter. This is potentially a good test for the equity market. A bull market tends to shrug these things off; a bear market tends to accentuate them. On Friday, Wal-Mart fell $2.91 (4.7%); on Monday it dropped another $1.77 (3%). The early returns are that the market isn’t taking it well.

The other proximate test is the earnings report for Apple, released today after the close. Apple reported great second-quarter numbers, handily beating estimates, but harshly revised its forward outlook lower. In bull markets, investors will focus on the current beat and speculate happily about how easy it will be to beat the lowered estimates. In a bear market, investors conclude that the beat represented sales pulled forward into the current quarter, don’t therefore give the company credit for the beat, and push the price lower since the future earnings (which after all are a more important part of the current price than the current single-quarter’s earnings) are expected to be weaker. Especially with interest rates (and therefore discount rates) low, this latter effect ought to be the dominant effect, but in my experience market reaction has had more to do with investor mood than analytics. With Apple, the shareholders form a virtual cult so expect to see many columns about how great it was that the company outperformed lofty expectations – and if Apple, already 13% off its highs over the last couple of weeks, cannot quickly stage a convincing rally (for more than one day!), it is a bad sign for the market as a whole.[1]

This is one way to take a market’s temperature. In the same way the way a boxer takes a punch can reveal whether he has a glass jaw, the way a market takes a metaphorical punch (or even perceives that a punch has been thrown!) can reveal much about the underlying strength of the bid.

Whatever investor confidence is doing, consumer confidence isn’t exactly buoyant. On the other hand, today’s 69.2 print on the Consumer Confidence index also wasn’t miserable: as recently as October, the index was at 40.9. Moreover, the critical “Jobs Hard to Get” subindex showed surprising strength, declining to 37.5 (see Chart, source Bloomberg) and giving hope that the recent Payrolls gains aren’t as ephemeral as some had thought they may be. Still, as the chart also shows – we’re a long way from a robust jobs market.

On Wednesday, the Federal Reserve will meet for the second day and release their policy decision around 12:30ET. The only additional data point they will see is a Durable Goods number (Consensus: -1.7%/+0.5% ex-transportation). If the Committee was going to do something hawkish, such as reduce the “at least” time frame for the projection of low rates, the odds are certainly better after two months of pretty good (although partially weather-induced) data and with the stock market high and having risen for months. I doubt, though, that they want to upset the gentle growth they’ve recently seen, especially with tensions rising on the Continent again.

As I’ve pointed out recently, some thinkers inside the fed have begun to question the usefulness of a permanently-low rate regime and the risk of the steady rise in money, which has pushed core inflation higher in 16 of the last 17 months. But those are still peripheral thinkers, and even the hawkish-leaning policymakers seem willing to go along to get along. At the same time, I think the odds of a QE3 announcement, or even hint, at this meeting is quite small for the same reasons cited above.

Now, the members of the FOMC mostly arrived at this week’s meeting by plane, and if any of them made their own reservations they may have noticed that domestic airfares have risen quite a lot recently. At least, I had noticed, and was not surprised to find that average domestic non-premium Y-class airfares reached a record $477 per ticket last month (see Chart, source Bloomberg, Airlines Reporting Corporation).

However, much of that record is due to jet fuel, which while near the highs of the last year is still 26% below the highs of 2008. The relationship between air fares and jet fuel is actually pretty interesting. From 1990-1998 or so, the gradual rise in air fares was decoupled from the jet fuel market, which was basically flat. After that period, but especially from 2004 onward, air fares more often moved in tandem with jet fuel prices (see Chart, jet fuel prices on right axis).

This point is actually made more powerfully by the following scatter-plot of the same data. Before 1998, air fares were essentially non-responsive to jet fuel prices. Since 1998, the variation in jet fuel prices explains 75% of the variation in the CPI-Airfares series (which is several levels down in the Transportation major group of CPI). Every penny rise in jet fuel prices causes a rise in air fares of about 0.09%.

The recent rise in airfares is somewhat beyond what would be expected from the recently-placid behavior of jet fuel, which raises the possibility that the increase represents other cost pressures, increasing profitability, or the influence of a general inflationary dynamic taking hold (also known as: our customers are expecting prices to rise, and we expect energy prices to resume rising, so let’s go ahead and increase prices). Now, air fares only represent 0.75% of the CPI, so if the year-on-year rate of increase went from essentially flat as of the March CPI to +13% where it was one year ago and where the Airline Reporting Corporation data suggest it could be heading, it would only add 0.1% to headline inflation. But the ample variability of air fares tends to increase the salience of the information in our minds – which is to say that in our personal CPI calculation, we will tend to overweight the importance of air fares, like we do gasoline, because the volatility makes it noticeable, and makes it hurt more.

I doubt that it will hurt enough to turn the FOMC into a bunch of hawks, but – these also aren’t the only prices that are rising visibly.


[1] By the way, I’m not necessarily a believer in bad karma, but if you are then you should be aware that at the end of the Apple earnings call the company played a strange saccharine song called “Happy.” Read the story, and listen to the song if you must, here.

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