Shortages are Unmeasured Inflation

October 24, 2021 3 comments

Recently, I’ve been saying occasionally that “shortages are unmeasured inflation.” In some conversations I have had, it became apparent to me that people were taking this statement as being a throwaway line: “inflation is bad, shortages are bad, therefore they’re kinda the same.” But what I mean is actually more profound than that, and so I figured I would explain and illustrate, and hopefully thereby to convince.

Let’s use some charts.

What has happened since the large increase in federal spending and transfer payments were implemented in several waves since the shutdown began is that demand in many product markets has shifted outward. This implies that output “Q” moves from c to d while the price level “P” moves from a to b. [1]

So a strong increase in demand causes an increase in the quantity exchanged at the new equilibrium, and an increase in the price of the good or service at that equilibrium. This is the nice, smooth, continuous markets, instantaneous-adjustment picture from Econ 101. It’s also not the way the real world works, especially with large shifts in demand.

If price only adjusts partially, maybe if “anchored inflation expectations” or a fear of being accused of gouging restrained vendors from raising prices enough to ration the available supply, then a shortage results. This is the same thing which occurs classically if a price cap is instituted from the outside. Now price moves up from a only to b’, but the quantity demanded at that price is at d’. Thus, the bracket on the chart below shows the size of the shortage at that price, where consumers want d’ but suppliers can’t/won’t provide that much.

Note that this shortage is a direct substitute for the increase in price that would otherwise happen if prices could instantly and fully adjust. Moreover, the picture is somewhat worse in the short-term because the supply curve – in the short-term – is much more inelastic at some point (because, for example, no matter how high the price gets we can’t deliver more used cars in the short run). So, in the picture below the short-run supply curve in blue implies that the large increase in demand pushes prices to b’ with output only at d’, until supply eventually adjusts to the long-run supply curve S(lr), when we end up in the new market-clearing equilibrium.

In this case, the difference between b and b’ is “transitory” inflation, caused by temporary supply constraints. But note that in this picture, there is no perceived shortage. The market clears at b’ and d’. In other words, the conditions leading to the “transitory” increase inflation are not the same ones leading to the shortages.

We can combine these; if in the last picture above vendors also constrain prices to b, then there is a shortage as the quantity demanded stays up at d rather than at the market-clearing level d’. But, again, in that instance the shortage reflects the fact that prices should have adjusted to b’ but did not. Also in that case, it would be inaccurate to claim that the inflation was transitory, since prices should remain at b even when the supply eventually adjusts to the long-run equilibrium. It would be the shortage that was transitory.

In theory, if we knew the shapes of the curves of supply and demand for each product market, we could estimate how much higher prices would be at equilibrium and therefore how much additional inflation the shortage implies. We could directly translate the shortages to an “equilibrium” price level and therefore inflation. It strikes me as plausible that we could develop a rough estimate of such a number, but I leave that to the PhD candidates looking for dissertation topics. In the meantime, just remember that with inflation over 5% presently and shortly headed above 6%…the inflation rate is understated, and we know that because there are lots of shortages.


[1] If the deficits, funded by Fed purchases of Treasuries, had just offset the loss in incomes due to the shutdown – perfectly, across all individual markets – then there would have been no demand shift and no net change in output or prices. And if the deficits had not been accompanied by an increase in the Fed balance sheet, then it would have been individuals buying the bonds and so the only effect would have been because the marginal propensity to consume of the people receiving transfer payments is higher than the marginal propensity to consumer of the people buying the bond issuance. But in this column I’m trying not to muddy the discussion with the argument of whether we need both fiscal and monetary stimulus to cause inflation. I’m just focused on the narrow question of what it means when I say “shortages are unmeasured inflation.”

Summary of My Post-CPI Tweets (September 2021)

October 13, 2021 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • Here we are, #CPI Day again – where did that month go!? – And everyone is gathered around for the number. So many interested people! So many experts on inflation suddenly!
  • Last night, @TuckerCarlson led his show with a monologue re inflation. And he got it basically right, which is unusual for nonfinancial media. But the point is, “transitory” inflation is now important enough to get the lead on one of the biggest cable opinion shows in the world.
  • Which of course is why there are so many experts suddenly. Demand creates its own supply. But I am not complaining. There’s only one Inflation Guy and he has his own podcast https://inflationguy.podbean.com and app (in your app/play store)! [Editor’s Note: See the last bullet]
  • More importantly some regional Fed folks are starting to sound queasy. Atlanta Fed’s Bostic and St. Louis Fed President Bullard. The NY Times! The Wall Street Journal! The Poughkeepsie News-Gazette! Made up that last one but it’s everywhere.
  • Not the Chairman though, and not the Treasury Secretary, both of whom want the same thing: more money. Who was it? In the Volunteers with Tom Hanks I think: Mo money means mo power.
  • Meanwhile 1y and 3y expectations in the Consumer Expectations Survey are at all time highs since the inception of the survey in 2013. Which of course is why Carlson is leading with it. Consumers are noticing.
  • Are they only noticing because of used cars? Seems unlikely. They’re noticing broader pressures, which we are starting to see and still will be watching for in this report.
  • Speaking of used cars…while the rate of change might come down on some of these spikes, there’s no sign the LEVEL is retracing. See latest Black Book survey. “Holding steady” around 30% y/y. But that’s down from 50% in May.
  • Consumers are also noticing shortages, which is unmeasured inflation. If you put a price cap below equilibrium, you get shortages. And if you get shortages, you can presume the equilibrium price is higher. Repeat: Shortages are Unmeasured Inflation
  • Now, there’s good news. Delays at China ports are down. Although some of this is seasonal and some is due to the fact that…all the ships are sitting in OUR ports. But there is SOME good news anyway. Had to search for it.
  • Question going forward is how much of the pressure on suppliers gets passed through. It will be more (a) the longer it lasts, and (b) the more suppliers see others passing along costs. And profit season is about to start, where we will hear some of those answers.
  • In this CPI report today: the Street is expecting a very tame +0.2% on core, after a soft +0.1% last month. That seems very, very optimistic to me. If we get +0.27%, the y/y core rate will uptick to 4.1%.
  • And AFTER this, the comps are terribly easy so core inflation will be moving higher almost certainly for the next 5 months. The total for those 5 months in 2020 was +0.43% on core. The TOTAL.
  • So, core will be moving back towards 5%, even if the monthly figures settle in only at 0.2% per month. I’m not very optimistic that’s going to happen. But the Street is!!
  • We will be watching the usual ‘reopening’ items of course, but also watching RENTS and the breadth of this figure. And let’s not ignore food although not in the core – it’s one thing that consumers notice more than other things when it’s persistent.
  • I expect Rents to continue to move higher. So looking for that. And watching Median CPI, which set a new multi-year high month/month last month. It’s at 2.42% y/y and will be higher this month.
  • I’d also look at some of the “re-closing” categories that dragged down core CPI last month to reverse. Again, not a lot of sign that most prices are declining, even if rates of change are slowing.
  • Good luck out there. 5 minutes to the figure.

  • The economists nailed it! Well, mostly. Core was +0.24%, so at the upper end of the forecast range before rounding up. Y/Y went to 4.04%, also just barely not rounded up. But been a while since we were worried about rounding. Let’s look at the breakdown though.
  • Airfares plunged again, another -6.4% m/m. That’s going to change soon if vaccine mandates provoke more labor shortages there. But it does appear, from my own anecdotal observation, that airfares have been actually declining.
  • Lodging Away from Home -0.56% m/m. Used cars -0.7% m/m. Car and Truck rental -2.9% m/m. So, most of the “reopening” categories are still dragging this month, what I’d thought was a one-off. I didn’t think they’d top-ticked the prices before.
  • But New cars and trucks were +1.30% m/m after 1.22% the month before. As I’ve said before, the New/Used gap that closed when Used car prices spiked can open again in two ways. Used car prices can decline (no sign of that) or New car prices can rise.
  • Now, that was your good news for the day.
  • Primary Rents were +0.45% m/m, boosting y/y to 2.43%. OER was +0.43% m/m, boosting y/y to 2.90%. Whoopsie. Totally expected. And yet, kept seeing how the eviction moratorium wasn’t really holding down rents. Hmmm.
  • Medical Care, though, remains a soft spot for reasons that I just can’t fathom. Flat m/m. Pharmaceuticals rebounded to be +0.28% this month, but Doctors’ Services fell -0.30% and Hospital Services followed a strong month with a tepid +0.11%.
  • Apparel also plunged this month, -1.12% m/m. Small category, big move. Still 3.4% y/y, which is big for clothing, but it’s weird. With ports backed up, I’ve been seeing stock-outs in a lot of sizes of the stuff I buy. Shortages are unmeasured inflation. But still.
  • Quick look at 10y breakevens has them +3bps since before the number. The rents spike has people spooked. And it should. That’s the steadiest component. All of these large moves in little categories tend to mean-revert.
  • Core goods decelerates to +7.3% y/y (yayy!). But core services accelerates to 2.9% y/y (boooo!).
  • Core CPI ex-shelter dropped to 4.66% from 4.79%. So that’s the effect of all of these small categories. Meanwhile, rents boomed. And core-ex-rent at 4.66% isn’t exactly soothing.
  • Chart of core ex-shelter, and shelter. In the middle, you get core at 4%. If you want core to get back to 2%, you need core-ex to really plunge because shelter isn’t about to reverse lower.
  • Speaking of shelter, I hate to say I told you so but…and we have a long way to go.
  • Now let’s look at tuitions. Since we are in the Sept/Oct period, we’re going to find the new level of tuitions, which will be smoothed out over the next year with seasonals. This month, the NSA jumped 0.56%, and the y/y rose to 1.73% from 1.20%.
  • Tuitions aren’t going to jump a ton this year, but in 2022 I expect them to take a bump – partly to reclaim colleges’ purchasing power and partly because the product will be better next year.
  • Sorry, error. That was for the Education and Communication broad category. College Tuition and fees rose 0.96% m/m (NSA), and to 1.72% y/y from 0.83% y/y. Sorry.
  • Other goods. Appliances +1.55% m/m. Furniture and Bedding +2.35% m/m. Motor vehicle parts and equipment +0.85% m/m. Medical equipment and supplies +0.96% m/m. So doctors? Not so much. EKG machine? Syringe? Give me your credit card.
  • Breakevens dropping back. That’s profit-taking on the pop. They’re going to keep going up I think.
  • Biggest core m/m declines annualized: Public Transportation (-46%), Car/Truck Rental (-30%), Womens/Girls Apparel (-28%), Jewelry & Watches (-18%), Misc Personal Goods (-13%).
  • Biggest core annualized m/m increases: Motor Vehicle Insurance (+28%), New Vehicles (+17%), Household Furnishings/Ops (+13%), Motor Vehicle Parts/Equip (+11%), Infants’/Toddlers’ Apparel (+11%).
  • I said pay attention to food, which is what people notice. Overall Food & Beverages was +0.87% m/m. Some big movers: Meats Poultry Fish Eggs (+29% annualized), Other food @ home (15%), Cereals/baking products (13%).
  • Oh my. Median. My early estimate, which I hope is wrong, is +0.45% m/m. If I’m right that would be the highest in 30 years. On MEDIAN. Not meaningfully higher than that m/m since 1982.
  • If that’s right, the y/y would be 2.78%. Still short of the 2019 highs, but not for long.
  • That median calculation tells me I need to look at the diffusion and distribution charts. Which will take a couple of minutes to calculate. Please hold.
  • While we are waiting for the diffusion stuff, here are the four-pieces charts.
  • Piece 1: Food & Energy. The most volatile, but recently it’s just been up. And this is the part that people notice. Normally ignored because it mean-reverts. But it’s hard to get near-term bearish on energy or food, especially as the latter involves lots of pkging and transport.
  • Core goods. Coming off the boil because of Used Cars. Staying as high as it is because of New Cars and other durables. Sort of concerning it isn’t dropping faster.
  • Core services less rent of shelter. The one encouraging piece although it relies heavily on medical. Service providers not yet passing through wage increases so much. This is where the spiral would really happen, if it did.
  • Piece 4, and the news of the day. Rent of Shelter is now shooting higher, after being held down by the eviction moratorium and lack of mobility. This will set multi-decade highs over the next year, and as the slowest piece makes “transitory” much harder to believe.
  • The Enduring Investments Inflation Diffusion Index. Not that you need this chart to convince you, but price pressures are the broadest in about 15 years. And getting broader, fast.
  • So, here is the distribution of y/y price changes by base component weights. Note two things: (1) there is a long right tail, which is symptomatic of inflationary periods. Core above median. (2) The whole middle has shifted higher. This is of course largely rents.
  • So…we are getting higher inflation from the slow-moving pieces, and higher inflation from the fast-moving pieces. What’s not to like.
  • And finally, here is a chart of the weight of all components that have y/y inflation above the Fed’s target (which equates to about 2.25% on CPI, roughly). Highest in a long time. Only 1 in 5 purchase dollars is going to something inflating less than the Fed’s target.
  • So in sum…the overall 0.2% on core, which was nearly 0.3%, was the best news of the day. There is nothing in the details, distributions, or trends to make you think this is about to end.
  • Because of comps, we can be confident that y/y core and median inflation are going to accelerate for at least the next 5 months. And there’s nothing to convince me that the monthlies are going to stay nice and tame.
  • Transitory is dead. There is too much liquidity. The Fed now needs to choose whether to drain liquidity (not just taper), and live with much lower asset prices, or keep pumping asset prices “for the rich,” while we all ultimately lose in real purchasing power.
  • Powell is over a barrel, but to be fair he was also the cooper.
  • FWIW, I think the taper will happen. It will stop when one of two things happens: (1) Brainard replaces Powell or (2) Stock prices decline 15%. The Fed is fighting a war and they don’t even know it yet. They are working to keep the bread and circuses flowing.
  • That’s all for today. I will have the summary post up on https://mikeashton.wordpress.com  in an hour or less. Visit our website https://enduringinvestments.com ! Get the Inflation Guy app. Check out the podcast “Cents and Sensibility.” And stay safe out there.
  • Biden to meet with ports, labor on supply chain bottlenecks
  • I mean, this will definitely help, right? “Mister President, since you asked, we’ll clean it up.”

Biden to meet with ports, labor on supply chain bottlenecks

  • Just heard that the Inflation Guy app has been “temporarily” pulled from the Google Play store. Uh-huh. Totally normal. Waiting for the notice from Twitter that I’ve been kicked off for “spreading disinformation.”

One of the ways you can tell this is getting bad is that the people who told us this was all transitory, had nothing to do with money, and would be over soon are doing one or more things from this list:

  1. Pretending they never said it.
  2. Pretending they didn’t mean what they obviously meant.
  3. Getting angry because they were wrong and you were right.
  4. Accuse you of also being wrong because you didn’t specifically say Used Cars was going up.
  5. Trying to talk over, or squelch, the people who are bearing the bad news.

Last month, we had an 0.1% on core. But when you looked at the details, it wasn’t really soothing because it was being held down by the “COVID categories” which were falling again. You didn’t really have to squint, but you had to look below the headline. This month, we almost printed an 0.3% on core, and that was only because of those same categories (plus apparel), for the most part. You didn’t need to look hard to see the problem. Primary rents had their biggest m/m jump since 1999. OER, the biggest jump since the heart of the housing bubble in 2006. Those are big pieces, and we have a great deal of confidence that they are going to continue to rock-n-roll. After all, we have long said that rents were being restrained mainly by the eviction moratorium and would begin to normalize after the moratorium was lifted. Quod erat demonstrandum.

The trajectory of inflation is becoming clearer. The debate is no longer whether inflation is going up but how high it will get and when the peak will happen. That’s the right debate. The ancillary debate is whether the next ebb will be at 2% or something higher, like 3%. Some outliers still see the next ebb as serious deflation, but those are the same people who thought we wouldn’t see inflation when the Fed started printing money that the Treasury spent. [Note to the purists: yes, the Fed doesn’t “print” money, but it’s silly to argue that buying bonds for reserves isn’t equivalent ‘because it’s an asset swap.’ That’s just sophistry. It’s also an asset swap when I buy a refrigerator for cash, but circumstances have clearly changed for both buyer and seller when I do so. Anyway, go sell your crazy somewhere else. We’re all stocked up here.]

There is at least a sliver of good in this mess, and that’s that while investors in the main totally blew the chance to buy cheap inflation protection before this all happened (because they believed inflation was not a risk), and totally forgot that inflation affects not only asset prices but stock and bond correlations, they are re-learning these lessons from the 1970s and 1980s. And so investing hygiene will be better going forward. We have more tools to hedge inflation now than we did in the 1970s, and failing to use those tools in a healthy investment portfolio will no longer be acceptable.

And I know I don’t need to say it, but my company Enduring Investments is here to help those investors. Just like all of those other experts, except we’ve been here for longer.

Summary of My Post-CPI Tweets (August 2021)

September 14, 2021 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • Happy last- #CPI – day-of-summer! Is the transitory spike over?
  • Before we get started, a little housekeeping. Get the Inflation Guy app in your app store! And if you want to see some super-embarrassing photos of me, check out the Bloomberg Businessweek story just out today by @beth_stanton https://www.bloomberg.com/news/articles/2021-09-14/inflation-guy-michael-ashton-sees-more-on-the-way-as-investors-worry
  • The story is terrific. Beth is a fantastic journalist. But as for the pictures…I can just say, “I’m working on it.”
  • Anyway back to our story…This is the first time in months that the interbank CPI market has been at or slightly below the economist consensus estimate for headline inflation. (Pretty close though.) Previously, the interbank market was generally higher, and more accurate.
  • The last five actual prints on core CPI are +0.34%, +0.92%, +0.74%, +0.88%, and 0.33%. The consensus for today is a lowish 0.3% (something like 0.27%).
  • So economists – and the inflation market – are pricing in at least a LITTLE ‘transitory’ here with core inflation coming down from the peak…although I’ll note that 0.27% annualized is 3.3%. That’s still well above the Fed’s target. Not that they care very much.
  • That sort of month/month core CPI print today would see y/y drop to 4.2% from 4.3%, since last year we got +0.35% in August. Transitory! Yay! We win! Except that celebration will be short-lived.
  • The next 6 months of core range from +0.03% to 0.19% m/m. Very easy comps. So unless something weird happens, core inflation is going to be higher in 6 months than it is today.
  • I think there’s a little upside risk to the number today, partly because expectations are so tame. Used cars, which are past the y/y peak, still rose in price last month according to Black Book. So that would be a surprise.
  • However, that would distract from the more important issue this month and going forward: with the eviction moratorium lifted in many parts of the country, how fast do those units turn over at much higher rents?
  • I don’t really think that will be a big effect THIS month – too soon – but it will become increasingly important going forward. I’d even say it is THE story going forward in terms of how high core CPI will get in this ‘transitory’ bump.
  • OER and Primary Rents have started to see a little bump higher, although they were softer last month than in the prior month. I’m trying not to be obsessed with the wiggles. Anyway the lows are long past for rents.
  • Let’s be real: just as people waved away Used Cars as a “reopening category” or “idiosyncratic,” they’ll say the same with housing. “One time effect!” they’ll say.
  • But what will be harder to explain away will be inflation’s BREADTH. Our diffusion index is the highest in years, because it’s not JUST the reopening categories.
  • So be careful of all the “ex-cars” and “ex-reopening categories” metrics. They did that in the 1970s too. An increase in the number of anecdotes is what inflation IS, after all. Go listen to my “Diamond Water Paradox” podcast. https://InflationGuy.podbean.com/e/ep-2-diamondwater-paradox/
  • The PPI is telling us that the upstream pressures on materials, shipping containers, wages, etc are strong, and those pressures are broad. Yes, a lot of em are pressures on goods and not services. But it’s much more dangerous than hotel prices just catching up to the prior drop.
  • The next question people will ask: “Does this print mean the Fed taper is on?” And the answer is, I give a taper a 50-50 chance of starting and a 15% chance of completing. I don’t think the FOMC will be able to stomach the market correction.
  • So buy dips in breakevens if you see them, but I’d be more skeptical at selling nominals outright. Not sure the Fed will lock nominal rates as they did post-WWII, but they’re leaning against you.
  • And I said this last month and repeat it: Stocks probably go up either way on today’s number, because that’s what stocks do these days (until they don’t).
  • That’s all for now. My gut says a better chance for a high surprise than a low surprise today. And watch what happens to median CPI, later. Get the Inflation Guy app! Listen to the podcast! Follow the blog! https://mikeashton.wordpress.com Visit us at https://enduringinvestments.com  ! Good luck!

  • Team Transitory starts a comeback with a goal just before halftime!
  • 0.10% on core m/m, dropping the y/y to 4.0%. Not just a miss, but a big miss.
  • Used cars fell hard, -1.54% m/m. Last month I pointed out the m/m movement in the private surveys is only the same SIGN about half the time. But I fell for that this month as Black Book went up but CPI went down.
  • Lodging Away from Home -2.92% m/m. Gosh, wait a minute, look at this…
  • Are we going to have to call these the “re-closing” categories? Airfares -9.11%. Lodging AFH -2.92%. Used cars -1.54%. Car/Truck Rental -8.48%. Wow!
  • However, New Cars and Trucks – where you’re seeing the chip shortages and plant shutdowns for want of parts – was +1.22% m/m.
  • OER was +0.25% m/m, and Primary Rents put in a larger rise to +0.31% m/m. So let’s not get too excited about that miss right now…
  • Primary Rents, re-accelerating slowly. It will not be long until this is over 5%.
  • And OER. Again, these are the big pieces.
  • So core goods fell to +7.7% y/y from +8.5%, and core services fell to +2.7% from +2.9%.
  • Worth noting as the Biden Administration goes after pharmaceutical producers: CPI for Medicinal Drugs remains in deflation. Go get ’em, Joe.
  • Core CPI ex-shelter (which means less when Shelter isn’t leading the charge) fell to 4.79% y/y. In June this was 5.81%.
  • Apparel was +0.37% m/m, keeping y/y at 4.2%. Apparel is a small category, but we import almost all of it. So it isn’t surprising to see this rising for a change (but last month it had declined). At a 3% weight in the basket though, it doesn’t dominate anything.
  • Medical care outside of pharmaceuticals was flat in Doctor’s Services (+0.01% m/m), but up big in Hospital Services (+0.85% m/m). So the overall Medical Care subindex gained despite the weakness in drugs.
  • It’ll be interesting looking at the breadth this month. Seven of the eight major subindices rose, with only Transportation declining due to the Used Cars flop. Still shaking my head at the re-closing categories.
  • College Tuition and Fees +0.88% m/m. But that doesn’t annualize the way you think it does. It always jumps in August and September and then levels out for 10 months. The y/y is up to 0.83%. This is NOT quality adjusted, or it would be lots higher.
  • So the biggest decliners in non-food-and-energy: Car/Truck Rental (-65% annualized), Public Transportation (-49% annualized), Lodging Away from Home (-30%), Motor Vehicle Insurance (-29%), Used Cars and Trucks (-17%).
  • Biggest gainers: Jewelry and Watches (+23%), Motor Vehicle Parts and Equipment (+22%), Household Furnishings and Ops (+16%), New Vehicles (+16%), Men’s and Boys’ Apparel (+13%).
  • So…here’s the thing. My early guess at Median CPI is +0.33% m/m, which would be the highest since early 2007. So folks, this isn’t as tame a number as it looks like. Rents are rising, and inflation is broadening.
  • If you took out Used Cars, Lodging Away from Home, etc when they were spiking, then to be fair you should be taking them out now when they’re declining. Because that’s most of the story here.
  • Quick chart of y/y core goods and services inflation. Core Services has a much larger weight, and much of it is rents. Core goods off the boil but has a ways to decelerate yet.
  • Let’s do the 4-pieces chart and the diffusion index then wrap up.
  • Piece 1: Food & Energy. Steady upward pressure, but of course this tends to be mean-reverting.
  • Core goods – I already basically showed this chart. Used cars starting to decelerate and pull this down, but New cars accelerating. And broad pressure elsewhere. Watch this. If it goes only back to 3%, that’s a big deal. It’s been a deflationary force for many years.
  • Core Services less Rent of Shelter. Steady downward pressure in pharma, but upward in hospital services. Downward in public transportation. But still, not collapsed yet.
  • And piece 4, rent of shelter, the biggest and slowest and the story for the next year-plus. Going lots higher.
  • Actually while the diffusion index is calculating let me start the wrap-up. First: this number was truly weird in that reopening categories that had been leading the so-called ‘transitory’ spike were the ones that went down. I don’t know that anyone was looking for that.
  • But OUTSIDE of those “re-closing” categories, inflation was pretty solid. Rents and OER rose, although we haven’t yet seen much effect of the end of the eviction moratorium. We will. And there was pretty good breadth.
  • So what does this mean for the Fed? GREAT NEWS! A larger-than-expected decline in core CPI will give the doves what they need to demur on tapering. I think the odds of tapering just dropped. But they didn’t much want to taper anyway.
  • I don’t think this really changes the narrative – rents are going to drive core inflation higher, and the broadening inflation is going to help un-anchor inflation expectations – but it gives the most dovish Fed in 40 years cover.
  • 10-year breakevens at this hour are -2.5bps or so. They’ll be a little heavy as the carry traders lighten up, but this is a dip that is worth buying IMO. Of course, there aren’t many retail products where you can make that play.
  • Here’s the last chart. I pointed out the rents thing, which will be one big story going forward. The other is the broadening of inflation. The Enduring Investments Inflation Diffusion Index declined (vy slightly) this month, but it’s still at levels rarely seen in last 20 years.
  • That’s a wrap for today. I appreciate the follows, re-tweets, and counterpoints. If you’re interested in investing implications of all of this, hit our contact form at https://www.EnduringInvestments.com  Download the Inflation Guy app. Try out the podcast! Thanks for tuning in.

The upshot of today’s figures is simple: we expected the Used Cars, Hotels, and other “COVID categories” to flatten out after their big rebound. But no one that I know was looking for them to plunge again. That’s weird, but it makes analysis pretty simple. If you thought that it made sense to look through those one-off spikes to the underlying trends before (although the underlying trends weren’t all that encouraging, they were better than the spikes!) then you ought to probably look through the re-collapse. And outside of those “re-closing” categories, inflation is broadening and rents are accelerating, just like I’ve been expecting. So don’t get too excited that we’ve seen the peak in inflation just yet.

Remember the comparisons to last year get super easy here for the next six months. September 2020 was +0.19% on core inflation; then we have +0.07%, +0.17%, +0.04%, +0.03%, and +0.10%. And Lodging Away from Home won’t plunge every month – I’ll take the “over” on all six of these. And that means y/y core inflation is going to be accelerating from today’s 4.0%, for at least the next six months.

Moreover, median inflation is going go be rising towards those numbers too, as will trimmed-mean and the other better measures of the inflation distribution’s central tendency. There’s not much in this figure that is bona fide good news for the Fed. But I think they’ll take the win anyway, even if it’s on a bad call by the referee.

When Over-Ordering is More Than Hoarding

September 8, 2021 1 comment

It is a lament I have heard recently from the manufacturing/supply side, but also an excuse I’ve heard from some of the economist ranks for why “this supply chain issue will all get sorted out; people are just going crazy.” In this column I want to explain why “overordering” is not only perfectly rational but actually demanded by some typical operational procedures.

The complaint is “our customers are not only ordering what they used to order, but they’re ordering far more than they used to. Basically, they’re hoarding and we have had to ration our product and only partially fill orders/only fill them for our top customers.” Now, hoarding is a real thing, but moreso for consumers than in B2B. There are, though, some serious reasons (by which I mean, ‘reasons that are held by serious people’) why it makes sense to increase orders at a time like this. And it’s not because you are assuming you’ll get 50% fill rates on your orders, so you order double in the hopes that you’ll get the actual amount you want. That’s an “unserious” reason.

One of the reasons I have written about before. Back in January, I wrote an article called “The Optionality of Inventories,” in which I predicted the companies would move away from lean inventory models because inventory serves as an option against bad things happening: if bad things don’t happen, you’ve paid a little more for your inventory; if bad things happen, you have a large gain (loss averted) because you had a cushion. That article is worth a quick read. I also point out that, as inflation increases, there is a financial incentive to hold larger inventories because the inventories themselves are increasing in value. To the extent that more firms are recognizing the option value of inventory, it makes total sense that the demand gets fiercer the closer to raw materials you get. The entire supply chain needs to hold more inventories.

But there’s another “serious” reason that is related to the length of the supply chain itself. “Fred, last year you only ordered 1,000 units. This year you ordered 2,000 units! I know your business hasn’t doubled. Why are you doing that?” Fred might well be doing this because lead times are increasing, and that mathematically increases his reorder point and quantity.

Reorder quantity mathematics, at the simplest level, is just “number of days of lead time” times “average use per day,” and you reorder when inventory declines below that number plus some “safety stock” which is essentially a fudge factor. So, if we are using one ton of flour per day, and it takes us a week to get flour, then we need to reorder whenever we get down to seven tons of flour (call it 8, just in case. That extra one is the ‘safety stock.’) And, when we reorder, we reorder at least seven tons of flour since by the time that order arrives, we’ll be down to one ton of flour. But if the lead time now stretches to two weeks, we are suddenly ordering 14 tons of flour even if our usage didn’t change.

That simple model works for very regular inventory usage patterns, but in many applications the quantity used (or demanded, if we are talking about holding finished goods inventories) is variable. In that case, the reorder point and quantity also depends on the variance in the order flow. Again, inventories are like options, and so the sophisticated way to think about the safety stock is the option value where the stock-out (you run out of inventory) is the strike price. If you want to never lose on that bet, you have to have a high option price (safety stock); moreover, the higher is volatility, the higher is the level of inventory required to maintain a given ‘acceptable’ level of stock outs.[1]

How does 2021 compare to 2019, the last time manufacturers faced “normal” order patterns that they are now seeing customers exceed? Well, there have been substantial increase in lead times, and substantial increases in every kind of volatility you can imagine. Lead times across the globe have increased probably 30-50% at least, and that means that required inventory needs to increase 30-50% at a minimum, plus more because volatility has increased.

So that customer who is ordering a lot more right now than they historically have is not doing it to “hoard.” They’re probably doing it just to manage inventory properly. Of course, that puts more pressure on the supply chain, and increases lead times further. It represents a one-time increase in GDP, as intended inventory accumulation adds to output in the period it is accumulated, and that pressure also boosts price pressure. And ‘round and ‘round we go.

And all of this, we should take pains to remember, started when governments decided to use cardiac paddles to resuscitate a patient they’d actively tried to kill, and central banks made sure they were hooked up to a strong current to do so. The fact that the body economic is convulsing should not be a surprise to anyone. The question is whether we can sue for malpractice.


[1] The only way to guarantee that you’ll never run out of inventory, if there’s any variance in the demand for the inventory, is to hold massive amounts of inventory. So in practice you have to pick an acceptable stock-out frequency, which enters into the calculation.

Are Home Prices Too High?

September 2, 2021 2 comments

There is an advantage to squatting in the same niche of the market for years, even decades. And that is that your brain will sometimes make connections on its own – connections that would not have occurred to your conscious mind, even if you were studying a particular question in what you thought was depth.

A case in point: yesterday I was re-writing an old piece I had on the value of real estate as a hedge, to make it a permanent page on my blog and a “How-To” on the Inflation Guy app. At one point, I’m illustrating how a homeowner might look at the “breakeven inflation” of homeownership, and my brain asked “I wonder how this has changed over time?”

So, I went back in the Shiller dataset and I calculated it. To save you time reading the other article, the basic notion is that a homeowner breaks even when the value of the home rises enough to cover the after-tax cost of interest, property taxes, and insurance. In what follows, I ignore taxes and insurance because those vary tremendously by locality, while interest does not. But you can assume that the “breakeven inflation” line for housing ought to be at least a little higher. In the chart below, I calculate the breakeven inflation assuming that mortgage rates are roughly equal to the long Treasury rate (which isn’t an awful assumption if there’s some upward slope to the yield curve, since the duration of a 30-year mortgage is a lot less than the duration of a 30-year Treasury), that a homeowner finances 80% of the purchase, pays taxes at the top marginal rate, and can fully deduct the amount of mortgage interest. I have a time series of the top marginal rate, but don’t have a good series for “normal down payment,” so this illustration could be more accurate if someone had those data. The series for inflation-linked bonds is the Enduring Investments imputed real yield series prior to 1997 (discussed in more detail here, but better and more realistic than other real yield research series). Here then are the breakeven inflation rates for bonds and homes.

It makes perfect sense that these should look similar. In both cases, the long bond rate plays an important role, because in both cases you are “borrowing” at the fixed rate to invest in something inflation-sensitive.

The intuition behind the relationship between the two lines makes sense as well. Prior to the administration of Ronald Wilson Reagan, the top income tax rate was 70% or above. Consequently, the value of the tax sheltering aspect of the mortgage interest made it much easier to break even on the housing investment than to invest in inflation bonds (had they existed). That’s why the red line is so much lower than the blue line, prior to 1982 (when the top marginal rate was cut to 50%) and why the lines converged further in 1986 or so (the top marginal rate dropped to 39% in 1987). The red line even moves above the blue line, indicating that it was becoming harder to break even owning a home, when the top rate dropped to 28%-31% for 1988-1992. Pretty cool, huh?

Now, this just looks at the amount of (housing) inflation of the purchase price of the home needed to break even. But the probability of realizing that level of housing inflation depends, of course, on (a) the overall level of inflation itself and (b) the level of home prices relative to some notion of fair value. This is similar to the way we look at probable equity returns: what earnings or dividends do we expect to receive (which is related to nominal economic growth), and what is the starting valuation level of equities (since we expect multiples to mean-revert over time). That brings me back to a chart that I have previously found disturbing, and that’s the relationship between median household income and median home prices. For decades, the median home price was about 3.4x median household income. Leading up to the housing bubble, that ballooned to over 5x…and we are back to about 5x now.

That’s the second part of the question, then – what is the starting valuation of housing? The answer right now is, it’s quite high. So are we in another housing bubble? To answer that, let’s compare the two pictures here. In the key chart below, the red line is the home price/income line from the chart above (and plotted on the right scale) while the blue line is the difference between the breakeven inflation for housing versus breakeven inflation in the bond market.

In 2006, the breakeven values were similar but home prices were very high, which means that you were better off taking the bird-in-the-hand of inflation bonds and not buying a home at those high prices. But today, the question is much more mixed. Yes, you are paying a high price for a home today; however, you also don’t need much inflation to break even. If home prices rise 1.5% less than general inflation, you will be indifferent between owning real estate and owning an inflation bond. Which means that, unlike in 2006-7, you aren’t betting on home prices continue to outpace inflation. It’s a closer call.

I can come up with a more quantitative answer than this, but my gut feeling is that home prices are somewhat rich, but not nearly as much so as in 2006-07, and not as rich as I had previously assumed. Moreover, while a home buyer today is clearly exposed to an increase in interest rates (which doesn’t affect the cash flow of the owner, but affects the value the home has to a future buyer), a home buyer will benefit from additional “tax shelter value” if income tax rates rise (as long as mortgage interest remains tax deductible!). And folks, I don’t know if taxes are going up, but that’s the direction I’d place my bets.

The Political Temptation Posed by “Price Gouging”

The arc of explanations about the rise in inflation and the end of the disinflationary era was foreordained:

  • There’s no inflation.
  • What you’re calling inflation is just a series of one-offs.
  • This is just a ‘transitory’ phenomenon, a one-off at the broad economy level, and will soon fade.
  • “It’s actually okay.” (NY Times: Inflation Could Stay High Next Year, and That’s OK)
  • It’s greedy manufacturers and vendors that are price-gouging. Where is my pitchfork?

In the current arc, we are already easing past level 3, as “transitory” is starting to be stretched a bit to “well, not past 2022” (Former Fed Chair Ben Bernanke opined yesterday at an online event that inflation would “moderate” in 2022). And we’ve seen signs of #4, and even some #5. The blame game is heating up, and with an Administration under pressure for its handling of…well, everything…I suspect we will move sooner rather than later into the full-blown level 5, complete with price controls in some industries and possibly economy-wide. Yes, there’s a very clear lesson from history that price controls don’t work to restrain inflation, but (a) today’s politicians don’t seem to really know much history, and (b) price controls need not be about restraining inflation – for some, it’s worth the political points.

Since it’s a term we will hear more of, I thought I’d try and put a little more structure around the accusation of “price gouging.” It is an easy term to throw around, but what does it mean?

Developed economies are still mostly free markets, in that buyers and sellers are given wide latitude to negotiate on price and quantity. In certain markets, where there are limitations on competition (electric utilities being a classic example) or vast differences in negotiating power or information (health insurance?) there are limits on the terms of trade but for the most part, if you want to buy an apple from the apple vendor you can strike whatever deal suits you both. In a free market, either the buyer or the seller can choose not to transact at the proffered price; ergo, economists assume that if a transaction occurs then both buyer and seller made themselves better off or at least not worse off. Unlike many economist assumptions, this one doesn’t seem like a bad one, at least in most cases.

If the price is “too high” for the buyer, then the buyer can complain but the buyer can always choose to not transact. So there’s only two senses in which “price gouging” might mean something:

  1. The price is egregiously high because the seller knows you really have no alternative, as the buyer, other than to buy. If there is a mandate to buy insurance or lose your liberty, but no cap on the price of insurance, then the insurance provider can charge any price it wants. This is infrequent. Arguably, in the aftermath of hurricanes it might apply to building materials, but even in that case I would argue #2 below is a more-accurate sense of the word.
  2. The price is, in some sense, “unfair.”

What is “unfair?” We do, as social animals, have some innate sense of fairness. A classic result from “the ultimatum game,” where one person is endowed with money that he/she chooses unilaterally how to split with a second person who can in turn accept the split or reject it (in which case both parties get nothing) is that under experimental conditions splits that are worse than 70:30 tend to be rejected by the responding party – in other words, the respondent would rather get zero than 30%, if it feels “unfair.” It is in that context that “price-gouging” accusations could be related to “anchored” inflation expectations. If a vendor is charging a very high price, but the buyer expects price changes to be large, volatile, and generally not in the buyer’s favor, then an accusation of “price gouging” is less likely than if the buyer expects price changes to be low and random. So, it might be that accusations of price gouging simply means that the buyers have not adjusted to a new inflation/pricing paradigm, and perceive the price increases as unfair even if they are objectively fair.

If that’s the case, then the buyer is going to lose in cases where the higher prices are a result of changes in the supply/demand balance. Higher prices are how limited supply gets rationed among the buyers – it is a feature, not a bug, of the capitalist system. In the case where a surge in demand (caused by, say, massive government transfers to consumers) causes stock-outs and rising prices, then accusations of price gouging are just sour grapes. Rising prices in this case are simply normal inflation happening in an environment that has not adapted to normal inflation again. (Listen to the Inflation Guy Podcast, episode 2, where I point out that “supply chain problems” is exactly what inflation caused by too much money looks like.)

Nevertheless, where the “price gouging” accusation is code for “this feels unfair,” it is a terrific opportunity for a political lever. Politicians will feel that they can make people happy by instituting price controls, and blaming the wealthy industrialist, even though economics and history tell us that this isn’t the right answer. But it is a siren song, and I think that we are very likely to start hearing this more and more.

Once price controls are instituted, what follows is that the stock market craters (since the difference between input costs and consumer prices is some part profit), a black market develops in the restricted goods and services, and many products get impossible to acquire or rationed by a lengthening waitlist rather than by price.

Can you really control prices in the Internet age? It hardly matters. Politicians don’t really care about controlling prices after all; they merely want to appear as if they’re on the side of the voters. Bashing suppliers is one easy way to do that. I don’t think it will be long now. Keep the torches and pitchforks at the ready.

Inflation Guy Inaugural Podcast Published

August 20, 2021 4 comments

I wrote recently about the new (free!) Inflation Guy app, which you can get in your app store.

Now, there’s also a podcast for the Inflation Guy. It is called “Cents and Sensibility: The Inflation Guy Podcast,” and you can get it on PodBean here.

I’ve got a long list of topics, but I am always adding more. Follow, and let me know if you have a request/idea for a topic!

Categories: Announcements

Average Inflation or Price-Level Targeting: Where Are We Now?

One of the reasons the Federal Reserve has been slower than usual to respond to the upswing in inflation, in addition to claiming that it believes any acceleration to be ‘transitory,’ is that the FOMC cleverly changed its modus operandi a couple of years ago to focus on “average inflation targeting,” or AIT. This adjustment in policy had been debated for many years, as the Committee grew concerned that the Fed could lose credibility (ha ha) in the downward direction if it did not commit to its 2% target symmetrically. They were afraid that, if investors believed they would respond aggressively to inflation but not to disinflation, they would start to incorporate this asymmetry into their investment decisions and push the economy uncomfortably close to price stability.

Parenthetical editorial comment – the idea that the Fed needed to fight against the notion that it might be too hawkish is a head-scratcher. It is unclear how the Federal Reserve could be less dovish than it has been in practice for the last dozen years.

In any event, AIT is similar to price-level targeting, although it is more flexible in terms of the period over which the average is intended to be taken. The Fed meant to signal that it would allow a period of above-target inflation to persist, until at least the period of below-target inflation had been compensated. But again, AIT is vague about what all of this means. However, it happens to have been timely as the Fed now can evince patience with higher inflation, since there had been an extended period during which prices were “too stable.”

How are they doing?

In my recent article “CPI Forwards Show Inflation Concerns Aren’t Ebbing,” I discussed how inflation forwards could be estimated, and give a steady reading on particular points in the future. Here is what that would look like today. If we measure 2.25% target CPI growth (which is roughly 2% on PCE, given the historical spread), then from the announcement of AIT the chart below shows the actual inflation index, and what is implied about the future.

This chart would suggest that the Fed chose an inauspicious time to begin focusing on AIT, since already the undershoot from 2019 has been fully retraced and then some. Moreover, the market seems to believe that the Fed is going to have to focus on a new level, as prices will never get back down to a level implied by 2.25% from the inception of AIT.

As I said, though, the great thing about AIT (from the standpoint of a political economist) is its vagueness. If we instead take as the starting point of the average the period just after the global financial crisis, when rents were recovering at last, then you get a much more agreeable picture. Looked at this way, the market is generously giving credit to the Fed for making a perfect landing, very gradually, over the next 5-10 years.

That seems a bit too generous by half in my opinion, but the takeaway is this: even choosing an extremely long averaging period, the Fed has already used up as much slack as it had saved up. If the next year’s worth of inflation outturns deliver what I think they will deliver, then either the inflation curve is going to become increasingly inverted or the Fed will have to recognize that investors are not buying the AIT framework.


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Summary of My Post-CPI Tweets (August 2021)

August 11, 2021 1 comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! And, of course, download the Inflation Guy app from your app store!

  • Now for the walk up: We’ve now had four “high” surprises in a row from the CPI report. In each case, the market for the setting (in the interbank CPI market) has been closer than the economists’ estimate, but still too low.
  • The last four prints on CORE CPI are +0.34%, +0.92%, +0.74%, and +0.88%. The economist consensus for today is 0.4%, with the market closer to a rounded-up 0.5%.
  • (N.b. Core CPI doesn’t trade, but the headline CPI index traded at 273.1 yesterday and that implies 0.54% m/m on headline and something a little less on core)
  • If the economists are right, y/y headline will drop down to 5.3% (just barely) and core to 4.3% from 4.5%. That will be the first decline in quite a while. Unfortunately, the comparisons to last year get easier from here. For the next 7 mos, core is comping 0.14% on average.
  • So even if today we see an ebb in y/y due to base effects, I believe we still have significantly higher highs in core inflation ahead.
  • Now, on the details: we may ACTUALLY see a DECLINE in Used Cars CPI, as the Black Book Used Vehicle Retention Index, the best leading indicator of Used Car CPI, dropped 2.5% last month.
  • But before you get too excited, note that the change in the BB index m/m only has the same SIGN as the change in the used car/truck index about 50% of the time over the last decade. Lagged 1 month, it’s about 60%.
  • So better chance for a decline in used cars next month. But it’s a risk of a drag, and it hasn’t been a risk for a while. One way or the other, the BIG contributions from Used Cars are past.
  • On the other hand, there’s still other “reopening categories” such as airfares, lodging away from home, and car/truck rental that are likely to still be jumpy. And New Cars as well, though this is less obviously a ‘reopening category’ and more about supply chain.
  • Who cares about those, honestly. If that’s where the strength comes from, economists just wave their hands dismissively and say “transitory.” Where I’m focused is shelter (of course), and on BREADTH.
  • Shelter will eventually rise a lot. For a while, the eviction moratorium was holding the average-paid-rent below asking rent increases. And, with another (questionable) extension in the moratorium, that effect is still there.
  • But we have started to see some increases in Primary rents and OER anyway. The difference is just too wide. So, while the meat of that acceleration is ahead of us by some ways, I’m expecting to see it start to happen.
  • And breadth – that’s the real story to watch. Our diffusion index is the highest in years, because it’s not JUST the reopening categories (whatever you read). The scariest number would be another 0.5% on core but without contribution from reopening categories.
  • Now what’s the market impact? Interesting question. There now looks like there is a majority of Fed heads who are willing to at least talk about tapering, and a high core number will reinforce that. But the important voices on the Committee remain firmly dovish.
  • Personally I think that, faced with the decision of somewhat higher inflation vs sharply lower markets, the Fed will err on the side of somewhat higher inflation and keep hoping their models are right.
  • So buy dips in breakevens (the high tails are not priced in, anyway), but not sure I’d be as eager to sell strength in nominals. Stocks probably go up either way, because that’s what stocks do these days (until they don’t).
  • There’s a lot of chatter from companies about being forced to push through price increases and seeing consumers actually not push back as much as they thought, so this is feeling less transitory every day. Don’t think we are going back to 0.1%-0.2% per month soon.
  • That’s all for now. My gut tells me the consensus has finally gotten to something close to a fair bet, but I won’t be shocked at all if we get another 0.7% on core. I also won’t be surprised by a small miss lower caused by some one-off change. So fair, but large error bars.

  • Well, on headline CPI it was finally a tie between economists (slightly too low) and the market (equally too high). But pretty close. Core was 0.33% m/m, slightly soft of estimates.
  • 0.33% m/m, of course, is still 4% annualized on core. But let’s see the breakdown.
  • Glancing I can see the curious bit will be the softness in Primary Rents. 0.156% m/m vs 0.23% last month. That seems odd, but importantly it also is unsustainable. Primary rents are going to go MUCH higher.
  • In reopening categories, Airfares FELL -0.14% m/m (+2.7% last mo). Lodging Away from Home +6% (+6.95% last). Used Cars +0.22% m/m – no decline, but feels like it after +10.5% last month! New Cars +1.72% m/m.
  • Now here’s a big surprise in a very little category. So not much impact, but car and truck rental -4.6% m/m. Last month +5.2%. Rented a car recently? That’s an odd one. But only 0.13% of CPI so rounds to 0.01% effect.
  • The broad core categories: Core Goods +8.5% y/y (8.7% last month); Core Services +2.9% (3.1% last month).
  • Core inflation ex-shelter decelerated to only 5.3% y/y from 5.8%. That’s a little tongue-in-cheek. But to be fair, used cars is still a large part of this.
  • Only large declines (<-10% annualized) in core were Car & Truck Rental and Motor Vehicle Insurance. Large increases in Lodging Away from Home (101%), Personal Care Services (29%), New Vehicles (23%), Car parts/equipment (13%) and Car maintenance/repair (11%). All m.m ann’lized.
  • Early guess at Median is that it will be 0.30%, which would be the highest in several years if I am right. And that speaks to breadth.
  • Here is y/y Rent of Primary Residence. Again, this has a long way to go, to well above the prior levels in fact, unless the boom in housing prices never get reflected in rents.
  • And here is Owners’ Equivalent Rent. Which is moving higher a little more earnestly, but still reasonably inert.
  • Haven’t mentioned apparel. On a nonseasonally-adjusted basis it fell 1% m/m, but seasonally adjusted +0.04%.
  • And I haven’t mentioned Medical Care. Overall +0.26% m/m. Breakdown: Drugs +0.17% (-0.39% last month), Doctors’ Services +0.40% (+0.26%), Hospital Services +0.55% (+0.22%). Some signs there.
  • CPI – Doctors’ Services (y/y). Interesting ratchet pattern.
  • …if you ever think you understand the CPI, just look at Health Insurance. In the CPI, Health Insurance is a residual since consumers don’t pay most health insurance directly. Went from +21% to -9% y/y over last year.
  • So, the four-pieces breakdown. Then we’ll look at diffusion. Here is Food & Energy. No surprise. Not core, but felt in the pocketbook acutely especially by lower-wage employees.
  • Core Goods – slightly off the boil, thanks to Used Cars. This will come back down as the y/y Used Car spike gradually leaves the data. I’m not worried about this staying at 8%. But 4% or 5% given global shipping problems – wouldn’t surprise me.
  • Core services, ex rent-of-shelter. Air fare softness, motor vehicle insurance softness, car and truck rental softness – none of those likely to remain very soft in the near term I don’t think. And medical care heating up a little.
  • And rent of shelter. To be sure, a lot of this is Lodging-Away-from-Home. But then, so was most of the decline. This piece is going MUCH higher over the next year. Our model for OER has it over 5% next year.
  • Now, the big story is the diffusion. Inflation is broadening. Our inflation diffusion index is the highest in nine years. So it isn’t just the reopening categories, folks. Your eyes ain’t lying.
  • Here is the distribution of category price changes. Six months ago, this was skewed to the left. Now, it’s skewed to the right. Long tails to the high side is a signature of an inflationary process.
  • So, let’s sum up. The reopening categories are lessening in importance as we knew they would. Is inflation transitory then? It depends on the answer two two questions:
  • is shelter inflation going to rise? And/or is that transitory? Shelter is slow, and right now it is depressed by the eviction moratorium. It has a LONG way to go, unless home prices and wages plunge. I don’t see those things happening. Ergo, we’re going to see more here.
  • Is inflation due to supply chain constraints in a narrow group of categories? Answer here is no. Price acceleration is broadening. Apparent shortages, resulting in higher price, is how supply/demand imbalances are reconciled in a market economy – even if it’s demand-side.
  • The comps for core inflation get easier going forward. 0.35% next month, but then 0.19%, 0.07%, 0.17%, 0.05%, 0.03%, and 0.10%. Core inflation is going to reach new highs into early 2022. And Median inflation is going to gradually accelerate too as inflation broadens.
  • Last month, the CPI was high but it really WAS mostly about Used Cars. This month is lower, but it’s more worrisome because of the broadening of inflation pressures. I think there’s no turning back now. Inflation expectations are going to be broken.
  • Will the Fed care? I give a ‘taper’ sometime this year maybe a 50-50 chance, although I don’t think it will last very long since the moment that stocks and bonds soften, QE will be back. Every taper so far has led eventually to larger QE!
  • I give almost no chance of an actual hike in the overnight rate, for a very long time. I don’t think Powell or Brainard are going to turn into hawks – they may express alarm at inflation but they would be more alarmed by an equity bear market. Hope I’m wrong.
  • That’s all for today. Remember to download the Inflation Guy app. Tune into @TDANetwork at 1:45ET today. And register for the Simplify webinar tomorrow at https://us02web.zoom.us/webinar/register/5216230941517/WN_O20LE_xlRUOAe7ysdVBDnA  Harley Bassman and Mike Green are the hosts! Busy busy Inflation Guy. Thanks for tuning in!

Well, I had said “the scariest number would be another 0.5% on core but without contribution from reopening categories.” We didn’t exactly get that; it was a little softer on core and some of the reopening categories still contributed. But not all of them. The number of inflating categories is getting broader, and shelter is starting to rise – although still very slowly, thanks to the continued eviction moratorium. All that means is that the rise in rents will be smeared over a longer period, and won’t really get started for a few months although I think there are starting to be clues in the data that shelter costs are percolating. With soft comps, this means that late Q3 and Q4 are very likely to see a sharp acceleration in core inflation. If we only average 0.3% m/m on core inflation, then by March (February’s print) core inflation will be at 5.4%, compared to 4.3% now.

Will that matter to the Fed? Until the people come with torches, probably not. However, these days – I wouldn’t count out the possibility of torch-bearing mobs.

CPI Forwards Show Inflation Concerns Aren’t Ebbing

August 9, 2021 1 comment

One of the most important things I learned as a markets person was the relationship between “spot” prices and “forward” prices. A spot price is the price today, if you buy a particular investment or commodity. A forward price is the price that you agree today to pay in the future on some date for delivery of that investment/item.

To a non-markets person, this seems odd. If I want to buy a carton of milk, but the grocery store is out of milk so I tell the grocer “hold one of those cartons for me when they come in,” it wouldn’t occur to me that I should pay a different price than is on the shelf. Or, maybe, I might expect to pay whatever the price is, when the milk comes in. But I wouldn’t think that today I should arrange for a different price for that milk just because I get it in the future.

But of course, the idea of the present value of money is super important in investing. A dollar received in the future is worth less than a dollar received today. (That is, unless interest rates are negative. In that case, a dollar in the future is weirdly worth more than a dollar today, and we are in that bizarre situation I described once, in a really neat post, as ‘Wimpy’s World.’) But it isn’t just money that has a different value for future delivery than it does today. There are at least two ways that I can own a pound of gold six months from now. One is to buy a pound of gold, and pay for storage and for insurance for six months. The other is to arrange with someone today to deliver me a pound of gold in six months. In that case, I don’t have to pay for storage and insurance, so I’ll be willing to pay more for gold in the future. In commodities markets, we say that this curve is in “contango,” where futures prices are above spot prices.

The important thing to realize, though, is that all of these things converge. The spot price of gold will eventually converge to the 6-month forward price of gold…in, as it happens, about six months. If there is no change in the price of insurance and storage, every day the spread of the futures price over the spot price will decline by one day’s worth of those expenses. (n.b. – there are other parts of the carry, too; I’m abstracting here for illustration). If nothing else in the market changes, then the spot price will gradually rise towards that forward price. Here is the important bit that markets people learn: in some sense, that is not a true profit:

Buy today: $1700 plus $10 storage plus $10 insurance = $1720 cost of gold 6 months’ forward

Buy for forward delivery: $1720.

In both cases, if I sell the gold six months and one day from now at $1720, I have made zero money, even though in the first case I paid $1700 for it. But it looks like gold rallied.

I’m not really here to talk about gold. I’m here to talk about economists.

Economists don’t really internalize this well. Case in point is the question about whether inflation expectations are ‘anchored.’ An economist – in particular, a Fed economist – looks at the following chart of 2-year inflation swaps since February and says “Expectations for inflation two years in the future rose between February and May, and then have been flat-to-down since then.”

But that’s not really what happened.

Someone who bought inflation swaps in early May got something that a buyer of inflation swaps today doesn’t get. The May 15th version of inflation swaps, because of the way they work with a 3-month lookback, got half of the 0.6% March CPI print, plus the 0.8% April print, the 0.6% May print, and the 0.9% June print. The person who buys inflation swaps today doesn’t get March and April, and only half of the May uptick (plus June). Ergo, if nothing else changes we would expect the price for a 2-year inflation swap today to be lower than the price in mid-May.

As the high prints from the last few months pass into the rear view mirror (although there will be some high ones to come, I don’t really expect +0.9% m/m any time soon), the inflation swaps and breakevens markets should look softer. It’s just carry. But how much softer?

One way to find out what is really happening to inflation expectations is to look at the forwards. Let’s pretend for a minute that the CME had actually launched CPI futures a few years ago, and we had a CPI futures contract that traded in December 2023 (settling to the November CPI print that comes out that month). Over the last few months, what would have happened to the price of that futures contract? The chart below shows that it would have enjoyed a very steady rise over the last six months. The CPI futures contract settles (or anyway, it would have) to a particular price level. We would almost always expect the futures prices to be above the current NSA CPI number, which was 271.696 in June. But these prices – which I’ve calculated from an inflation swaps curve I build every day – are showing that investors have responded to these higher CPI prints by steadily raising their expectation of future prices.

If investors thought these last few months were going to be reversed in the coming months, then the forwards wouldn’t have responded in this way. Investors would be betting that the high prints would be followed by low prints that reverse the changes. However, that’s not what is happening. Investors are taking these high prints and putting them in the bank. While they might think the rise in the inflation rate is transitory, they don’t think the rise in the price level is transitory.

This is a key distinction. The inflation we are seeing, even if it later slackens, represents a permanent loss of purchasing power. How much of a permanent loss have we seen in the last couple of years? Here are my calculations of the theoretical futures curve for CPI, as of August 1st, 2019 compared to last Friday. The last column shows how much higher investors think prices will be on those dates today, compared to what they thought two years ago.

Notice that this is from well before the crisis, and so takes into account the plunge in prices from early 2020 and the recent increases. After all of the zigzags, investors expect prices to be about 5% higher in 2023 than they would have thought previously, and about 8% higher in 10 years.

And I think they’re too sanguine.

Categories: Investing, Theory Tags: , ,
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