Summary of My Post-CPI Tweets (May 2020)

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!

  • Once again CPI day, and unlike last month where expectations were very low, it seems people think they have a firmer grasp of inflation this month. Ha!
  • I suppose that’s relative, but while I think there will be some interesting stories today I wouldn’t read much into the near-term data. Some things we know will be happening just aren’t happening yet.
  • Some examples include hotels, food away from home, rent of residence, medical care…all of these have serious upward pressures going forward, but not clear today.
  • I’ll talk about these as we go today. The consensus forecast for core is -0.2%, dropping y/y core to 1.7% from 2.1%. Last April – so sweet, so long ago – was +0.198% on core so ordinarily we’d be expecting a small y/y acceleration today.
  • But remember that last month, median inflation was pretty much normal. All of the movement in core was in lodging away from home, airfares, and apparel.
  • I don’t know about apparel, but I doubt the other two have fallen as far this month. Surveys of used cars, another typical volatility source, have plunged though. Usually takes a couple months for that to come into the CPI, but with a big move like that, it might.
  • On the other hand, prices for medical care were virtually ignored in the survey for last month’s release. If they start surveying those more ambitiously, that’s going to be additive. No question in the medium-term, medical care prices are going up.
  • Rents will be very interesting. So, if someone skips a rent payment how the BLS treats it depends on whether the landlord expects to collect it eventually, some of it, or none of it.
  • Rent-skipping isn’t yet unusually prevalent, and the threat that Congress could declare a rent holiday will mean that NEW rents are definitely going to be higher (this is a new risk for a landlord). Remember it’s rents that drive housing inflation, not home prices.
  • Neither effect is likely appearing yet, but be careful of that number today. In fact, as I said up top, be careful of ALL of the numbers today!
  • In the medium-term, inflation is lots more likely than deflation because there is much more money out there chasing fewer goods and services (20% y/y rise in M2, better than 50% annualized q/q). But today?
  • And while no one will be surprised with a low number today, almost everyone would be shocked with a high number. But with a lot of volatility, a wider range of outcomes in BOTH directions becomes possible.
  • In other words, HUGE error bars on today’s number, which SHOULD mean we take it with a grain of salt and wait for a few more numbers. Markets aren’t good with that approach. OK, that’s it for the walk-up. Hold onto your hats folks. May get bumpy.
  • Core CPI fell -0.448%, meaning that it was very close to -0.5% m/m. The y/y fell to 1.44%. The chart looks like a lot of the other charts we’re seeing these days. But of course devil will be in the details.

  • Core goods -0.9% y/y from -0.2%; core services 2.2% from 2.8%.
  • CPI for used cars and trucks, coming off +0.82% last month, turned a -0.39% this month. That’s not super surprising. I suspect going forward that rental fleets will shrink (meaning more used cars) since most cars are rented from airports.

  • Lodging Away from Home again plunged, -7.1% after -6.8% last month. That’s a little surprising. In my own personal anecdotal observation, hotel prices in some places went up last month, although to be fair that’s forward. TODAY’S hotel prices are still being discounted.
  • However Primary rents were +0.20% after +0.30% last month. Y/Y slid to 3.49% from 3.67%. Owners’ Equivalent Rent was +0.17% vs 0.26% last month; y/y fell to 3.07% from 3.22%.
  • I would not expect any serious decline in rents going forward. It’s housing stock vs number of households, and if we’re trying to spread out that means MORE households if anything. Also, as noted earlier I expect landlords to raise rents to recapture ‘jubilee risk.’
  • Apparel was again down hard, -4.7% m/m. That’s not surprising to me. Transportation down -5.9% m/m, again no real surprise with gasoline. But Food & Beverages higher, up 1.40% m/m. That’s not surprising at all, if you’ve been buying groceries!
  • Still some oddness in Medical Care. Pharma was -0.13% m/m, down to +0.78% y/y from +1.30% last month. Doctors’ Services -0.08%. Both of those make little sense to me. But hospital services +0.50% m/m, pushing y/y to 5.21% from 4.37%. That part makes perfect sense!
  • Hospital Services Y/Y. Expect that one to keep going up. Overall, of the 8 major subsectors only Food & Energy, Medical Care, and Education/Communication were up m/m.

  • Core ex-housing fell to +0.6% y/y, vs +1.45% last month. That’s the lowest since…well, just 2017. The four-pieces chart is going to be interesting. As I keep saying though, the real story is in 2-3 months once things have settled and there’s actual transactions again.

  • Little pause here because some of the BLS series aren’t updated. I was looking at the -100% fall in Leased Cars and Trucks…and the BLS simply didn’t report a figure for that. Which is odd.
  • …doesn’t look like a widespread problem so we’ll continue. A quick look forward at Median – there’s going to be more of an effect this month but going to be up by roughly +0.15% depending on where the regional housing indices fall.
  • That will drop y/y median to 2.70% or so from 2.80%. You’ll see when we look at the distribution later, this is still largely a left-tail event. The middle of the distribution is shrugging slightly lower. Again, it’s early.
  • Biggest core category decliners: Car and Truck Rental, Public Transportation, Motor Vehicle Insurance, Lodging Away from Home, Motor Vehicle Fees (sensing a trend?) and some Apparel subcategories.
  • Only gainer above 10% annualized in core was Miscellaneous Personal Goods. But in food: Fresh fruits/veggies, Dairy, Other Food at Home, Processed Fruits/Veggies, Cereals/baking products, Nonalcoholic beverages, Meats/poultry/fish/eggs.
  • Gosh, I didn’t mention airfares, -12.4% m/m, -24.3% y/y. Some of that is jet fuel pass through. But it’s also definitely not going to last. Fewer seats and more inelastic travelers (business will be first ones back on planes) will mean lots higher ticket prices.
  • The airfares thing is a good thought experiment. Airlines have narrow margins. Now they take out middle seats. What happens to the fares they MUST charge? Gotta go up, a lot. Not this month though!

  • I’ll take a moment for that reminder – people tend to confuse price and quantity effects here, which is one reason everyone expects massive deflation. There is a massive drop in consumption, but that doesn’t mean a massive drop in prices.
  • Indeed, if it means that the marginal price-elastic buyer in each market is exiting long-term, it makes prices more likely to rise than to fall going forward. Producers only cut prices IF cutting prices is likely to induce more buyers. Today, they won’t.

  • 10-year breakevens are roughly unchanged from before the number. If anything, slightly higher. I think that’s telling – they’re already pricing in so little inflation that it’s getting hard to surprise them lower.
  • 10y CPI swaps, vs median CPI. Little disconnect.

  • Little delay from updating this chart. OER dropped to the lowest growth rate in a few years. But it’s not out of line with underlying fundamentals.

  • To be fair, underlying fundamentals take a while to work through housing, but lots of other places we’ve seen sudden moves. The only sudden move we have to be wary of is in rents if Congress declares a rent holiday.
  • Under BLS collection procedures, if rent isn’t collected but landlord expects to collect in the future, it goes in normally. If landlord expects a fraction, that is taken into effect. If landlord doesn’t expect to collect, then zero.
  • …which means that if Congress said “in June, no one needs to pay rent,” you’d get a zero, massive decline in rents…followed by a massive increase the next time they paid. That would totally muck up CPI altogether, and I would hope they would do some intervention pricing.
  • So that’s a major wildcard. To say nothing of the huge effect it would have on the economy. Let’s hope Congress leaves it to individual landlords to work it out with tenants, or at worst there’s a Rental Protection Program where the taxpayers pay the rent instead of the tenant.
  • OK time for four-pieces charts. For those new to this, these four pieces add up to the CPI and they’re all between 20% and 33% of the CPI.

  • Piece 1: Food and Energy. Actually could have been worse. Energy down huge, Food up huge (+1.5% m/m). But this is the volatile part. Interesting for a change as energy is reversing!

  • Piece 2, core goods. We went off script here. But partly, this is because the medicinal drugs component is lagging what intuition tells us it should be doing.

  • I said offscript for core goods. Here’s the model. We were expecting to be back around 0% over the next year, but not -1%.

  • Piece 3, core services less rent of shelter. This was in the process of moving higher before the virus. Medical Care pieces will keep going higher but airfares e.g. are under serious pressure. Again, I think that’s temporary.

  • Piece 4: rent of shelter. The most-stable piece; this would be alarming except that a whole lot of it is lodging away from home. I’ve already showed you OER. It has slowed, but it will take a collapse in home prices to get core deflation in the US. Doesn’t seem imminent.

  • Last two charts. First one shows the distribution of price changes. Most of what is happening in CPI right now is really big moves way out to the left. That’s why Median is declining slowly but Core is dropping sharply. It’s the tails.

  • And another way to look at the same thing, the weight of categories that are inflating above 3% per year. Still close to half. MOST prices aren’t falling and many aren’t even slowing. Some, indeed, are rising. This does not look like a deflationary outcome looming.

  • Overall summary – much softer figure than last month, but still pretty concentrated in the things we knew would be weak. A few minor surprises. But for us to get a real deflationary break, another big shoe needs to drop.
  • With money supply soaring and supply chains creaking, any return to normal economic activity is going to result in bidding for scarce supplies with plentiful money. You already see that in food, the one thing it’s easy to buy right now. That’s the dynamic to fear when we reopen.
  • And, lastly. I’ve made the point many times recently: inflation hedges are priced so that if you believe in deflation you should STILL bet on inflation because you don’t get any payoff if you’re right about deflation.
  • That’s all for today. Stop by our *new* website at https://enduringinvestments.com and let us know what you think. It needed a facelift! Good luck out there.

I think the key point this month is the point I made up top: we always need to be wary of one month’s data from any economic release. It’s important to remember that the release isn’t the actual situation, it’s a measurement of the actual situation and any measurement has a margin for error. All of these data need to be viewed through the lens of ‘does this change my null hypothesis of what was happening,’ and if the error bars are large enough then the answer almost always should be ‘no.’

However, markets don’t usually act like that. Although there’s not a lot of information in the economic data these days the markets act like there is. (I was, however, pleased to see the TIPS market not overreacting for a change.) Let’s look at this data for what it is: right now, the one thing we know for sure is that it’s hard to buy anything at all. Economic activity is a fraction of what it was before the lockdowns took effect – but that affects economic quantities transacted (GDP), not prices. We need to get back to something like normal business before we know where prices are going to reach equilibrium. From these levels, my answer is that in most cases the equilibrium will almost assuredly be higher. I think most consumer-to-consumer services are going to end up being a lot more labor-intensive, which is good for labor’s share of national income but bad for prices: declining productivity shows up in higher prices. And there’s lots more money out in the system. While some of this is because companies drew quickly on their bank lines lest those lines be pulled like they were in 2008-2009, a great deal of it is because the government is spending enormous sums (a lot of it helicopter money) and the Fed is financing that by buying the debt being issued. So while M2 growth probably won’t end up at 20% y/y for a long period, I think the best we can hope for is that it goes flat. That is, I think the money is here to stay.

Monetary velocity is falling, and in fact the next print or two are going to be incredibly low. Precautionary cash balances ballooned. But once the economy opens again, those precautionary balances will drop back to normal-ish and the money will still be there. It’s a cocktail for higher inflation, to be sure. The only question is how much higher.

Over the next few months, the inflation numbers will be hard to interpret. What’s temporary, and what’s permanent? Keep in mind that inflation is a rate of change. So hotel prices have plunged. Gasoline prices have plunged. But unless they continue to plunge, you don’t have deflation. You have a one-off that will wash out of the data eventually. If hotel prices retrace half of their plunge, that will be represented by a m/m increase from these levels. Airfares will end up higher than they were before the crisis, but even if they didn’t they’d likely be higher from here. The real question is whether the one-offs spread much farther than apparel/airfares/lodging away from home. So far, they’ve spread a little, but not a lot. We’re nowhere close to deflation, and I don’t think we’re going to be.

Why We’re Wrong About Restaurants

Figuring out the macro impact of the virus, while not easy, is in some ways easier than figuring out a lot of the micro. In some cases the impact seems pretty obvious, and probably is: airlines are likely to carry fewer passengers, and more of them will be business travelers, for a while (resulting, by the way, in higher airfares in CPI). But some of the effects are much harder to figure out than we think, and a lot of it comes down to the fact that people who are idly speculating about these things tend to be pretty poor about defining what the substitutes are for any product or service.

Actually, the question of ‘what is a substitute’ turns out to be hugely important in economic modeling, because it directly impacts the question of demand elasticity. If I am the only person who sells widgets, and you need a widget, then I probably have a lot of control over what you pay. But if someone else sells something that works about as well as a widget (but isn’t a Widget™), then I as the supplier likely have a lot less flexibility and I face a more elastic demand curve. This is one reason that salespeople are taught to remember that the customer doesn’t want a quarter-inch drill bit; they want a quarter-inch hole. In a more formal setting: it is enormously important in antitrust economics that the market is defined clearly when considering if a firm is monopolizing or attempting to monopolize[1], so much so that there is an index called the Herfindahl-Hirschman Index with which industry concentration can be expressed. But I digress.

We read that many restaurants will fail as a result of the COVID-19 crisis, because quite aside from the question of the financial damage done to the restaurant owner from a two-month hiatus in revenues there is the question of “will people even come back?” And, if people do come back, but the restaurant-owner can only fit half as many people in the restaurant due to social distancing, then many restaurants can’t survive. Right?

So we are told, but there are a ton of assumptions there and some of them don’t hold. One of the biggest assumption is the question of what consumers use as a substitute for restaurant meals. With airlines, there is a clear substitute for the vacation traveler and that’s the automobile. Moreover, a vacation is not a necessity per se. But everyone needs to eat, so we can say with some confidence that if the average American ate 2.5 meals per day before the crisis they will probably eat 2.5 meals per day after the crisis. Somehow, they need to get those meals. If they are not going to restaurants for some of those meals, what are the alternatives? The argument that restaurants will fail hinges partly on the idea that these alternatives are convenient enough and enough competition for restaurant meals that consumers will eschew eating out and so restaurants won’t be able to sell their product. But will they? The alternatives to a restaurant meal are (a) a meal cooked at home or (b) a meal delivered. Many restaurants might fail for financial reasons, but that happens all the time in the food preparation biz. The question is whether the total number of restaurants in the country will be dramatically lower in the post-virus world. If so, it means that people are choosing en masse to make a significantly higher percentage of their meals at home. Anyone reading this who is doing a lot of their own cooking these days will realize why that’s probably not a tenable outcome as long as we continue to need two incomes in most families! Some, surely, will cook more. But when this is over, I suspect that meals not prepared at home will be a similar portion of our diets as it was before.

“Meals not prepared at home” includes both restaurant meals and delivery meals. Since the total number of meals consumed will be roughly the same, I think we’ll see a bit more home-cookin’ and a lot more delivery. It will be the restaurants, even those that did not previously deliver, cooking those meals. Maybe more delivery-only restaurants will start up. But I really think that we will see almost as many restaurants a year from now as we do now.

A separate question is what happens to the price of a meal-not-cooked-at-home, and it seems to me that the answer must be that it goes a lot higher. A delivered meal requires more manpower (for delivery), especially if delivery is going to be efficient at all. And in-restaurant meals (for those dinners, like your anniversary dinner, for which there are no good substitutes) are going to be higher-priced both because the demand curve will be more inelastic in the same way that the demand curve for business air passengers is more inelastic, and because the supply will be constrained. But my point is that if the restaurant used to plate 100 meals per hour, they’ll still plate pretty close to 100 meals per hour. It’s just that 50 of those meals will be going out the door.

Is there a substitute for movie theaters? Absolutely, and it was already winning. Good-bye movie theaters (although I have seen something about drive-ins making a comeback). A substitute for sports venues? Not so much, so I think we’ll see some innovation about how we safely attend such events but we haven’t seen the last of major league baseball at Citi Field or rugby at Twickenham. I think that international visitors to Disney World will probably decline, but domestic visitors will probably increase, as Disney for the latter is a substitute for an island vacation. But those islands that depend on tourism – there will be some pain there as there aren’t many convenient ways to get to Martinique that don’t involve flying.

But while I’m sure some restaurants will close because they cannot figure out delivery or because their product doesn’t translate well to delivery (see this story about a high-end restaurant that is facing this dilemma), I think consumption of meals-not-cooked-at-home will ensure that we will have a similar number of restaurants in the future. The broader point is this: be careful when you’re thinking about the damage that certain businesses will experience. Be sure to think about what the market for the good or service is, and what the relevant competitors are. Again, this doesn’t mean that existing companies will always survive, but if you know that the market for (for example) automobiles is still going to be there then there will be companies that serve that market. If they are different companies than today’s companies, that’s just creative destruction and it isn’t a bad thing for the consumer. (And, personal pitch: if you or your company needs help navigating these waters, visit our new website at https://www.enduringinvestments.com and drop me a line.)


[1] See Tasty Baking Company and Tastykake, Inc. v. Ralston Purina, Inc. and Continental Banking Co. (1987) in which the plaintiffs argued that the relevant market was premium snack cakes and pies and defendants argued that their products competed in the market for ‘all sweet snacks,’ because obviously their combination was less dominant if there were lots of substitutes.

Categories: Economics, Economy, Virus

Inflation Shocks, Inflation Vol Shocks, and 60-40 Returns

Not surprisingly, there has been a lot of debate about the ultimate outcome of the current crisis in terms of causing inflation or disinflation, or even deflation. It is also not surprising that the Keynesians who believe that growth causes inflation have come down heavily on the side of deflation, at least in the initial phase of the crisis. Some nuanced Keynesians wonder about whether there will be a more-lasting supply shock against which the demand-replacement of copious governmental programs will force higher prices. And monetarists almost all see higher inflation after the initial velocity shock fades or at least levels out.

What is somewhat amazing is that there is still so much debate about whether investments in inflation-related markets and securities, such as TIPS and commodities (not just gold), make sense in this environment. A point I find myself making repeatedly is that given where inflation-sensitive markets are priced (inflation swaps price in 1% core inflation for the next 7 years, and commodities markets in many cases are near all-time lows), the potential results are so asymmetrical – heads I win, tails I don’t lose much – that it’s almost malpractice to not include these things in a portfolio. And it’s just crazy that there’s any debate about that. The chart below shows the trailing 10-year annualized real return for various asset classes, as a function of the standard deviation of annuitized real income.[1]

Most of the markets fall along a normal-looking curve in which riskier markets have provided greater returns over time. No guarantee of course – while expectations for future returns ought to be upward-sloping like this, ex post returns need not be – and we can see that from the extreme deviations of EAFE and EM stocks (but not bonds!) and, especially, commodities. Wow! So if you’re just a reversion-to-the-mean kind of person, you know where you ought to be.

Now, that’s true even if we completely ignore the state of play of inflation itself, and of the distribution of inflation risks. Let’s talk first about those risks.  One of the characteristics of the distribution of inflation is that it is asymmetric, with long tails to the upside and fairly truncated tails to the downside. The chart below illustrates this phenomenon with rolling 1-year inflation rates since 1934. Just about two-thirds of outcomes in the US were between 0% and 4% (63% of total observations). Of the remaining 37%, 30% was higher inflation and 7% was deflation…and the tails to the high side were very long.

This phenomenon should manifest in pricing for inflation-linked assets that’s a little higher than implied by a risk-neutral expectation of inflation. That is, if people think that 2% inflation is the most likely outcome, we would expect to see these assets priced for, say, 2.5% because the miss on the high side is potentially a lot worse than a miss on the low side. This makes the current level of pricing of inflation breakevens from TIPS even more remarkable: we are pricing in 1% for the better part of a decade, and so the market is essentially saying there is absolutely no chance of that long upward tail. Or, said another way, if you really think we’ll average 1% inflation for the next decade, you get that tail risk for free.

Finally, there’s the really amazing issue of how traditional asset classes perform with even modest inflation acceleration. Consider the performance of the classic “60-40” mix (60% stocks, 40% bonds) when inflation is stable, compared to when it rises just a little bit. The following table is based on annual data from NYU’s Aswath Damodaran found here.

Note that these are not real returns, which we would expect to be worse when inflation is higher; they are nominal returns. 60-40 is with S&P 500, dividends reinvested and using Baa corporate bonds for the bond component. And they’re not based on the level of inflation. I’ve made the point here many times that equities simply do poorly when inflation is high, and moreover 60-40 correlations tend to be positive (on this latter point see here). But even I was surprised to see the massive performance difference if inflation accelerates even modestly. Regardless of how you see this crisis playing out, these are all important considerations for portfolio construction while there is, and indeed because there is, considerable debate about the path for inflation. Because once there is agreement, these assets won’t be this cheap any more.


[1] Credit Rob Arnott for an observation, more than a decade ago, that an inflation-adjusted annuity for a horizon is the true riskless asset against which returns over that horizon should be measured. The x-axis here is the volatility of the return stream compared with such a (hypothetical) annuity. This is important because it illustrates that TIPS, for example, are lots less volatile in real space – the one we care about – than are Treasuries.

Categories: Investing, Stock Market, TIPS

Half-Mast Isn’t Half Bad

April 28, 2020 1 comment

As I watch the stock market, implausibly, rise to levels no one expected so soon after the crash, I am also sickened by the cheerleading from those whose fortunes – not to mention egos – are wrapped up in the level at which the Dow trades. Stock market fetishism always fascinates me as much as it repels me. Although my experience as a trader (and a short-term options trader, at that) would seem to suggest otherwise, my makeup is as a long-term investor. I want to buy value, and the mathematics of investing for me is that I want (a) high intrinsic value at (b) a low price. While people who are buy-and-hold investors of a certain age clearly benefit from higher prices, young investors clearly benefit from lower prices since they’re going to be net buyers for a long time. And the price at which you acquire intrinsic value matters. So does the price at which you sell, but not until you sell.

So to me, there’s nothing great about a price that’s high relative to intrinsic value, unless I am preparing to sell. In a broader sense, the idea that we should cheer for higher prices (as opposed to higher intrinsic values) is not only unseemly, but destructive and I’ll explain why in a minute. I will note that the fascination with watching prices ticking every second goes back a long ways: you can read in Reminiscences of a Stock Operator about the bucket shops of the early 1900s where speculators would watch and trade the stock market tape. The general increase in investor twitchiness and short-termism that has accompanied the growth of financial news TV, online investing, and the development of ETFs to trade broad market exposures intraday certainly adds numbers to the cheerleading crowd. But it isn’t new. Depressing, but not new.

The most fascinating example of this belief in the (non-intuitive, to me) connection between the value of the stock market and the value of ‘Merica was presented to me in the aftermath of 9/11. When we first trudged back to lower Manhattan, there were people handing out these cards:

Fight Osama! Buy Cisco! I never did see the connection, and it seemed to me at the time either delusional (the terrorists win if my investment in Lucent goes down) or nakedly self-serving. Certainly the way I feel about my country has nothing to do with where I’m able to buy or sell eBay today. And actually, they really weren’t coming for our 401(k)s, they were coming for our lives. But I digress.

The point I actually want to make is that when the Fed works to stabilize market prices, they’re having a negative effect by destabilizing economic variables. An analogy from manufacturing might be an entry point to this explanation: a truism in manufacturing is that you can stabilize inventory, or you can stabilize production, but you can’t stabilize both (unless your customers are accommodating and provide very smooth demand). If you want to stabilize inventory levels, then you need to produce more when business is high and less when business is low, so you’re on the production roller-coaster. If you want to keep production level, then inventory will be low when business is high and high when business is low, so you’re on the inventory roller-coaster. Only if business itself is stable – which is rare – can you do both.

A similar thing happens in capital markets. You can stabilize the cost of capital, but then you destabilize growth rates. Or you can stabilize growth rates, and the cost of capital (stock and bond prices) will fluctuate. This is true unless you can do away with the business cycle. If you choose, as the Fed has in recent years, to try and stabilize market prices at very high levels (stabilizing the cost of capital at very low levels), then when underlying activity is strong you’ll get a ton of speculative investment in capacity, new ventures that depend on the availability of cheap capital, and strong growth. And then when economic activity heads lower, you’ll find that lots of businesses go bust and the recession is deeper. In fact, it’s not just the speculative businesses that go bust, but the overbuilding in the expansion can cause even prudent enterprises to have more difficulties in the downturn.

The Fed’s historical response to this has been to let the speculative activity happen when the cost of capital is held too low, but not let companies go bust when economic activity wanes…so they lower the cost of capital even further.

I’m obviously not the first person to point out that the Fed’s constant intervention has deleterious effects and tends to increase the amplitude of boom and bust. And, for what it’s worth, I’m not blaming the current recession on the Fed. Clearly, the proximate cause of this recession was COVID-19 and the global economic shutdown. What made it worse was that the Fed, by holding down the cost of capital, had previously precipitated the development and preserved the success of many more speculative enterprises. And the fetishism about stock prices, and about how important it is to have lots of money “working for you” in the stock market, is also one of the reason that people don’t save enough.

Of course, right now is probably not the time for the Fed and Congress to pull back and let huge numbers of people and companies go bankrupt. There’s a case to be made for the sort of government response we are having in this episode, in which personal income is being replaced by money creation while workers are ordered to stay home. There will be a piper to pay for that policy – a loss of price stability which is a consequence of trying to preserve output stability, but a consequence that it’s arguably acceptable to pay. Afterwards, though, I hope that central banks can start to let natural rhythms replace the autocratic ones. I am not hugely optimistic on that score, but one place to start is this: stop lowering the bar for central banks to intervene in markets. Stop targeting equity prices and interest rates. It’s okay to let the Dow trade at half-mast, and the bull will come back without the Fed’s help.

In fact, if we don’t keep trying to artificially increase the length of the mast, the Dow might never need to trade down to half-mast in the first place. Certainly, intrinsic values don’t retrace 50% in a recession!

Summary of My Post-CPI Tweets (April 2020)

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 with interests in this area be sure to stop by Enduring Investments (updated site coming soon).

  • CPI Day! I have to be honest – with the markets closed and this number likely to not have a lot of meaning, I almost skipped doing this this morning. But, thanks to M2, lots more people are suddenly listening so…obviously CPI is starting to be important. So let’s try.
  • The consensus for today, to the extent “consensus” means anything, is for -0.3% headline and +0.1% on core. But these are even more guesses than usual.
  • The BLS stopped taking prices a couple of weeks ago. That will have less effect than if that had happened a few years ago, b/c they ‘survey’ some prices using database downloads from retailers e.g. apparel.
  • But it still means that we don’t know what they’ll do about missing prices. Normally the BLS imputes an estimated figure for an item based on similar items…but if whole groups of items or categories are missing, less clear. Do they assume zero? Prior trend?
  • I actually think that this number won’t have too many of those problems but there will be some and next month will be very odd – and some chance they don’t publish at all because they can’t get statistically significant data.
  • In the meantime…remember we are coming off of recent strong data. Core was 2.37% y/y last month, and in general has headed higher. Before this, I was expecting 2.5% core by summer. Now that will take longer! (You can imply the word “maybe” before every statement this month.)
  • Lodging Away from Home is one place we’ll surely see an effect this month, and airfares, but beyond that who knows. And we are dropping off a weak +0.16% from last March so the core y/y figure might even stay steady. Or it could drop 0.3%. Who knows.
  • What we DO know is headline inflation is going to fall and in a month or 2 will show negative changes, which will prompt “DEFLATION!” screams. But headline just follows gasoline. That’s important – it’s also the reason people think infl is related to growth. Only headline.

  • I doubt we’ll get very close to core deflation in this cycle. See my recent article Last Time Was Different for why I don’t think we’ll see similar effects. But mkts are priced for long-term disinflation and deflation.
  • Oh and of course yesterday’s M2 chart. Probably discuss that more later today. Anyway, I’d say good luck but with markets closed you can’t do anything anyway! So just “hang on” and we’ll try and figure this out over the next few months.

  • I will be back in 5 minutes with thoughts on the figures and diving as deep as I can this month.
  • Core -0.1% m/m, down to 2.1% y/y. That’s a bigger fall than expected, but with these error bars I wouldn’t be shocked. Normally missing by 0.2% on core is a big deal. More interesting is that they got headline right to within 0.1%! It ‘only’ fell -0.4% m/m in March.
  • Here are the last 12 core CPI prints. This chart is gonna look kinda wacky for a while.

  • Broadly, core goods were -0.2% y/y, a decline from flat. More amazing is core services, dropping to 2.8% y/y from 3.1%.
  • Haha, that core services number is EVEN MORE AMAZING than you think. Because it didn’t happen from Owners Equivalent Rent (+0.26% m/m, 3.22% y/y) or Primary Rents (+0.30% m/m, 3.67% y/y). Both slower y/y but basically same m/m from Feb.
  • So if rents didn’t decelerate, where do we get the big drop in core services? Lodging Away From Home was -6.79% m/m, dropping to -6.38% y/y from +0.78% last month. I should drop the second decimal.
  • BTW, good time to remember that VOLUMES of transactions don’t enter into CPI monthly. This is just a survey of prices. So if no one bought any apparel, but we have a price, that’s what gets recorded. Lodging fell because prices actually were down hard, as you probably know.
  • CPI for Used Cars and Trucks was +0.82% m/m. Some people were worried about autos but I’m not sure they should be. Big supply shock in cars because of parts supply chain. If I were a dealer I wouldn’t be marking down my existing inventory.

  • Airfares -12.6% m/m. That’s worth about 0.1% on core all by itself. So we expected big declines in airfares and Lodging Away from Home (worth about 0.06%), and got them. Core ex- those two items still had some softness, but not horrendous.
  • Core ex-housing declined from 1.70% y/y to 1.45% y/y. Again, a lot of that were those two items I just mentioned. But 1.45% core ex-housing is still higher than it was last July.
  • Now, in medical care I’m not sure how to think about any of this. Medicinal Drugs were -0.04% m/m, after -0.43% last month, pushing y/y to 1.31% from 1.85%. But lots of drugs are really hard to get right now and of course we now know most of our APIs come from China.
  • That may be a case of some shortages, because in the short term no one wants to be seen jacking up the price of drugs. Prescription drugs decelerated y/y; non-prescription accelerated.
  • Physicians’ Services +0.34% m/m vs +0.21% prior month. Hospital Services +0.40% vs -0.12%. How in the heck do you measure this when most of those doctors and services are doing one thing? And a very crucial one indeed. What’s the price of a hip replacement right now?
  • OK, biggest m/m changes down, other than fuel. Public Transportation -65% (annualized), car/truck rental -58%, Lodging Away from Home -57%, Infants/toddlers apparel -41%, womens/girls apparel -30%, footwear -29%.
  • Which makes me realize I forgot to mention Apparel was -2% m/m. That’s another 5bps off the core inflation rate.
  • There were still some increases on the month. Biggest ones other than food were Tobacco and Smoking Products (12.5% annualized), nonalcoholic beverages (+12%), and Used Cars and Trucks (+10%).
  • FWIW, the early look to me is that MEDIAN CPI will still be around 0.22% or so. That’s what long-tail negatives do to core! So while y/y Core dropped sharply, y/y median will still be around 2.8%.
  • So, coarse but…core -0.1% m/m. Add back 0.06% lodging, 0.10% airfares, 0.07% apparel and 0.07% for public transportation (cuffing it) and you get back to +0.2%. Which means that outside of those categories there wasn’t much disinflation pulse. Median will say same thing.
  • That probably more means that prices haven’t really reacted yet that that there will be zero impact of COVID-19. But I don’t think we’ll see a big impact lower on prices. At least not lasting very long.
  • Haven’t done many charts yet. But here’s one I haven’t run in a while. Distribution of y/y price changes by low-level item categories in the CPI. Look at that really long tail to the left. Take off just the last bar on the left and you get 2.37% core roughly.

  • Here’s the weight of categories over 2% y/y change, over time. Just another way of saying that we haven’t seen any big effects yet. Unknown is just how much the trouble in collecting affects this.

  • Pretty good summary and gives me more confidence in the data – they’re at least calling people! But interestingly, not so much doctors/hospitals. So asterisk by Medical Care.
  • BLS has posted this, explaining how they’re collecting prices. https://bls.gov/bls/effects-of-covid-19-pandemic-on-bls-price-indexes.htm#CPI
  • So let’s do the four-pieces charts and then wrap up. For those new to my monthly CPI tweets, these four pieces add up to CPI, each is 20%-33%, but each behaves differently from a modeler’s perspective.
  • First piece: Food and Energy. This will go much lower. As I said up top, we will be in deflation of the headline number pretty soon. But, I think, only the headline number.

  • Core goods. This declined a tiny bit, mostly apparel. I think the short-term effect here is indeterminate but might actually be higher as some goods made overseas get harder to get (ibuprofen??)

  • Here’s where the rubber meets the road. Core Services less Rent of Shelter. Was in a good trend higher and about to be worrisome. Dropped a bit, but with an asterisk on medical care.

  • Rent of Shelter – this looks alarming! And rents declining is the ONLY way you can get core deflation. But…Rent of Shelter includes lodging away from home. That’s the dip, is in that 1% of CPI. The 31% that is primary and OER, not so much.

  • That last chart calls for one more on housing. Here is OER, the biggest single piece of CPI. It’s right on model. As yet, no sign of any big effect from COVID-19 either now, or in the forecast that’s driven by housing market data.

  • End with 1 final chart. We started w/ M2 chart showing the biggest y/y rise in history. The counterpoint is “what if velocity falls.” But vel is already @ record low. To drop, you need lower int rates (from 0?), or huge long-lasting cash-hoarding.Hard to see.

  • Thanks for tuning in. I’ll collate these in a single post in the next hour or so.

So what was most amazing about today’s data? I suppose it was that, outside of the things we knew would be disasters (airfares, hotels) the effects of the virus crisis were very small. And you know, that sort of makes sense. If I’m a producer of garden rakes (I honestly just pulled that out of the air), why would I change my prices? I’m not seeing traffic, but it isn’t because my prices are too high. From a seller’s perspective, it only makes sense to lower price if lower prices will induce more business. Lowering the price of rakes isn’t going to sell more rakes. It isn’t that people have no money to buy rakes – with the government fully replacing wages of laid off workers, and covering the wage costs for small businesses so they don’t need to lay anyone off, and sending everyone a fat check besides, there’s no shortage of people with money to spend. (I know we read a lot about the tragedy of the millions being laid off, but it’s not much of a tragedy yet since they’re being paid the same as before!)

[As an aside, businesses with high fixed overhead and low variable costs – hotels are a classic example; it costs very little for the second occupied guest room – might lower prices significantly since if they can cover their variable costs then anything above that goes to covering fixed overhead. That’s what airlines did initially too, but when they realized after that knee-jerk response that they couldn’t fill the planes even if they offered free flights, they started canceling enormous numbers of flights. I’ve actually seen some of the fares that I track rise in the last week or two as the number of flights out of NYC has dwindled to very few! But it’s harder to mothball a hotel than to mothball a plane.]

The NY Fed published a really insightful article today entitled “The Coronavirus Shock Looks More like a Natural Disaster than a Cyclical Downturn.” Although they focused on the path of unemployment claims, a similar analysis can take us to the inflation question. In a natural disaster, we don’t see deflation. If anything, we tend to see inflation as some goods get harder to acquire. The amount of money available doesn’t decline, assuming the government deploys an emergency response that includes covering non-insured losses, and the amount of goods available drops. In today’s circumstance, we have more money available – as the M2 chart shows – than we did before the crisis, and if anything we will have fewer things to buy when it’s all over as supply chains will remain disrupted for a long time and a lot of production will surely be re-onshored. But you don’t need the latter point to get disturbing inflation. All you need is for the money being created to get into circulation rather than reserves (which is what is happening, which is why M2 is soaring), and for precautionary money-hoarding to be a short-term phenomenon. I believe the money will be around long after the fear has died away, because for the Fed to drain a few trillion by selling massive quantities of bonds is much, much more difficult than to add a few trillion by buying bonds that the Treasury coincidentally needs to sell more of right now.

The quality of the CPI numbers will be sketchy for a while, but I am fairly impressed that this release wasn’t as messy as I was prepared for. The inflationary outcome may well be messy, though! With 14% money growth, and little reason to expect a lasting velocity decline, it’s hard to get an innocuous inflation outcome. But markets are still offering you inflation hedges at prices that imply you win even if inflation drops a fair amount from the current level. If you don’t have those hedges, you’re making a very big bet on deflation.

Happy Easter.

Last Time Was Different

April 4, 2020 5 comments

They say that the four most dangerous words in investing/finance/economics are “This time it’s different.”

And so why worry, the thinking goes, about massive quantitative easing and profound fiscal stimulus? “After all, we did it during the Global Financial Crisis and it didn’t stoke inflation. Why would you think that it is different this time? You shouldn’t: it didn’t cause inflation last time, and it won’t this time. This time is not different.”

That line of thinking, at some level, is right. This time is not different. There is not, indeed, any reason to think we will not get the same effects from massive stimulus and monetary accommodation that we have gotten every other time similar things have happened in history. Well, almost every time. You see, it isn’t this time that is different. It is last time that was different.

In 2008-10, many observers thought that the Fed’s unlimited QE would surely stoke massive inflation. The explosion in the monetary base was taken by many (including many in the tinfoil hat brigade) as a reason that we would shortly become Zimbabwe. I wasn’t one of those, because there were some really unique circumstances about that crisis.[1]

The Global Financial Crisis (GFC hereafter) was, as the name suggests, a financial crisis. The crisis began, ended, and ran through the banks and shadow banking system which was overlevered and undercapitalized. The housing crisis, and the garden-variety recession it may have brought in normal times, was the precipitating factor…but the fall of Bear Stearns and Lehman, IndyMac, and WaMu, and the near-misses by AIG, Fannie Mae, Freddie Mac, Merrill, Goldman, Morgan Stanley, RBS (and I am missing many) were all tied to high leverage, low capital, and a fragile financial infrastructure. All of which has been exhaustively examined elsewhere and I won’t re-hash the events. But the reaction of Congress, the Administration, and especially the Federal Reserve were targeted largely to shoring up the banks and fixing the plumbing.

So the Federal Reserve took an unusual step early on and started paying Interest on Excess Reserves (IOER; it now is called simply Interest on Reserves or IOR in lots of places but I can’t break the IOER habit) as they undertook QE. That always seemed like an incredibly weird step to me if the purpose of QE was to get money into the economy: the Fed was paying banks to not lend, essentially. Notionally, what they were doing was shipping big boxes of money to banks and saying “we will pay you to not open these boxes.” Banks at the time were not only liquidity-constrained, they were capital-constrained, and so it made much more sense for them to take the riskless return from IOER rather than lending on the back of those reserves for modest incremental interest but a lot more risk. And so, M2 money supply never grew much faster than 10% y/y despite a massive increase in the Fed’s balance sheet. A 10% rate of money growth would have produced inflation, except for the precipitous fall in money velocity. As I’ve written a bunch of times (e.g. here, but if you just search for “velocity” or “real cash balances” on my blog you’ll get a wide sample), velocity is driven in the medium-term by interest rates, not by some ephemeral fear against which people hold precautionary money balances – which is why velocity plunged with interest rates during the GFC and remained low well after the GFC was over. The purpose of the QE in the Global Financial Crisis, that is, was banking-system focused rather than economy-focused. In effect, it forcibly de-levered the banks.

That was different. We hadn’t seen a general banking run in this country since the Great Depression, and while there weren’t generally lines of people waiting to take money out of their savings accounts, thanks to the promise of the FDIC, there were lines of companies looking to move deposits to safer banks or to hold Treasury Bills instead (Tbills traded to negative interest rates as a result). We had seen many recessions, some of them severe; we had seen market crashes and near-market crashes and failures of brokerage houses[2]; we even had the Savings and Loan crisis in the 1980s (and indeed, the post-mortem of that episode may have informed the Fed’s reaction to the GFC). But we never, at least since the Great Depression, had the world’s biggest banks teetering on total collapse.

I would argue then that last time was different. Of course every crisis is different in some way, and the massive GDP holiday being taken around the world right now is of course unprecedented in its rapidity if not its severity. It will likely be much more severe than the GFC but much shorter – kind of like a kick in the groin that makes you bend over but goes away in a few minutes.

But there is no banking crisis evident. Consequently the Fed’s massive balance sheet expansion, coupled with a relaxing of capital rules (e.g. see here, here and here), has immediately produced a huge spike in transactional money growth. M2 has grown at a 64% annualized rate over the last month, 25% annualized over the last 13 weeks, and 12.6% annualized over the last 52 weeks. As the chart shows, y/y money growth rates are already higher than they ever got during the GFC, larger than they got in the exceptional (but very short-term) liquidity provision after 9/11, and near the sorts of numbers we had in the early 1980s. And they’re just getting started.

Moreover, interest rates at the beginning of the GFC were higher (5y rates around 3%, depending when you look) and so there was plenty of room for rates, and hence money velocity, to decline. Right now we are already at all-time lows for M2 velocity and it is hard to imagine interest rates and velocity falling appreciably further (in the short-term there may be precautionary cash hoarding but this won’t last as long as the M2 will).  And instead of incentivizing banks to cling to their reserves, the Fed is actively using moral suasion to push banks to make loans (e.g. see here and here), and the federal government is putting money directly in the hands of consumers and small businesses. Here’s the thing: the banking system is working as intended. That’s the part that’s not at all different this time. It’s what was different last time.

As I said, there are lots of things that are unique about this crisis. But the fundamental plumbing is working, and that’s why I think that the provision of extraordinary liquidity and massive fiscal spending (essentially, the back-door Modern Monetary Theory that we all laughed about when it was mooted in the last couple of years, because it was absurd) seems to be causing the sorts of effects, and likely will cause the sort of effect on medium-term inflation, that will not be different this time.


[1] I thought that the real test would be when interest rates normalized after the crisis…which they never did. You can read about that thesis in my book, “What’s Wrong with Money,” whose predictions are now mostly moot.

[2] I especially liked “The Go-Go Years” by John Brooks, about the hard end to the 1960s. There’s a wonderful recounting in that book about how Ross Perot stepped in to save a cascading failure among stock brokerage houses.

Why We Can Be Pretty Sure China is Lying About COVID-19

March 28, 2020 14 comments

This post has nothing to do with inflation (although to the extent that China’s problems are worse-than-advertised, the supply shock could be worse-than-expected and the resulting inflation impulse larger-than-expected). However, as a longtime participant in the financial markets – which, over the last decade or two has increasingly meant an observer of China and Chinese data – I have been absolutely flabbergasted at the evident willingness of press, government officials, and healthcare experts to accept at face value the reports China has released about the development of COVID-19. At worst, some observers will allow that these numbers might not be “verifiable,” but this is generally expressed as sort of a minor issue. Now, I realize that there are potentially partisan reasons to slant interpretations one way or t’other, but I don’t think this is a case of ‘ a little bit of wiggle room’ in the figures.

Just for fun, I decided to take what China has said about its experience with COVID-19 and use what we know about the development of the virus in the US to project what the true cases probably are. Obviously, as with any model, there are wide error bars…but it’s simply implausible that China is experiencing anything like what they claim to be experiencing. Here’s the math of it.

We know from the US and the rest of the world that the virus cases grow around 33% per day until they downshift “at some point.” See for example this outstanding chart from the Financial Times from last week.

That point of shifting is somewhat speculative and probably depends on a lot of things. But for our model we’ll assume that the virus grows in China at 33% per day and downshifts to a 2% growth rate (which is roughly what South Korea’s growth rate in new cases is now, so we are being very generous) at the point China claimed that the growth rate of new cases was starting to decline, roughly around February 11.

We also can infer from US numbers that the death rate is around 5%, with deaths taking about 5 days and recoveries about 17 days. So, we look backwards about 5 days to see the number of open cases, and realize about 5% of those will die. Similarly, we look backwards about 17 days and realize that about 95% of those cases eventually recover (recoveries take longer because they tend to be cases that were caught earlier, plus a ‘recovery’ is not defined until we get two negative tests while a death is pretty clear). There are a number of combinations of period lookbacks/mortality that work, but that’s about the best case. We can’t get a model that is consistent with the number of deaths we have in the US with a longer resolution time unless the fatality rate is much higher; if the fatality rate is lower than 5% it implies that cases resolve even faster than 5 days after detection which seems unlikely. Globally, the ratio of deaths to (deaths + recoveries) is about 16% (see here under “closed cases” for a source of that data), so 5% is quite conservative. Similarly, we can’t have the low number of recoveries we have unless recoveries take a lot longer than deaths to resolve, or the recovery rate is a lot lower (death rate is a lot higher) than 5%.

And that 5% is with the US having some advance warning, and outstanding medicine. I don’t have any reason to believe it would be lower in China. So those are the parameters I’m going to use. 33% growth rate of infections downshifting to 2%, 5% mortality rate, with resolutions happening in 5 days for death and 17 days for recovery.

The first case in China dates from 12/16/19.

Growing at the aforementioned rates, from 1 case on 12/16/19, China ought to have been around 72 cases by end of December. They admitted to 27. Since at low numbers the growth rate has a lot to do with idiosyncratic details of the particular cases, we will re-set to 27 on 12/31, to be generous. But recognize that there is some reason to think China was low by a factor of 2-3, two weeks in.

Growing at the aforementioned rates, China ought to have been around 14,300 by January 22, when they told the WHO they had 547 cases. (From here on, all of the data comes from Bloomberg whose numbers differ slightly, but insignificantly, from the Johns Hopkins data). So they’re off by a factor of about 25 from what we would expect, based on the experienced growth rates of other countries.

Around February 11, China claims to have had 44,653 cases. By our growth rates, it should have been more like 4.3 million. China must have had spectacular medicine! (even if we grow the 547 number from Jan 22, they would have been at 125k by Feb 11). So it looks like by Feb 11 China was already off by a factor of between 3 and 100. The 3 requires us to believe that they were being completely honest on Jan 22 when they said 547.

So let’s assume the new cases downshift on Feb 11 to only 2% growth. Even starting from their 44,653, we would see 109k cases by now (March 27) if growth rates were only 2%. Literally the only way to get to China’s figures is to say that the transmission rate was never very high, despite the widespread travel around the Chinese New Year and the fact that as the origin of the pandemic is it reasonable to conclude that their recognition of the danger of this disease would take a little longer. And if all of those things are true, then the aggressively autocratic crackdown seems really over the top, given the vanishingly-small prevalence of the disease in a country of 1.4 billion people.

Going back to our original trends of 33%, downshifting to 2%, and with the death and recovery rates I am estimating: I think the actual number of cases in China is more like 10 million, with 465k dead and 7 million recovered. Honestly, it’s hard to explain why their traffic and power usage is recovering so slowly if only 0.006% of the country ever contracted the virus and an even tinier fraction died. The economy should have immediately sprung almost fully back when the quarantine was lifted. Most people in China wouldn’t even know anyone who had been infected…only 1 person in 17,000 ever got the disease. The numbers would just be too small to notice.

We don’t just have to believe China is inherently deceitful…we just need to believe that the country doesn’t have miraculous medical powers. And we need to believe in math. There are other reasons why the numbers could be technically accurate, and yet not illuminating. It might be the case that China simply isn’t testing people very aggressively, so that it is the case that only 81,340 people have tested positive, and only 3,292 of those have died. In that case their numbers would be accurate but not necessarily the whole truth since the country would also be having the small issue of seeing a bunch of other bodies piling up for “unknown” reasons. That inconvenient fact would eventually become hard to not notice, which is one reason why it might make sense to expel external journalists…

Categories: Uncategorized
%d bloggers like this: