Developed Country Demographics are Inflationary, not Deflationary

I’m a relatively simple guy. I like simple models. I get suspicious with models that seem overly complicated. In my experience, the more components you add to a model the more likely it is that one of them ceases having explanatory power and messes up your model’s value. In this it is like (since tonight is Major League Baseball’s All-Star Game I thought I’d use a baseball analogy) bringing in relievers to a game. Every reliever you bring in has some chance that he just doesn’t have it tonight, so therefore you ought to bring in as few relievers as you can.

Baseball managers don’t seem to believe this, so they bring in as many relievers as they can. Similarly, economists don’t seem to believe the rule of parsimony. The more complexity in the model, the better (at least, for the economist’s job security).

Let’s talk about demographics and inflation.

Here’s how I think about how an aging population affects inflation:

  1. Fewer workers in the workforce implies a lower unemployment rate and higher wages, c.p.
  2. A higher retiree/active worker ratio implies lower saving, which will tend to send interest rates higher and equity prices lower, and tend to increase money velocity, c.p.
  3. A higher retiree/non-retiree ratio probably implies lower spending, c.p.

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around #3, and the idea that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. But if there’s lower spending, that doesn’t necessarily indicate a wider output gap because of #1. The best you could say about the effect on the output gap of an aging population is that it is indeterminate: potential output growth should decline because of workforce decline (potential output growth » growth in the # of workers + growth in productivity per worker), while demand growth should also decline, leading to uncertain effects on the output gap.

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MVºPQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

So, my model is simple, and you don’t need to have a lot of extraneous dynamics if you simply say: slower potential growth implies higher potential inflation, and demographics implies lower potential future growth. Qed.

One other item I would point out about the three points above: all three are negative for stock markets. If you truly believe that the dominant effects are lower spending, less savings, and higher wages the you can’t possibly think that demographics are anything other than disastrous for equity valuations in the future.


Summary of My Post-CPI Tweets (July 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • OK, 15 minutes to CPI. Here goes.
  • Last mo, we had an 0.17% on core m/m, exactly on expectations but after a weak 0.10% in April.
  • The Dec/Jan 0.24%/0.35% seem far away, but even farther away are the 0.14%s of last June and July. That is, comps remain relatively easy.
  • Really no big surprises last month. Still haven’t seen core goods acceleration or any sign of tariff effects. Core ex-housing is rising but still quite low.
  • In fact, I think the big story going forward, not this month per se but for the balance of the year and 2019, is what happens to core goods prices. With trucking prices rising aggressively, tariffs up and globalization down, I’d expect to see movement there.
  • In that vein, keep an eye on Apparel, which though small is an important signal on core goods.
  • This month, economists are looking for 0.18% on core, pushing y/y JUST BARELY to 2.3% with rounding. The consensus nailed it last month.
  • My thesis is that we should be seeing more core inflation than that going forward. So far, that thesis has been unrewarded but I really didn’t expect a whole lot to come through until the second half. This first half was just catching up from base effects of 2017.
  • You can see that median is basically back on the slow uptrend from 2014-15-16-17. Inflation will keep rising. The only question (which would be a scary outcome) is whether it accelerates past that former trend into a new self-feeding inflation cycle. No sign of that yet.

  • Just 5 minutes til showtime.
  • 16% m/m on core, just barely pushing y/y to 2.3%, 2.255% to three decimals on the NSA core index…
  • Bloomberg being really slow posting subcomponent info.
  • Here’s the last 12 core CPIs. Certainly nothing seems terribly alarming here on the surface.

  • OK, Bloomberg. Gonna scrape the data myself. BRB.
  • Breakevens are unimpressed. 10y breaks were +1 before the number, mostly a reaction to the energy plunge and rebound, and are +0.5 now. But sometimes takes a bit for people to dive into the numbers.
  • we see Used cars and trucks are +0.72% m/m, yay! Finally some movement. Still -0.66% y/y, so not showing the inflation of the private surveys. Private surveys have noted some shift in used car composition, and it may be that the BLS just isn’t correcting for that.
  • Owners’ Equivalent Rent was +0.25% m/m for the second month in a row, but that caused y/y to decelerate to 3.37% from 3.41%. That’s interesting because last month the rise in OER was a big chunk of the rise that we got so…something else was moving this month.
  • Primary Rents also decelerated, to 3.58% from 3.63%. That’s actually lower than the y/y has been for a while as this continued to decelerate. But it’s not going to collapse while housing prices continue to boom.
  • Medical Care accelerated further, to 2.45% from 2.38% y/y. That’s not as big a jump as last month, but it’s the right sign. Still low. Pharma retreated a bit but doctor’s services picked up the slack.

  • Apparel dropped on the month, pushing y/y down to 0.6% from 1.4%. So canary on core goods is still chirping.
  • Bloomberg still hasn’t updated the core goods and core commodities figures…odd. Anyway, they’re -0.2% on core goods (tiny acceleration) and 3.1% on core services (tiny acceleration) on a y/y basis.
  • Lodging Away from Home, which surged last month to 4.4% y/y, plunged to 1.6% y/y this month.
  • Core ex-shelter rose to 1.41%, highest since mid-2016. That’s still low, but it’s what we want to watch along with core goods. It hasn’t been above 2% since 2012. Hasn’t even been close.

  • This is interesting…wireless telephone services inflation is positive. It’s not like that NEVER happens but this time we might go higher. After you go to infinite data…how do you improve quality dramatically? And it’s quality that drives this series lower.

  • Core goods’ rise is encouraging for inflation…but still a ways to go before it gets to +1%. However it’s on model at the moment.

  • Will have the four-pieces charts in a moment. But while I’m waiting on the calculator…this month’s data is interesting because it was not housing. Some of the rise in core was due to new and used cars rebounding, but not enough to offset the deceleration in housing. >>
  • That may mean that inflation is broadening to more categories outside of the ones that have been driving inflation for a while. Core ex-shelter’s rise is something to watch. That’s what inflation actually looks like – it’s not dramatic, and not isolated in a few categories.
  • inflation markets are tres unimpressed. 10y breakevens now down on the day.
  • We’re not really seeing a broadening in this diffusion measure, so it may just be that the left-tail deflationary stuff is going away. A tightening of the distribution, that is.

  • OK four pieces. Piece 1: Food & Energy. Good for owners of TIPS, but mean-reverting so we mostly ignore for forecasting.

  • Core goods, Piece 2, I’ve already shown. Rising and will keep rising.

  • Piece 3: Core services less rent of shelter. Starting to look interesting. The 3% level is key.

  • Piece 4: Rent of Shelter. Still elevated. It’s done the heavy lifting on inflation for a while and probably won’t do much more for a while. Continued acceleration in core will rely on ex-shelter core services, and on core goods. Both of which seem to be rising.

  • Bottom lining: Once again, no big surprises here and nothing that will alter the Fed’s trajectory. But the underlying pressures here are pretty clear and show no signs of waning. We are not going to gently converge on 2% core PCE.
  • What I said at the beginning remains the key question: are we just going back to the rising – but slowly rising – inflation trend from 2014-2017, or will we start to accelerate above that trend?
  • Acceleration above that trend would be very concerning, unless it was caused by one-offs (like cell phones and other one-offs caused the 2017 departure on the downside). It would indicate that inflation has moved into a self-reinforcing phase.
  • I suspect that’s where we are headed. But so far, the evidence that we are there doesn’t exist (there’s no contrary evidence either – it’s just unknown at this point).
  • Early look at median…my estimate is 0.23% m/m. If I am right, this takes the y/y to 2.80%. This will be really dramatic!
Categories: CPI, Tweet Summary

Tariffs Do Not Cause Price Declines

July 5, 2018 6 comments

Adding to a good’s price does not make its price decline.

It’s worth repeating that a couple of times, because it seems to be getting lost in the discussion about tariffs – in particular, in the discussion about tariffs levied on US commodities. Grains prices have been plummeting, as the chart below showing front corn and soybean prices (source: Bloomberg) illustrates.

There are many reasons that grains prices may be declining, but if “tariffs have been levied on US production” is one of them then there is some really weird economics happening. Corn and soybeans are commodities. Specifically, this means that they are essentially fungible – corn from site “A” is essentially the same as corn from site “B.” So what does this mean for the results of a tariff?

If China stops buying soybeans from the US altogether, it means that unless they’re going to stop eating soybeans they will buy soybeans from Brazil. But if Brazil sells all of their soybeans to China, it means that Germany can no longer soybeans from Brazil. So where does Germany buy its soybeans from? Well, it seems that the US has beans that are not spoken for in this scenario…in other words, when we are talking about commodities a tariff mostly just reorganizes the list of who is buying from whom. If soybean prices are falling because China isn’t buying our soybeans, it means a great deal for Russia or Germany or whoever else is going to buy beans from us instead of from China’s new supplier. More than that, if global soybeans prices are falling because of tariffs then it means that everyone is getting cheaper soybeans because China is changing who they’re buying from. If that’s the case, then we really need to slap tariffs on everything and watch prices decline!

Let’s go back to elementary microeconomics. Adding a tariff is reflected in our product market supply and demand curves as a shift in the supply curve to the left: the quantity that producers are willing to supply at any price declines, because the price to the producer declines. Put a different way, the market price required to induce any particular quantity supplied rises by the amount of the tariff. Now, whether that causes market prices to rise a lot or a little, or quantity supplied to fall by a lot or a little, depends on the elasticities of supply and demand. If demand if fairly inelastic (which seems reasonable – you may be able to substitute for “beans” but it’s hard to substitute for “grains”), then you will see more of a price response than a quantity response, at least in the short run where the supply of beans is fairly inelastic. But that price response is up, not down.

By the way, this gets a little hard to illustrate with supply and demand curves, because with a tariff what you have are now two separate markets and separate prices for the same good. This is what confuses some people – if China is no longer buying from the US, doesn’t that mean that demand for US beans has declined, and therefore prices should decline? The crucial point is that we are talking here about commodity goods, and supplies are fairly interchangeable. If we are talking about Harley Davidson motorcycles, the answer is different because if Europe stops buying Harleys, they have to buy a different product altogether. In that case, the global price of “motorcycles” might be relatively unaffected, but the price of Harleys will rise (and the output decline) relative to other motorcycles. So, a tariff on Harley-Davidson motorcycles definitely hurts the US, but a tariff on soybeans – or even “US soybeans” since that is not a universal distinction – should have virtually no effect on US producers. And certainly, no effect on the global price of soybeans.

There are other reasons that grains prices may be declining. Since Brazil is a major producer of beans, the sharp decline in the Brazilian Real has pushed the US dollar price of beans lower (see chart, source Bloomberg). In the chart below, the currency is shown in Reals per dollar, and inverted. This is a much more important factor explaining the decline in grains prices, as well as one that could easily get worse before it gets better.

I think the discussion of the effects of tariffs has gotten a bit polluted since the decline in grains seems to coincide with the announcement of tariffs from China. I think the price decline here has fed that story, but it’s bad economics. Piecemeal tariffs on commodity products are not likely to appreciably change the supply and demand outcome, although it will result in rearranging the sources of product for different countries. Tariffs on non-commodity product, especially branded products with few close substitutes, can have much larger effects – although we ought to remember that from the consumer’s perspective (and in the measurement of consumer inflation), tariffs never lower prices faced by consumers although they can lower prices received by producers. This is why tariffs are bad – they cause higher prices and lower output, and the best case is no real change.

DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have both long and short positions in grains, and in particular long positions in Beans and Corn, this month.

A Real Concern About Over(h)eating

I misread a headline the other day, and it actually caused a market analogy to occur to me. The headling was “Powell Downplays Concern About Overheating,” but I read it as “Powell Downplays Concern About Overeating.” Which I was most delighted to hear; although I don’t normally rely on Fed Chairman for dietary advice[1] I was happy to entertain any advice that would admit me a second slice of pie.

Unfortunately, he was referring to the notion that the economy “has changed in many ways over the past 50 years,” and in fact might no longer be vulnerable to rapidly rising price pressures because, as Bloomberg summarized it, “The workforce is better educated and inflation expectations more firmly anchored.” (I don’t really see how an educated workforce, or consumers who have forgotten about inflation, immunizes the economy from the problem of too much money chasing too few goods, but then I don’t hang out with PhDs…if I can avoid it.) Come to think of it, perhaps the Chairman ought to stick to dietary advice after all.

But it was too late for me to stop thinking about the analogy, which diverges from what Powell was actually talking about. Here we go:

When a person eats, and especially if he eats too much, then he needs to wait and digest before tackling the next course. This is why we take a break at Thanksgiving between the main meal and dessert. If, instead, you are already full and you continue to eat then the result is predictable: you will puke. I wonder if it’s the same with risk: some risk is okay, and you can take on more risk up to a point. But if you keep taking on risk, eventually you puke. In investing/trading terms, you rapidly exit when a small setback hits you, because you’ve got more risk on than you can handle. Believe me: been there, done that. At the dinner table and in markets.

So with this analogy in place, let’s consider the “portfolio balance channel.” In the aftermath of the Global Financial Crisis, the Fed worked to remove low-risk securities from the market in order to push investors towards higher-risk securities. This was a conscious and public effort undertaken by the central bank because (they believed) investors were irrationally scared and risk-averse, and needed a push to restore “animal spirits.” (I’m not making this up – this is what they said). It was like the Italian grandmother who implores, “Eat! Eat! You’re just skin and bones!” And they were successful, just like Grandma. The chart below (source: Enduring Investments) plots the slope of the securities market line relating expected real return and expected real risk, quarterly, going back to 2011. It’s based on our own calculations of the expected real return to stocks, TIPS, Treasuries, commodities, commercial real estate, residential real estate, corporate bonds, and cash, but you don’t have to believe our calculations are right. The calculation methodology is consistent over time, so you can see how the relative value in terms of risk and reward evolved.

The Fed succeeded in getting us to eat more and more risky securities, so that they got more and more expensive relative to safer securities (the amount of additional risk required to get an increment of additional return got greater and greater). Thanks Grandma!

But the problem is, we’re still eating. Risk is getting more and more expensive, but we keep reaching for another cookie even though we know we shouldn’t.

Puking is the body’s way of restoring equilibrium quickly. Abrupt market corrections (aka “crashes”) are the market’s way of restoring equilibrium quickly.

This isn’t a new idea, of course. One of my favorite market-related books, “Why Stock Markets Crash” by Didier Sornette, (also worth reading is “Ubiquity” by Mark Buchanan) talks about how markets ‘fracture’ after bending too far, just like many materials; the precise point of fracture is not identifiable but the fact that a fracture will happen eventually if the material continues to bend is indisputable.

My analogy is more colorful. Whether it is any more timely remains to be seen.

[1] To be fair, I also don’t rely on Fed Chairman for economic advice.

Signs of a Top, OR that I am a Grumpy Old Man

June 20, 2018 4 comments

I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

Summary of My Post-CPI Tweets (June 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Until the end of June, you can get $9.99 off (one month free, or a discount off the already-discounted annual plan) by using code “tryme”. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • 27 minutes to CPI! Here are my pre-figure thoughts:
  • Last month (April CPI) was a big surprise. The 0.098% rise in core was the lowest in almost a year, rewarding those economists who see this recent rise as transitory. (I don’t.)
  • But underneath the headlines, April CPI was nowhere near as weak as it seemed. The sticky prices like housing were stronger and much of the weakness came from a huge drop in Used Cars and Trucks, which defied the surveys.
  • Medical Care and Apparel were also both strong last month.
  • Now, BECAUSE the weakness was concentrated in a small number of categories that had large moves, median inflation was still +0.24% last month, which drives home the fact that the underlying trend is much stronger than 0.10% per month.
  • The question this month is: do we go back to what we were printing, 0.18%-0.21% per month (that’s the 2 month and 6 month avg prior to last month, respectively), or do we have a payback for the weak figure last month?
  • To reiterate – there were not really any HIGH SIDE upliers to potentially reverse. Maybe housing a touch, but not much. To me, this suggests upside risk to the consensus [which is around 0.17% or so and a bump up (due to base effects) to 2.2% y/y].
  • I don’t make monthly point forecasts, but I would say there’s a decent chance of an 0.21% or better…which number matters only since it would accelerate the y/y from 2.1% to 2.3% after rounding. So I agree with @petermcteague here, which is a good place to be.
  • Note there’s also the ongoing risk each month of seeing tariffs trickle through or trucking pressures start to diffuse through to other goods prices. Watch core goods.
  • So those are my thoughts. Put it this way though – I don’t see much that would cause the Fed to SLOW the rate hike plans, at least on the inflation side. Maybe EM or something not US economy-related, but we’d have to have a shockingly broadly weak number to give the FOMC pause.
  • Starting to wonder why we even both with an actual release. Economists nailed it, 0.17% m/m on core, 2.21% y/y.
  • That’s a 2.05% annualized increase. Which would be amazing if the Fed could nail that every month.

  • Core goods accelerated to -0.3% from -0.4%, so the jump there hasn’t happened. Core services moved up to 3.0% from 2.9%. That is the highest core services since Feb 2017, but not absurd.
  • still waiting on core goods acceleration…

  • Used cars and trucks again dropped sharply. -0.89% after -1.59% last month. That’s m/m. The y/y is -1.68%. Again, that’s at odds with all of the private surveys and is a big disconnect. I can’t explain it.
  • Owners’ Equiv Rent put in another solid month +0.25% m/m, up to 3.41% y/y. Starting to get a bit ahead of our model again.

  • Large jump in lodging away from home, 2.93% m/m. That takes the y/y to 4.29%. LAFH is only 0.9% of CPI, but that’s an outlier that will probably come back next month.
  • Medical Care scored a solid 0.2%, accelerating to 2.38% y/y.

  • Pharma (3.73% vs 2.65%), Doctor’s Services (0.55% vs 0.31%), and Hospital Services (4.74% vs 4.49%) all accelerated.
  • Apparel was flat on the month, but that moved y/y up to 1.4% vs 0.8%.
  • Neither stocks nor breakevens care about this figure. Summer has set in. It used to be that the summer lull was a couple of weeks in August. Then it went to all of August as the US mirrored Europe. Now it pretty much starts in June and lasts until Labor Day.
  • I forgot to mention Primary Rents, by the way. They actually decelerated to 3.63% y/y from 3.70%, which takes some the sting out of a potential OER reversal. The Primary Rents move was countertrend so it should also retrace next month. But only 1/3 of the weight of OER.
  • The Primary Rents move does tend to reinforce the message of our model, that OER is a tiny bit out over its skis. However as that chart illustrated, it can diverge a bunch from our model.
  • Biggest m/m declines were in Car and Truck Rental and Public Transportation (what’s up with vehicles??), followed by Mens and Boys’ Apparel. I’ve mentioned Used Cars and Trucks. Household Furnishings also weak.
  • Biggest m/m increases are the aforementioned Lodging Away from Home, Infants and Toddlers’ Apparel, Motor Fuel, and Medical Care Commodities (mostly Pharma).
  • All of the median categories are Rent and OER subcategories which are hard to get a read on, but median should again be mid-0.2s, probably 0.26-0.27% m/m pushing y/y to nearly 2.7% on Median CPI! Last mo was highest since 1/09; this would be highest since 2008.
  • This is median BEFORE today’s figure, which will come later. And I could be wrong about it.

  • Core ex-housing, something worth watching especially since housing seems back in an uptrend, rose to 1.29% from 1.21%. That’s the highest since Jan 2017, but it hasn’t been higher than 1.61% since early 2013. Right now can still claim it’s a housing story.
  • Putting together the four-pieces charts.
  • Still not much action in inflation markets. From the swap curve: US #Inflation mkt pricing: 2018 2.2%;2019 2.2%;then 2.3%, 2.4%, 2.4%, 2.4%, 2.5%, 2.5%, 2.4%, 2.5%, & 2028:2.5%.
  • Four Pieces: Food & Energy first. Roughly 21% of CPI.

  • Core Goods, about 19% or so of CPI. Rising very slowly. If core inflation is to reach ‘escape velocity’ this needs to rise a fair amount. Tariffs will help that, eventually.

  • Core services, less rent of shelter. About 27% of overall CPI. Lot of medical care here, which as we expected has been pulling this higher. Again, for CPI to reach escape velocity you’d want to see this above 3%.

  • And the big kahuna, housing, about 1/3 of overall CPI. Had a steady run-up, got ahead of itself and came back to model, and now is accelerating again. Housing indeed looks tight, and this should continue especially if wages continue to accelerate.

  • Diffusion look at inflation is still pretty dull. Slightly less than half of all categories of CPI are accelerating faster than 3%. But that’s been very consistent between 40% and 50% (obviously at ~50%, median CPI would be at 3%).

  • OK, last overall point. May was an easy hurdle to get an acceleration in y/y, as May 2017 was only +0.08. June and July of last year were both +0.143%, so again we should see more acceleration. Y/y core CPI should be at 2.3% next mo & hit 2.4% in Sept just on base effects.
  • …that’s merely assuming 0.2% per month from core CPI, which is between what TTM core says it is and what median stays it is. If we print just a smidge above 0.2% per month we could hit 2.5% in November. Again, that’s assuming no big acceleration in underlying pressures.
  • I happen to believe there ARE some underlying pressures so I think we’ll hit 2.5% sooner than that and median will press 3%. Nothing super alarming for the Fed, but somewhat discomfiting. The real test will be once we hit Dec and Jan and those hard comps.
  • That’s all for today. Thanks for tuning in, and thanks for subscribing to the modestly-priced premium channel. I really appreciate your voting with your dollars in this way!

Breakevens eventually did care a little bit, rising a tick or so. Market-wise, today’s number continues to do two things. First, it doesn’t really give any reason for the Fed to arrest or delay its current plans to gradually hike overnight rates. There was no surprise here – this is still all very much in the realm of base effects as we drop off the strange deceleration from last year. Second, there’s really no reason for interest rates in the US to stay below 3%. In an expanding economy with accelerating inflation which is already at 2.2%, or 2.7% on median, a 3% nominal yield makes little sense. Real yields, and nominal yields, are too low. So, honestly, are breakevens…inflation swaps are showing forward expected inflation rates of no more than 2.5% out for many years, even though median inflation (and headline inflation!) is already above that level. You have to have a great deal of faith in an untested hypothesis – the idea that inflation expectations will be ‘anchored’ and overwhelm any effects from tariffs, actual production bottlenecks, and monetary largesse, to keep inflation low and steady – to be actively shorting inflation at these levels, and if you’re buying Treasuries at yields below 3% you are actively betting on inflation declining.

If it seems a strange time to be making that bet, I agree with you. But market sentiment is clearly biased in favor of a belief that the weather will always be sunny and warm and that neither inflation nor commodities will go higher, or equities or bonds lower, from these levels. The contrary evidence about inflation, anyway, continues to build and to my mind it requires an increasing effort of will to ignore that evidence.

European Inflation Concerns Also Rising?

In this space I write a lot about inflation, but specifically I focus mostly on US inflation. However, inflation is substantially a global process – a paper by two ECB economists in 2005 (and our independent followup) found that nearly 80% of the variance in inflation in the G7 and G12 could be accounted for by a common factor. This observation has investment implications, but I’m not focusing on those here…I’m just presenting that fact to explain why I am about to show a chart of European inflation.

Right, so technically it’s my second article in a row in which I mention European inflation. In last Friday’s “Potpourri for $500, Alex”, I noted that core European inflation rebounded to 1.1% after being counted for dead at 0.7% last month. But what is illustrated above is the inflation swaps market, and so is forward-looking. I think this looks a lot more dramatic: investors expect 5-year European inflation to average 1.5% over the next 5 years (a year ago, they were at 1.1% or so and two years ago the market was at 0.7%), and to converge up towards 1.8% where the 5y, 5y forward inflation swap indicates the approximate long-run expectation since it’s not significantly influenced by wiggles in energy.

What is especially interesting though is not the overall trend. Inflation markets everywhere, with the exception of the UK, have been trending higher for a couple of years – you are forgiven if you hadn’t heard that, but the ‘disinflation’ lobby is strong (most of the equity houses have some skin in the game in that direction, after all). No, what is most interesting to me is that inflation swaps have been trending higher recently even though energy prices have been in retreat and even though European yields (outside of Italy) have mostly been in decline. It isn’t as if Euro area growth has been setting the world afire. The currency has been weakening as US growth seems to be outstripping growth on the continent and as the European ‘experiment’ once again looks to be under stress.

What Euro inflation investors may believe, though, are two things. First, a trade war is really bad for inflation, and probably moreso for Europe than the US since there is a larger external sector. Trade frictions are bad for everyone, of course, but a splintering of the Euro bloc would be the ultimate in trade frictions. Second, the ECB is being much slower to stop QE and raise rates than is the Fed. Heck, the ECB’s deposit facility is still at -0.40%, where it has been for 2016. While I am in the camp that rates are of limited importance when economic liquidity is far larger than the economy demands (that is, when there are inert excess reserves), that’s not a mainstream view and as much as I would like to believe otherwise, markets respond to the mainstream view and not mine!

For some time, we’ve favored European ILB over US ILB, and that has been a steady if unexciting trade. Even after this move, European inflation bonds are still considerably cheap to US TIPS, which are themselves still fairly cheap relative to nominal US rates.

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