This Pork Chop Is Grounded
The CPI release on Friday amply demonstrated why inflation trading folks tend to ignore PPI. The PPI figure had scared people into thinking that the rise in consumer inflation, long-awaited (and coming!) was nigh.
It wasn’t. Headline CPI rose+0.2%, but the miss was entirely due to the miss in core inflation. Core CPI at -0.1% missed the consensus guess by a full two-tenths, which is a bit like a three-touchdown favorite losing by two touchdowns: it happens, but not very often. I, however, was delighted, since the model I follow had been giving a much lower central tendency to the year-on-year number.
Ex-housing, core inflation was +2.8% year-on-year, down just a little bit but obviously still indicating inflation higher than the Fed would like to see. I don’t generally create ex- numbers unless there is a good reason; some elements of inflation are always running faster and some are always running slower than the average, so all you do in most cases when you remove “outliers” is produce a number that happens to agree with your forecast. But in this case, we have a large part of the CPI number which has been very obviously polluted by the existence first of the housing bubble, and now of the lagged response to the housing bust. It makes sense to see what “everything not coming off a bubble” is doing.
Now, while 2.8% is above the Fed’s target range, and I am sure they would be uncomfortable if they thought core-ex-housing was something worth looking at, there really isn’t anything they can do about it. There is no way, politically, that they can tighten with 10% unemployment and core inflation at 1.6% and declining (even if that’s not the right way to look at it). If Bernanke wants to make sure he spends the next several years in hearings before Congress about the necessity of having an independent Federal Reserve, tightening monetary policy right now would be a great way to ensure that.
Even if core inflation begins to head higher (which it will, probably in late Q3 or early Q4 if not before), it’s just not really likely that the FOMC can defend its decision to pursue price stability by slowing an economy that still has 9% or 10% unemployment and needs to gun the engine a bit just to have a chance of achieving a sub-trillion-dollar deficit. (Heck, Bernanke is testifying on Monday before the House Financial Services Committee on the topic “Prospects for Employment Growth: Is Additional Stimulus Needed?” Can you imagine the FOMC hiking rates at the same time the Congress is preparing another big stimulus?) The Fed may try and sneak rates up away from 0% in the context of “removing unusual stimulus measures,” but with low capacity utilization of labor and capital, PIIGS instability, continuing bank seizures and a dollar that doesn’t seem to need any help right now for some reason, that is one pork chop that’s going to be hard to throw past the hungry wolf. Short rates will not move very far from zero for some time, if they move at all.
I am also sure that most policymakers, in their private thoughts, wouldn’t mind a slightly higher inflation rate than their stated goal. Inflation of 3-4%, if it were contained, wouldn’t be a disaster from a resource-allocation perspective and would certainly be useful in terms of helping the nation grow out of its liabilities. But the problem, as ever, is that while it is simple for a monetary authority to create inflation, it is devilishly difficult to create just a little inflation.
Regardless of whether the Fed and the Congress and the President would like a little bit of inflation or not, we can count on them to keep saying loudly that they don’t, and that they’ll be aggressive to address inflation. Absolutely the worst outcome is that bond vigilantes figure out the game early and start pushing up rates. Every government auction that clears at these rates is an unmitigated victory for a legislature committed to living beyond its means. But you know what? I think the bond vigilantes seem to be getting a clue. Friday’s CPI might throw them off the scent for a while, but…rates seem to me likely to be heading higher.
Speaking of auctions, on Monday the Treasury will be auctioning off $8bln of 30-year TIPS. It isn’t a big auction, but these are big DV01s and this is the first 30y TIPS auction in many moons. At a real yield of a bit above 2% it isn’t a fabulous must-own bond, but it’s not too bad and there are a lot of investors who need long-term inflation immunization. I suspect it will be a good auction.
Interestingly, and again illustrating my obsession with all things inflation, implied volatilities on inflation options have been sneaking higher recently after sliding a very long way since last summer. Options on inflation (caps, floors) are very expensive to buy, and fairly illiquid although the interbank market the last several months has seen some action, so I don’t really suggest anyone run out to buy inflation caps even though it seems like the right thing to do. But they had gone from insanely-expensive last summer (option prices implying that inflation by itself would be several times as volatile as nominal rates) to only very-expensive a month or so ago. But some buyers seem to be pushing vols higher again. Needless to say, nervousness about inflation variance implies a better environment in which to be auctioning long inflation-linked bonds!