Earlier today I was on Bloomberg<GO> when the PCE inflation figures were released. As usual, it was an enjoyable time even if Alix Steel did call me a ‘big inflation nerd’ or something to that effect.
The topic was, of course, PCE – as well as inflation in general, how the Fed might respond (or not), and what the effect of the new Administration’s policies may be. You can see the main part of the discussion here, although not the part where Alix calls me a nerd. A man has some pride.
My main point regarding the PCE report was that PCE isn’t terribly low, but rather right on the long-run average as the chart below (all charts source Bloomberg) shows. Of course, PCE has been lagging behind the rise in CPI, but because it had been “too tight” previously this isn’t yet abnormal.
However, in the interview I didn’t get to the really nerdy part. Perhaps my ego was still stinging and so I didn’t want to highlight the nerdiness? No matter. The nerdy part is that the reason PCE is low is actually no longer because of Medical Care, but because of housing. This next chart plots the spread of core CPI over core PCE, through last month’s figures, versus Owners’ Equivalent Rent (OER).
Housing has a much higher weight in the CPI than in the PCE, and as you can see the plodding nature of OER means that the correlation is somewhat persistent because housing inflation is somewhat persistent. Right now, OER (which, frankly, I thought would have leveled off by now) is rising and showing no signs of slowing, and this fact has served to widen the CPI-PCE spread back to its historical average and likely will cause it to widen to an above-average level. I suppose the good news there is that it is still true that outside of housing, core inflation is still not rising aggressively. Core services ex-housing are looking perkier, but core goods continue to languish as the dollar remains strong. The strength of the dollar almost beggars belief if it’s true that the rest of the world hates us now, but it is what it is.
The bigger point, for markets, is “so what?” There is nothing about a 1.7% core PCE that presents any urgency for Chairman Yellen. As I said on the program: as Yellen approaches the end of her chairmanship (in January 2018, since she insists Trump won’t chase her out before), I believe it is much more likely that she wants to be remembered for pushing the unemployment rate very low – because she believes inflation is easily controlled – than that she wants to be remembered for being a hawk that stopped inflation from getting going. She isn’t worried about inflation, and so the question is whether she wants to be criticized for adding “too many” jobs, or not adding enough. Not that monetary policy has much to do with that, but I believe she clearly will err on the side of keeping policy too loose. The Fed isn’t tightening this week, and I find it unlikely that they will tighten in March, unless inflation expectations rise considerably further than they have already (see chart of 5y5y inflation forward from CPI swaps, below). Even after the big rally since late last year, 5y5y is well below the long-term average through 2014.
And even if inflation expectations do rise further, the excuse from the chair will be easy: expectations are rising because the end (and possible reversal) of the globalization dividend and the imposition of tariffs will lead to higher prices. But there is nothing that Fed policy can do about this – it is a supply-side effect, just as high oil prices due to OPEC production restraints would represent a supply-side effect that the Fed shouldn’t respond to. So the excuses are all there for Dr. Yellen. History will show that she missed a chance to shrink the Fed’s balance sheet and avert the worst of the next inflationary upturn, but that history will not be written for some time.
 Ridiculous, of course. I embrace my nerdiness, at least when it comes to inflation.
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. Plus…buy my book about money and inflation, published in March 2016. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.
- Last CPI of 2016…fire it up!
- Core +0.23%, a bit higher than expected. Market was looking for 0.16% or so.
- y/y core CPI rises to 2.21%. The core print was the second highest since last Feb.
- For a change, the BLS has the full data files posted so brb with more analysis. Housing subcomponent jumped, looking now.
- Just saw this. Pretty cool. Our calculator https://www.enduringinvestments.com/calculators/cpi.php … pretty cool too but not updated instantly.
- BLS-Labor Statistics @BLS_gov: See our interactive graphics on today’s new Consumer Price Index data http://go.usa.gov/x9mMG #CPI #BLSdata #DataViz
- As I said, housing rose to 3.04% from 2.90% y/y. Primary Rents jumped to 3.96% from 3.88%; OER 3.57% from 3.54%.
- Household energy was also higher, so some of the housing jump was actually energy. But the rise in primary rents matters.
- Will come back to that. Apparel y/y slipped back into deflation (dollar effect). Recreation and Education steady. “Other” up a bit.
- In Medical Care, 4.07% vs 3.98%. That had recently retraced a bit but back on the + side. Drugs, Prof. Svcs, and Hospital Svcs all +
- Medicinal drugs. Not a new high but maybe the retracement is done.
- Core services up to 3.1% from 3.0%; core goods -0.6% vs -0.7%.
- That’s consistent with our view: stronger USD will keep core goods in or near deflation but it shouldn’t get much worse.
- The dollar is just not going to cause core deflation in the US. Import/export sector is too small.
- Core ex-housing rose to 1.20% from 1.12%. Still not exactly alarming!
- Not from this report, but wages are worrying people and here’s why:
- However, wages tend to follow inflation, not lead it. I always add that caveat. But it matters for Fed reaction function.
- Next few months are the challenge for renewed upward swing in core CPI – Jan and Feb 2016 were both high and drop out of the y/y.
- Early guess at Median CPI, which I think is a better measure of inflation…my back of envelope is 0.24% m/m, 2.61% y/y…new high.
- CPI in 4 pieces. #1 Food & Energy (about 21%)
- CPI in 4 pieces. #2 Core Goods (about 20%)
- CPI in 4 pieces. #3 Core Services less Rent of Shelter (about 27%)
- CPI in 4 pieces. #4 Rent of Shelter (about 33%)
- This is why people are worried re’ inflation AND why people dismiss it. “It’s just housing.” Yeh, but that’s the persistent part.
- Scary part about rents is that it’s accelerating even above our model, and we have been among the more aggressive forecast.
- OK, that’s all for this morning. Anyone going to the Inside ETFs conference next week? Look me up.
We end 2016 with the outlook in limbo, at least looking at these charts – unless January and February print 0.3% on core inflation, core CPI will be hanging around 2% for at least the next few months. Median inflation is more worrisome, as it will probably hit a new high when it is reported later today, but it doesn’t get the ink that core CPI or core PCE gets.
To my mind, the underlying trends are still very supportive of a cyclical (secular??) upswing in core inflation. Here’s a summary of two of the pieces that people care about a lot. Housing is much bigger, but slower; Medical Care is more responsive, but smaller.
I suspect that chart is enough to keep most consumers jittery with respect to inflation, but as long as retail gasoline prices stay below $3/gallon there won’t be much of an outcry. But that doesn’t matter. M2 money growth accelerated throughout 2016 as the economy improved, and ended the year at 7.6% y/y. Interest rates are rising, which will help push money velocity higher. It’s hard to see how that turns into a disinflationary outcome.
I was planning to write an article today about the shape of the yield curve. Since the Global Financial Crisis, the Treasury curve has been very steep – in early 2010 the 2y/10y spread reached almost 300bps, which is not only unprecedented in absolute terms but especially in relative terms: a 300bp spread when 2-year yields are below 1% is much more significant than a 300bp spread when 2-year yields are at 10%.
But what I had planned to write about was the phenomenon – well-known when I was a cub interest-rate strategist – that the yield curve steepens in rallies and flattens in selloffs. The chart below shows this tendency. The 5-year yield is on the left axis and inverted high-to-low. The 2y/10y spread is on the right axis. Note that there is substantial co-movement for the recession of the early 1990s, throughout the ensuing expansion (albeit with a general drift to lower yields), in the recession of the early 2000s, the ensuing expansion, and the lead-up to the GFC.
I was ready to point out that the steepening and flattening trends tend to be steady, and I was going to illustrate that they feed on themselves partly for this technical reason: that when the curve is steep, steepening trades (selling 10-year notes and buying duration-weighted 2-year notes, financing both in repo) tend to be positive carry and therefore easier to maintain, while on the other hand when the curve is flat the opposite tends to be true. So the actual causality of the relationship between steepening and rallies is more complex than it seems at first blush.
It would have made a very good article, but then I noticed that since 2010 or so the tendency has in fact reversed!
Specifically, from 1987-1995 the correlation of the level of the 5-year spread to the level of the 2s/10s spread was -0.78. From 1995-1999, the correlation flipped to +0.48 (but I didn’t bother to de-trend the data and I suspect that correlation stems more from the strong, 350bp decline in interest rates from 1995-1999). From 1999-2009, the correlation was -0.81. Since 2010, the correlation is +0.60: the curve has tended to flatten in rallies and steepen in selloffs. And, in the recent bond market selloff, the curve steepened as long rates rose further than short rates.
This is interesting. Clearly, carry dynamics cannot explain why the relationship is inverted. I think the answer, though, is this: since 2010, the overnight has been anchored. That isn’t different than in the past – from late 1992 to early 1994, the Fed funds target was anchored at 3%. But the difference is that back then, traders acted as if the Fed might eventually move the overnight rate in a meaningful way. Since 2010, investors and traders have attributed no credibility to the Fed, with virtually no chance of a substantial move over a short period of time. Accordingly, while short interest rates historically have tended to be the tail wagging the dog, while longer-term interest rates move around less as investors assume the Fed will remain ahead of the curve and keep longer-term inflation and interest rates in a reasonable range…in the current case, short term rates don’t move while longer-term rates reflect the market belief that rates will eventually reach an equilibrium but over a much longer period than 2 years as the Federal Reserve is dragged kicking and screaming.
I happen to agree, but it isn’t a great sign. I suppose it was destined, in a way – “open mouth” operations can only work in the long run if the Fed is credible, and the Fed can only be credible in the long run if it delivers on its promises. But it hasn’t. This is probably because the Fed’s forecast have been worse than abysmal, meaning its promises were based on bad forecasts. In such a case, changing one’s mind when the data changes is the right thing to do. But even more important, if your forecasts are frequently wrong, is to shut up and stop trying to move markets where you want them with “open mouth” operations. I have said it for 20 years: the worst thing Greenspan ever did was to make “transparency” a goal of the Fed. They’re just not good enough at what they do to make their activities transparent…at least, if they want to maintain credibility.
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Administrative Note: On Monday I will be conducting the third and final in a series of webinars on inflation and inflation investing. This series will be done on the Shindig platform, sponsored by Enduring Investments, in cooperation with Investing.com. This webinar is on “Inflation-Aware Investing.” You can sign up directly with Shindig here, or find the webinar link at Investing.com.