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Summary of My Post-CPI Tweets (July 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!

  • Welcome to CPI day from the Rocky Mountains! Inflation indicators are getting more and more important these days, and today’s number will be interesting as always.
  • First, let me mention that I will be on @TDANetwork with @OJRenick today at 9:15ET to discuss the CPI and other inflation items. Tune in!
  • In this month’s CPI, we will probably continue to see some of the data collection issues from the last few months, but fewer. As the US has opened back up, the readings should start being cleaner. So the volatility we see will start to represent actual volatility in pricing.
  • I think we should continue to be cognizant of the underlying context, and that is that M2 growth in the US is at all-time records. Can we have 23% money growth and no inflation?

  • Keynesians would say yes – in fact, with the massive output gap, we should be in outright deflation. There may be some nuance (inflation anchoring keeps it from happening immediately), but the sign is clear.
  • Monetarists would say that after velocity corrects the unusual, huge precautionary demand for cash balances (lowering velocity), we should see problematic inflation. How much? Hard to say, but I’ll say I’m not aware of a society that has had 20% m2 growth and NOT had inflation.
  • So far, the monetarists are winning. While core inflation has dipped the last few months, it’s all in the ‘left tail’ of the distribution: used cars, airfares, lodging away from home, and apparel account for it all. Median inflation has barely budged.
  • So the story going forward is that we are going to eventually see a bounce in those tail items, so if we’re going to get deflation we need to see broader deceleration in prices.
  • The consensus today is for 0.1 m/m on the core CPI. That seems low to me. Unless something weird happens with primary rents and OER and they start to slow markedly, any rebound in those tail items is going to take inflation up. But we will see, in just a few minutes. Good luck!
  • Higher than expected core: +0.19% m/m, +1.19% y/y. As I noted up top, that’s not super surprising actually.

  • Sorry – erratum: seasonally adjusted core was +0.235, not 0.19%. So almost gave us a double-tick surprise.
    • In some of the unusuals from past months, yes we’re seeing corrections: Airfares +2.60% m/m (last month -4.88%); Lodging Away from Home +1.21% (last month -1.53%). Used Cars still soft, -1.19%. That’s actually surprising.
  • I suppose it is just in the lag, but used car prices rebounded in a major way in the private surveys (see chart). the Black Book index is higher than before Covid.

  • Interestingly, the upside core surprise happened DESPITE softness in primary rents (+0.12%, 3.22% y/y vs 3.48%) and OER (+0.09%, 2.84% y/y vs 3.06%)
  • Seeing strength in medical care, not surprisingly. That’s been hard to survey over the last couple of months. Doctors +0.45% m/m, 2.10% y/y (was 1.80); Hospitals +0.37% m/m, 5.29% y/y (was 4.86%) Pharma still soft, flat this mo but y/y up to 1.38% vs 0.97%
  • Forgot to mention Apparel, that other one-off. +1.66% this month, though still down hard y/y.
  • Hospital Services y/y

  • Core ex-housing rose slightly, to +0.35% y/y from +0.29% y/y. Still very low, but I suspect the lows are in.
  • Although this is an upside surprise, core still fell vs last month on a y/y basis because we rolled off a +0.28% from last June. Core goods were -1.1% vs -1.0% last month, core services +1.9% vs +2.0% last month (y/y). So there’s still some downward pressure. But it’s turning.
  • I’m afraid this is going to be abbreviated this month as I need to go get ready for @TDANetwork. I’ll be on at about 9:15 ET. Later I’ll update the four-pieces charts.
  • Bottom-lining it: the monetarists win another round as the broad deflation Keynesians would predict is nowhere in evidence. Some of the one-offs are correcting. We do need to keep an eye on the softening in rents.
  • NONE of this will bother the Fed yet…I doubt any of them got out of bed for this number. Thanks for tuning in!

Today’s CPI examination is somewhat abbreviated as I am on ‘vacation’ and my inspection of the report was interrupted by my TDA Network appearance. We’ll be back to normal-length next month. The basic story for the June CPI core inflation figure is a bit of a return to the mean, with most of the left-tail items (with the exception, only temporary, of used cars) rising and retracing some of the dramatic declines we saw in March, April, and May and at the same time a bit of softening of rents. I think the rental softness is also temporary, and tied to a lack of traffic over the last few months – but that’s the only potential fly in the ointment.

The takeaway for this month is really provided by the chart of the last 12 months’ core CPI print, the second one above. Heading into COVID, core CPI was printing around 0.2%-0.25% fairly consistently. March, April, and May were deep exceptions, but June is back to the former trend. To be fair, median CPI this month was very low, at +0.12% m/m and “only” 2.60% y/y. That deceleration was tied to softness in South and West regional Owners’ Equivalent Rent indices, which as I said would surprise me if it was repeated. Rents had recently retreated to our model, and have now slipped below (see chart below).


So, is a dramatic acceleration in inflation evident in the data? Not yet, although the acceleration in M2, coupled with my conviction that the precautionary demand for cash balances will eventually relax, makes me confident that we will see that in the quarters to come. But if we can’t say that breakout inflation is here, neither can we say that there is the least sign of deflation in these figures. Again, if the Keynesians are right, then the huge output gap means that aggregate demand will be insufficient to keep prices up, and deflation will ensue. In the Keynesian world, the only reason this hasn’t happened yet is that inflation expectations are well-anchored or, in other words, merchants haven’t caught on yet that they can’t charge what they were previously charging. In the monetarist mindset, the fact that there is far more money in bank accounts than there was just a few months ago means that eventually the nominal price of goods will be bid up since the price is after all just an exchange rate (of dollars for stuff), and when there are many more dollars then the price of those dollars declines (the price of stuff rises). The reason inflation hasn’t happened yet, according to this view, is that people are clutching nervously onto those cash balances, rather than spending it.

But there are signs that nervousness is ebbing – such as in the price of automobiles and many online goods. If the country lurches back into lockdowns, and the recovery turns back into a deeper recession, then that nervousness may continue for longer. American consumers, though, suck at saving and big cash balances and high savings rates are not usually persistent.

Categories: CPI, Tweet Summary

Trust Masters, not Models

June 25, 2020 4 comments

Normally, when I write about markets, I try to point at models but there is a lot of guesswork and gut-work in analysis. When times are sort of normal, then models can be a big part of what drives your thinking. But times have not been ‘normal’ for a very long time, and this is part of what drives big policy errors (and big forecasting errors): if you are out of the ‘normal’ range, then to make a forecast or comment usefully on what is going on you need to have a good feel for what the model is actually trying to capture. You need to know where the model goes wrong.

When I was a rates options trader – stop me if I’ve told this story before – I found that I preferred to use a simple Black-Scholes pricing model instead of some fancy recombining-trinomial-tree-with-heteroskedastic-volatility-model. That was because even though Black Scholes doesn’t match up super well with reality, I at least had a good feel for where it fell short. For example, the whole reason we have a volatility smile is because real-world returns have fat tails, but pricing models like Black Scholes are based on the normal distribution. When the smile flattens, it means returns are becoming more like they’re being drawn from a normal distribution; when it steepens it means that the tails are becoming fatter. So that’s easy to understand.

If you understand why an option model works, then it’s easier to think about how to price something esoteric like an option on an inflation swap (which can trade at a negative rate, but actually isn’t a rates product at all but rather is a way of trading a forward price), and not mess it up. But if you just apply and try to calibrate a bad model – especially if it’s really complicated – then you get potentially really bad outcomes. And that is, of course, exactly where we are today.

We haven’t been ‘normal’, I guess, for a couple of decades. Central banks, and in particular the Federal Reserve, have dealt in the markets with a heavier and heavier hand. Nowadays, the Fed not only has expanded its balance sheet by trillions in a very short period of time, but it has expanded the range of markets it is involved in from Treasuries to mortgages to ETFs and now individual corporate bonds. And, since the whole point of this is because the Fed wants to make sure the stock market stays elevated (they are preternaturally terrified at the notion of a wealth effect from a market crash, even though historically the wealth effect has been surprisingly small) I suspect it is only a matter of time before they directly intervene in equity markets.[1] C’est la vie. There is no normal any more.

But at least the ‘normal’ we have had over the last decade was just modestly outside of the prior normal. Things didn’t work right according to the ‘traditional’ way of thinking about things; momentum became ascendant in a way we’ve never seen before and value almost irrelevant. We are now, though, working on a whole different part of the number line. This means that economists will continue to be surprised at almost everything they see, and it means that any model you look at needs to be informed by a good intuition about how the hell it works.

So, for example, let’s consider the money supply. Over the last 13 weeks, M2 is up at a 63% annualized rate. With two weeks left in the quarter, it looks like we will end up with something like a 10.25%-10.50% growth in the money supply for the quarter. The Q2 average money supply, compared to Q1 (important in looking at the MV=PQ equation), is going to be about 13.85% higher. That’s not annualized! Remember, the old record in M2 growth for a year was a bit above 13%, in 1976.

The current NY Fed Nowcast for 2nd Quarter GDP – keeping in mind that no one has any idea, this is as good a guess as any – is -19.03%. I really like the .03 part. That’s sporty. That would mean q/q growth of -4.75%.

If we want the price deflator to come in around 1.75% (+0.44% q/q), which is where it was for the year ended in Q1, then that means money velocity needs to fall about 16% for the quarter. (1-4.75%)*(1+0.44%)/(1+13.85%)-1 = -15.97%. If money velocity falls less, and that GDP estimate is correct, then inflation comes in higher. If money velocity falls more, then inflation comes in lower. If GDP growth is actually better than -19% annualized, then inflation is lower; if GDP is worse, then inflation is higher. We don’t need to worry much about the M2 numbers themselves, as they’re almost baked in the cake at this point.

The biggest amount that money velocity has ever fallen q/q is about 5%. But clearly, these are different times! We’ve also never seen a 19% decline in growth.

Weirdly, our model has M2 money velocity for Q2 at 1.159, which would be a 15.6% decline in money velocity. Let me stress that that is a total coincidence, and I put almost zero weight on that point estimate. Contributing to that sharp decline, in our model, is the small decline in interest rates from Q1, the increase in the non-M1 part of M2, the small increase in global negative-yielding debt, and (most importantly) a large increase in precautionary demand for cash balances due to economic uncertainty. (This is why it’s hard to get velocity to stay down at this level. The current low levels depend on low interest rates, which will probably persist, but also on dramatic precautionary savings, which are unlikely to). Small changes in money velocity will have big effects on inflation: if our model estimate for velocity was right, we’d see annualized inflation for Q2 at 4.3% or so. Here’s how confident I am in our model: for Q3, it is seeing unchanged velocity (approximately), which with money trends and the GDP Nowcast figures from the NY Fed would imply that y/y inflation would rise to 6.22%, about 17.5% annualized for the quarter. Not going to happen.

Here’s where knowing a bit about the underlying process and assumptions really matters. Velocity is effectively a plug number, in that bureaucrats are good at measuring money and pretty good at measuring GDP and prices, but really bad at measuring velocity directly. So velocity is solved for. And our model (along with every other model, probably) treats the response of money velocity to the input variables as more or less instantaneous. For small changes in these variables – movements in money growth from 4% to 6%, or GDP from 2% to 0% – the assumption about instantaneity is pretty irrelevant. The economy adjusts prices easily to small changes in conditions. But that’s not true at all for big changes. On the available evidence, many prices (if not most) accelerated a bit in Q2, which surprised almost everyone including us. But no matter what the model says, prices are not going to drop 5% in a quarter, or rise 5% in a quarter, for the entire consumption basket. Price changes take time – heck, rents don’t change every month, and it takes time to rotate through the sample. Also, manufacturers don’t tend to make large changes in prices overnight, preferring to drip it in and see consumer response. But here’s the point: the model doesn’t know this. So I suspect we will see money velocity this quarter around 1.14-1.17…not because I believe our model but because I think prices will accelerate by a little bit and I think the real uncertainty surrounds the forecast of GDP. Over time, velocity and inflation will converge with our model, but it will take time.

For what it’s worth, I think that GDP growth will be a little lower than the NY Fed thinks, for a different model reason: the model assumes that changes in various economic data can be mapped to changes in GDP. But that assumes a fairly stable price level…what they’re really mapping this data onto is the nominal price level, and assuming that the price level doesn’t change enough to matter. So I think some of the dollar improvement in durable goods sales, for example, reflects rising prices and not growth, which would be manifested in a slightly lower GDP change and a slightly higher GDP deflator change.

What does this mean and why does it matter?

For one thing…and you already knew this…models are currently trash. They mean almost nothing by themselves. You should ignore it all. I give very little credence to the NY Fed’s forecast. I am pretty sure Q2 GDP growth will have a minus sign, but I couldn’t tell you between -15% and -25% and neither can they. Which is why the -19 POINT OH-THREE is so sporty. But by the same token, you should listen more to the model-builder, and to people who understand what’s going on behind the models, and to people who are taking measurements directly rather than taking them from models. Because this is going back to the art of forecasting, and away from the science. We are over-quanted in this world, and we are over-committed to models, and we are overconfident in models, and we are over-reliant on models. They have a place, just as the autopilot has a place when conditions are placid. When things get rough, you want a real pilot holding the controls.[2]

There used to be a couple of guys in Boston who were auto mechanics and had a radio show. People would call up and describe the noises their cars made, and the guys would ask whether it made the noise only turning left, or both directions, and whether it got worse when it was humid, and other things that sounded crazy to you and me. And then they would diagnose the problem, sight-unseen. Those are the people you want to take your car to. They’re the ones who understand how it really works, and they don’t need to hook your car up to a computer to tell you what the problem is. I took my car to them, and they really were geniuses at it. So look for those people in market space: the ones who can tell by the sound of the squeal what is really going on under the hood. They won’t always be right, but they will have the best guesses…especially when something unusual happens.


[1] Ironically, I think that something else they are considering would have a much bigger effect on equity markets than if they directly bought equities, but I don’t want to talk about that in this space because it also has big implications for inflation-related markets and would create some really delicious relative value trades that I don’t want to discuss here.

[2] Although I didn’t think I’d remark on this in today’s comment: this is also why the Trump Administration’s move today to loosen the Volcker Rule to let banks take more risks with their capital is very timely. There is a lot of bumpy flight ahead of us and we should want seasoned traders making the markets with actual capital behind them, not robots looking to scalp an eighth.

Categories: Analogy, Investing, Trading

The Flip Side of Financialization of Commodities

Recently, a paper by Ilia Bouchouev (“From risk bearing to propheteering”) was published that had some very thought-provoking analysis. The paper traced the development of the use of futures and concluded that while futures markets in the past (specifically, he was considering energy markets but notes the idea started with agricultural commodities) tended towards backwardation – in which contracts for distant delivery dates trade at lower prices than those for nearer delivery dates – this is no longer as true. While others have noticed that futures markets do not seem to provide as much ‘roll return’ as in the past, Mr. Bouchouev suggested that this is not a random occurrence but rather a consequence of financialization. (My discussion of his fairly brief paper will not really do it justice – so go and read the original from the Journal of Quantitative Finance here).

Let me first take a step backward and explain why commodities markets tend towards backwardation, at least in theory. The idea is that a producer of a commodity, such as a farmer growing corn, has an affirmative need to hedge his future production to ensure that his realized product price adequately compensates him for producing the commodity in the first place. If it costs a farmer $3 per bushel to grow corn, and he expects to sell it for $5 per bushel, then he will plant a crop. But if prices subsequently fall to $2 per bushel, he has lost money. Accordingly, it behooves him when planting to hedge against a decline in corn prices by selling futures, locking in his margin. The farmer is willing to do this at a price that is lower than his true expectation, and possibly lower than the current spot price (although, technical note: Keynes’ ‘Theory of Normal Backwardation’ refers to the difference between his expected forward price and the price at which he is willing to sell futures, so that futures prices are expected to be downwardly biased forecasts of prices in the future, and not that they are expected to be actually lower than spot ‘normally’). He is willing to do this in order to induce speculators to take the other side of the trade; they will do so because they expect, on average, to realize a gain by buying futures and selling in the future spot market at a higher price.

Unfortunately, no one has ever been able to convincingly prove normal backwardation for individual commodities, because there is no way to get into the collective mind of market participants to know what they really expect the spot price to be in the future. Some evidence has been found (Till 2000) that a risk premium may exist for difficult-to-store commodities (agricultural commodities, for example), where we may expect producers to be the most interested in locking in an appropriate profit, but on the whole the evidence has been somewhat weak that futures are biased estimators of forward prices. In my view, that’s at least partly because the consumer of the product (say, Nabisco) also has a reason to hedge their future purchases of the good, so it isn’t a one-sided affair. That being said, owners of long futures positions have several other sources of return that are significant and persistent,[1] and so commodity futures indices over a long period of time have had returns and risks that are similar to those found in equity indices but deriving from very different sources. As a consequence, since the mid-2000s institutional investment into commodity indices has been significant compared to the prior level of interest, even as actual commodity returns have disappointed over the last 5-10 years. Which brings us back to Mr. Bouchouev’s story again.

He makes the provocative point that part of the reason commodity returns have been poorer in recent years is because markets have tended more toward contango (higher prices for distant contracts than for those nearer to expiry) than backwardation, and moreover that that is a consequence of the arrival of these institutional investors – the ‘financialization’ of commodities futures markets, in other words. After all, if Keynes was right and the tendency of anxious producers to be more aggressive than patient speculators caused futures to be downwardly biased, then it stands to reason that introducing more price-insensitive, institutional long-only buyers into the equation might tilt that scale in the other direction. His argument is appealing, and I think he may be right although as I said, commodities are still an important asset class – it’s just that the sources of returns has changed over time. (Right now, for what it’s worth, I think the potential return to spot commodities themselves, which are ordinarily a negative, are presently a strong positive given how badly beaten-down they have become over time).

All of that prelude, though, is to point out a wonderful corollary. If it is the case that futures prices are no longer biased lower by as much as they once were, then it means that hedgers are now getting the benefit of markets where they don’t have to surrender as much expectation to hedge. That is, where an oil producer might in the past have had to commit to selling next year’s oil $1 lower than where he expected to be able to sell it if he took the risk and waited, he may now be able to sell it $1 higher thanks to those institutions who are buying long-only indices.

And that, in turn, will likely lead to futures curves being extended further into the future (or, equivalently, the effective liquidity for existing markets will be extended further out). For example, over the last decade there have been several new commodities indices that systematically buy further out the curve to reduce the cost of contango. In doing so, they’re pushing the contango further out, and also providing bids for hedgers to be able to better sell against. So Mr. Bouchouev’s story is a good one, and for those of us who care about the financial markets liquidity ecosystem it’s a beautiful one. Because it isn’t the end of the story. Chapter 1 was producers, putting curves into backwardation to provide an inducement to draw out speculators to be the other side of the hedge. Chapter 2 is Bouchouev’s tale, in which financial buyers push futures markets towards contango, which in turn provides an inducement to draw out speculators on the other side, or for hedgers to hedge more of their production. In Chapter 3, also according to Bouchouev, the market balances with hedgers reacting to economic uncertainty, and speculators fill in the gaps. Of course, in Chapter 4 the Fed comes in and wrecks the market altogether… but let’s enjoy this while we can.


[1] …and beyond the scope of this article. Interested parties may refer to History of Commodities as the Original Real Return Asset Class, by Michael Ashton and Bob Greer, which is Chapter 4 in Inflation Risks and Products, 2008, by Incisive Media. You can contact me for a copy if you are unable to find it.

Summary of My Post-CPI Tweets (June 2020)

June 10, 2020 8 comments

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

  • It’s #CPI day again! These days it seems we live a year in every month, and from a data perspective that’s kinda true. There used to be months when there were no truly surprising data points. Here is my walk-up.
  • Before I do, let me invite folks to take a look at our newly renovated website at https://enduringinvestments.com. It’s like we finally made it into 2018!
  • Anyway, nowadays those data points that used to be surprising every few months come about once every ten minutes or so. Will CPI be one of them? It’s certainly been an…interesting…number over the past few months.
  • The BLS has had to wrestle with collection issues, such as the fact that in the teeth of the crisis they didn’t want to be placing a burden on medical care professionals to respond to a survey. So measuring prices was difficult.
  • And of course the BLS also recently had the issue with coding Unemployment, because we’ve never had a situation like this and so the book doesn’t explain what to do! CPI has some of those too.
  • There was also a much greater dispersion than usual in prices collected, because of wildly different circumstances at each outlet. Lots and lots of craziness. But the net was that we were -0.10% on core in March, -0.45% in April.
  • Here is one example, from this month, that will be important in Used Cars. The Mannheim index had a massive jump, while the Black Book index slipped slightly further. So how do you forecast CPI for Used Cars??

  • It appears that while used car prices rebounded at the wholesale market, they didn’t at the retail level. I think that, and all of the rebound stories, are “yet.” But who knows what that means for this month.
  • I think we ought to get a healthy rebound in Lodging Away from home, which has fallen 14% or so over the last couple of months. And Airfares. But maybe not until next month.
  • Here’s the thing. From the top down and bottom up, it looks very likely that prices will be accelerating going forward. Clearly, everything is getting more labor-intensive and we’re re-onshoring cheap overseas production in some cases. And here’s the top-down case, which is M2.

  • The rise in M2 is unprecedented, and while a near-term precautionary demand for money will depress velocity, the Fed is in a real corner when velocity rebounds, and it will.
  • But that’s not today. Today the consensus forecast is for flat m/m figures on both core and headline. Food will be a big positive contributor, energy a negative contributor (probably) for another month. Net result: wild guesses.
  • To me, it feels like we’re due for an upside surprise. I would guess Medical Care is due for something funky. But I don’t make forecasts in normal times; sure as heck am not going to do it NOW. Good luck folks.
  • It’s almost creepy. Core CPI was very close to flat, at -0.06% m/m and 1.24% y/y. That’s ridiculously close to forecasts given all of the difficulties.
  • I forgot to mention too that the range in forecasts was not all that wide either…there wasn’t anyone with a -0.3% or +0.3% forecast on core. Which is wild!
  • Last 12 core CPIs:

  • Food and Beverages was (only) +0.72% m/m, raising the y/y to 3.88% from 3.39%. I don’t normally focus on non-core items but this is one where we’ve seen massive moves. So I was surprised we didn’t see more.
  • Here is the y/y change in food & beverages. Not at all bad yet. Food at home is +4.8% y/y, but still not as high as those prior peaks. More coming I am afraid.

  • On to more interesting items. Used Cars and Trucks were -0.39% m/m, which weirdly raises the y/y figure to -0.37% from -0.75% last month. But that’s part of the weakness in m/m core. Black Book was closer, as it has been.
  • But used car prices will come back, so get your deals while you can. Wholesale prices have largely rebounded to the pre-covid levels. Retail will get there, once people are shopping.
  • Overall, core goods fell to -1% y/y from -0.9%, and core services to 2.0% from 2.2%.
  • BTW used cars correction: -0.35% this month, not -0.39%, on the m/m. My error.
  • On rents, Primary Rents were unchanged y/y at 3.49%. Owners’ Equivalent was approximately unch at 3.06% vs 3.07%.
  • BUT Lodging Away from Home fell further. -1.53% m/m, bringing y/y to -15.06% from -13.91%. That’s a bit at odds with what I’ve seen personally, but a big reason for the weakness in core.
  • Also airfares was -4.9% m/m, clearly at odds with what is actually happening to city-pairs prices. This must have something to do with when they collected the data, or perhaps there are fewer first class seats and that’s affecting the avg.
  • Y/y the BLS says -29% fall in airfares, which itself doesn’t seem too crazy, so maybe this month is some kind of catch-up. But again, airfares are certainly going to rise – unless we simply forget about social distancing and start running full planes again.
  • So on core, it seems the usual suspects again this month. Rents fine, airfares and used cars and lodging away from home big losses.
  • How about Medical Care? m/m +0.49%, to 4.90% y/y from 4.81% y/y. Pharma flat, but y/y up to 0.93% from 0.78%.
  • Doctor’s Services finally showed some life as doctors’ offices reopen (another place we’re going to see increases if they can take fewer patients, but maybe it’s not nice to do it right away). +0.65% m/m, to 1.80% y/y from 1.23%.
  • But Hospital Services only +0.11% m/m, and the y/y declined to 4.86% from 5.21%. Again, that’s weird in a time of Covid. I think while the last couple of CPI reports were pretty clean, we’re starting to see some stale prices affect the numbers.
  • I’m not saying that because of the overall result…flat core cpi m/m was about right. But it’s WHERE we are seeing some of these things that’s weird.
  • Now, I totally buy Apparel at -2.29% m/m, -7.90% y/y. That makes total sense to me and less clear that turns into a positive number. We’re not going to start making apparel again in the US. I think we’ll get back to flat prices eventually.
  • OK this is interesting. Alcoholic beverages is 1% of the CPI, but this is Alcoholic Beverages at Home since the other part doesn’t make sense. Note that last two peaks were around big recessions? Expect more upside here! Surprised it isn’t already higher.

  • Biggest core declines on the month (annualized monthly change): Car Insurance -67%, Public Transportation -37%, Car/Truck Rental -34%, Women’s Apparel -30%, Men’s Apparel -29%, Lodging AFH -16.8%, Footwear -16%.
  • Biggest gainers, other than Meat, Poultry, Fish, and Eggs (+55% annualized) and Dairy (+12.6%): Recreation (+11.1%) and Motor Vehicle Parts/Equipment (+10.6%) Guess if you’re not buying new cars, you’re fixing the old one.
  • FWIW, Median is going to be very interesting this month. It’s probably going to be around +0.27% ish. Likely to be the highest since January. That’s yet another reminder this inflation ‘slowdown’ is ALL IN THE LEFT TAIL. Big drops in just a few categories.
  • However, one of those left-tail items is not shelter. So, core ex-shelter is now the lowest since well before the GFC. We are nearing non-shelter deflation. Get ready for the agitated headlines.

  • Again, worth remembering is that that dramatic picture is ALL IN THE LEFT TAIL.
  • Hey, let’s talk about the Fed for a second and then I want to turn to Recreation. This number will not change – and actually, no number would – the Fed’s trajectory. They’re going to stay easy, easy, easy. Even when inflation signs emerge.
  • IN FACT, this dip in prices will help the Fed ignore the acceleration, because they’ll say it’s just a rebound. But the key will be that the acceleration will NOT just be in the tail, bouncing back, but the middle of the distribution.
  • So, the Recreation category (5.8% of CPI) rose 0.88% m/m, pushing y/y to 2.11% vs 0.94% previous. Larger jump than Food & Beverages.
  • In the subcategories of Recreation, the biggest jump by far was in Other recreation services, which was +4.99% y/y versus +1.61% last month. Why?
  • In the sub-sub-categories below Other recreation services, we have Admissions rising 3.63% vs 1.23%. But the BIG increase was “club memberships for shopping clubs, fraternal or other organizations, or participant sports fees”. +7.34% y/y vs +2.55%. Discuss.
  • OK 4 pieces of CPI. Actually 5 today. First Food & Energy. Thanks to Food, not as bad by now as I’d thought we’d have been.

  • Piece 2 is core goods. Apparel, e.g.. Not surprising we’re down here, although Pharma (only +0.9% y/y) continues to surprise me. Pharma will rise once we start onshoring APIs. In the meantime, core goods is weak, but not sure it gets much weaker.

  • Core services. Again, polluted by lodging away from home and airfares. This will snap back over the next few months, because I don’t think Medical Care is about to plunge and it’s steadier than Lodging AFH and Airfares.

  • Piece 4, which COULD be alarming: rent of shelter. But, of course, this is all Lodging AFH (I mistakenly put this in core services less ROS in my prior tweet!). So let’s look at piece 4a, that breaks out the stable part of rents.

  • There is nothing surprising here happening to OER. And in fact, home prices seem to be holding up just fine and foot traffic has been increasing. In uncertain times, what’s better than your own home? If you expect deflation, you better find it here. And you won’t.

  • 10y Breakevens today +3.5bps. That’s interesting, and it suggests people are looking past the current figures. But 10y Breaks are still at 1.28%, with implied core inflation well below 2% for a decade.
  • But it’s still a really big bet that deflationary forces will win. And that seems increasingly unlikely.
  • Breakevens are not as big a bet at 1.28% as they were at 0.94% when I wrote this: https://mikeashton.wordpress.com/2020/03/11/the-big-bet-of-10-year-breakevens-at-0-94/
  • OK, that’s it for now. I look forward to the days when all of the one-offs are done. One last comment: if median CPI is in fact +0.27%, then y/y Median would rise. In fact, anything above 0.21% m/m would mean y/y increases from its current 2.70%…
  • I will publish a summary of all these tweets later. Thanks for tuning in. Be sure to visit the website at https://enduringinvestments.com and tell me what you think about the new look.
  • Oh, one more fun chart. Here is the Apparel series. Clothing prices in the US are now down to levels we haven’t seen since 1988. I can finally break out that old tie. Oh wait, it’s price not fashion.

Another month, another set of crazy figures from Airfares, Lodging Away from Home, Apparel, and Cars. Outside of those, there really haven’t been many big surprises. I guess it’s surprising booze inflation isn’t higher yet. But if we were entering into a deflationary period, we wouldn’t see core decelerating only because of left-tail events, and we wouldn’t see Median CPI accelerating. This really gives every sign of just being a set of one-offs that will pass out of the data before long and be replaced by the true underlying trend. Prior to COVID-19, that trend was a gradual but unmistakable acceleration in inflation, so in my view that’s probably the best outcome you can hope for if you are a bond investor: that we settle back to something like 3% in median inflation and 2.25-2.5% in core inflation. There is as yet no sign of the collapse in housing that we would need to usher in another Depression-like scenario, and for all the errors the Fed made back then the one they have not made this time, indubitably, is the error of failing to add enough liquidity. Indeed, the error they’ve made this time is that they have added far, far too much liquidity and there is no good way to remove it.

That isn’t this month’s story, and it isn’t this quarter’s story. Short-maturity TIPS, not surprisingly, trade at very low implied inflation rates even though energy prices have aggressively rebounded – right now, TIPS carry is awful and if you own a short TIPS bond you’re not looking at next year’s inflation. Beyond the front end of the TIPS curve, though, pricing of inflation-linked bonds relative to nominal bonds is almost comical. Yes, real yields are very low and it’s hard to love TIPS just for TIPS. I don’t understand, though, why TIPS aren’t currently beloved compared to all forms of fixed-rate debt. Some of it is indexed money, but I don’t understand why the indexed money is insisting on smashing into a wall. This will all become obvious eventually, and people will look back, and everyone will remember how they were very bullish on breakevens and can’t believe how everyone else messed up. And everyone will be an inflation expert.

Today’s figure doesn’t mean anything to the Fed, as I said before. Well before this all happened, Chairman Powell had effectively abandoned the inflation mandate. Late last year, he’d declared “So, I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” And then, on February 11th in front of the House Financial Services Committee Powell, in response to a question from Congressperson Ayanna Pressley (D-MA) about whether the central bank could ensure economic conditions such that “anyone who wants to work and can work will have a job available to them,” Powell responded that the Fed will ‘never’ declare victory on full employment. Not a word about inflation in his response. With Unemployment in the teens right now, I think we can safely say it will be a very long time before the Fed makes inflation its primary worry.

But, I think eventually they will.

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.

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