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Summary of My Post-CPI Tweets (May 2021)

May 12, 2021 1 comment

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!

  • Nice, sunny morning for #CPI here in the Northeast. Get ready for some fireworks today! I honestly can’t remember a time when a wider range of potential prints was not only possible, but plausible.
  • Last month, we saw a significant upside surprise as core inflation came in at +0.34% m/m. Yet, at some level this isn’t a surprise to those of us who are buying things.
  • What was really interesting about last month is that some of the big movers we expected – most notable among them used cars – did nothing special (Used Cars rose 0.55% m/m, yawn).
  • And yet, the upside surprise was also not in housing. Rents remained soft (more on that in a minute). So Median CPI, which we focus on more, was actually only +0.15% m/m.
  • Think about that…what that means is that the inflation surprise last month was due to large moves in smaller components – ones that no one expected to jump. If that doesn’t describe what inflation feels like in the real world, I’m not sure what does.
  • So turning to this month and the months ahead. We’re still waiting for rents (both primary rents and OER) to reflect the heat in the housing market and in the meteoric rise in asking rents.
  • My premise is that the abrupt and unusual divergence here is caused largely by the CDC’s eviction moratorium from last August, which has been extended several times – but which was recently vacated by a judge as being an overreach by the CDC.
  • I don’t know if that’s the last word, but in any case I wouldn’t expect that to have an effect THIS month. If we see a larger rise in rents, it’s organic from the general frothiness in housing and probably not from this effect, yet.
  • Also, we’re watching for used cars to catch up to private surveys. That’s a huge effect. Used Cars is 2.75% of the CPI, and New Cars has also seen upward pressure (it’s another 3.75%). That could easily add 0.1%-0.2% to core this month by itself.
  • There are lots of other places we may see pressure. There are shortages of containers, shipping, drivers, packaging, semiconductor chips, cotton, chlorine, ketchup, lumber, and the list goes on. Many of those categories are upstream to a LOT of consumer products.
  • Moreover, let’s not forget that there is a shortage of labor in certain sectors of the service economy. We haven’t gotten the Atlanta Fed Wage Tracker this month, but Average Hourly Earnings showed a big jump. That also feeds into consumer prices.
  • So economists this month are calling for 0.3% on core CPI, which thanks to base effects would move y/y to 2.3%. Given the usual CPI/PCE spread, that means we’d basically be at the Fed’s long-term target, FWIW.
  • This is much better than last month’s guess from the economists’ models, but with used cars alone I think you ought to be looking for that much. There are forecasts out there for +0.4% and even a few at +0.5%. Big shops, not people looking for notoriety.
  • That’s really not crazy at all. In fact while the Street consensus is 0.3%, the inflation derivatives market is closer to 0.4% as the NSA print traded yesterday several times around 265.9 (0.1% higher than the economists’ 265.6 guess).
  • Last month, the interbank market was also 0.1% higher than the economists, and they were right. FWIW the inflation market feels long to me, but there’s a lot of slower money at play too so the usual hedge-fund-flush MAY not necessarily follow any disappointment.
  • Regardless of what happens, the Fed will say transitory, and perhaps they are right. But either way, it’s economic volatility and that benefits no one (unless you’re long convexity). Not investors, and certainly not consumers. Good luck out there. 8min until #CPI.

  • Bug, meet windshield.
  • Core CPI +0.92% m/m. Yes, you read that right. Waiting for someone to say misprint. 2.96% y/y.
  • Incredibly this has nothing to do with rents. That’s amazing. A big move like that in core…hard for it not to involve rents. Primary Rents +0.20% m/m. OER +0.21% m/m. Ham-on-rye rent numbers as they say.
  • But Used Cars were +10.0% m/m, which means that series basically caught up to the private surveys in a single month. The good news is that removes some of the dry powder for future months.
  • These charts are comical. This is core goods (+4.4% y/y) and core services (a mere +2.5%).
  • The last time Core Goods was as high as +4.4% y/y was in 1991.
  • Airfares +10.2% m/m, which is part of that services jump. Lodging away from home +7.7%. Those are Covid/reopening categories.
  • Apparel as a whole was +0.32% m/m. It’s a small category but I’d been wondering why it had been so tame given that there was an embargo on certain Chinese cottons – I would have thought we’d have seen more.
  • In Medical, Pharmaceuticals were +0.63% m/m; Doctor’s Services ebbed a bit (-0.29% m/m) and Hospital Services was tame (+0.18% m/m).
  • A lot of my tweets are proceeding slowly because I have to check the numbers. Plus all of the charts re-scaled. Core ex-shelter is +3.57% y/y. Hasn’t been over 2% since 2012. Not over 3% since 1995.
  • OMG I buried the lede. Core CPI isn’t quite at 3%, though it rounded there. It hasn’t been ABOVE that since 1995. A quarter-century.
  • Core ex-shelter.
  • Sorry for the lag folks. My computers are literally throwing up on this data.
  • Interestingly, CPI for New Cars was only +0.26% m/m. In New Cars, there’s simply a shortage brewing but sticker prices haven’t risen very much. I think that’s a “yet”. The shortage is due partly to the shortage of chips of course.
  • OK, I am going to have to stop this here without a whole bunch of other stuff that is going to be great to look at…when my java/SQL connection decides to work. Here’s the bottom line though:
  • Core inflation at +0.9% is so outrageous that ironically the Fed will have an easier time ignoring it for now. And there were some things that we expected to catch up over multiple months, that caught up all at once. BUT there are also some things yet to come. >>
  • If primary and OER rents catch up merely to where they ought to be given historical relationships to asking rents, home prices, etc, then that’s another 1% or thereabouts on core CPI. And that’s harder to assume away than a used car spike. >>
  • But what we know is that next month, we will have the first core CPI y/y above 3% in more than a quarter-century. Because we still have one more easy comp from May. But we always knew this would be hard to read – and the smoke won’t clear until late this year.
  • Transitory? Better hope so. If not, look out below on stocks and bonds. That’s all for today. Thanks for tuning in and sorry I didn’t have more of my usual charts. If I get stuff working I may post them later.

Today’s month-over-month core CPI reading was the largest monthly figure since…wait for it…1981. That’s right, four decades ago. Yes, some of these things are going to be transitory. But they’re also going to be reprogramming consumers’ expectations. I’ve never been a big fan of the idea of anchored inflation expectations but as I wrote recently in “Once Again, You Ain’t Getting No Coke” whatever behavioral anchor there may have been is definitely threatened when there are large changes in prices.

Now let me add back a couple of the charts that I normally include, and maybe a couple of others. Here are the four-pieces charts. Each of these pieces is 1/5th to 1/3rd of the CPI consumption basket. There are lots of ways to cut the data but this is one I find useful. The first piece is Food & Energy. Little noticed in all of the craziness about core is that food and energy prices are also increasing markedly. Indeed, some food prices are rising as fast or faster than they did back when rising food prices helped spark the “Arab Spring.” Are we surprised at the unrest in Gaza? Get ready for more of that.

Second piece is core goods. Big piece of this is used cars. Kind of strange that new cars haven’t yet shown much of an uptick. The driver (no pun intended) of used cars is not just the huge tide of money of course, but also the smaller stock of used cars since rental fleets last year were shrunk a lot due to COVID. And rental car fleets are a big source of used cars.

Core services less rent-of-shelter is the third piece. Airfares, lots of personal services like child care, moving and storage, domestic services, etc. In a way, that’s a surprising piece here since this isn’t a raw materials gig, at least directly. But these services use packaging materials, cleaning materials, and other items whose prices are rising – and so are wages.

Finally, Rent of Shelter. The big bounce here is in Lodging-Away-from-Home, which was part of what was dragging it down. But rents themselves remain soft in the CPI, which I have to repeat is at odds with lots of the other ways we measure the cost of housing. This doesn’t mean that the CPI is ‘manipulated’; these discrepancies arise from time to time and we have a good reason to believe this is related to the eviction moratorium. I’m very confident rents will reconverge higher.

Now, because housing hasn’t lurched higher yet the median inflation figure will not be too bad. +0.3% m/m or so is what we’re likely to see, raising y/y to 2.17% or so. To be sure, +0.30% on median CPI is a big number for that series but not unprecedented. So today’s report is one reason that I always admonish people to look at median, not core. Core inflation is not going to rise at 11% this year. But remember the microwave-popcorn analogy: these one-off anecdotes are the way inflation is really experienced in practice. Maybe not 50% increases in used car prices, but a pop here and a pop there. This shows up as fatter tails on the high side of the distribution as opposed to the low side of the distribution when we are in a disinflationary environment. In an inflationary environment, we expect core inflation to be above median inflation because of those recurring “one-off” events. And, for the first time in a very long time, it is.

Finally, one more chart here and that’s of the EI Inflation Diffusion Index, which attempts to measure how widespread price increases are. It just peeked above zero for the first time since 2012. It keeps more distribution information than the median does, which is why it tends to rhyme with median but sometimes diverges.

Now let me sum up: the Fed doesn’t care. Oh, I am sure there are people at the Fed who will be alarmed, but the bottom-up people will see anecdotes and long-tails and not be worried. It’s the top-down people who are alarmed: the people who see money growth over 20% and have been bracing for what has historically always accompanied such money growth. But those people have no voice at the Fed. The main power around the table is concerned about making sure the unemployment rate is as near zero as possible. It’s an odd reversal from the Greenspan (and earlier) days, when the Fed believed that the way to maximize employment in the long run was to hold inflation low and steady. The Federal Reserve today behaves as if the best way to hold inflation low and steady in the long run is to maximize employment in the short run. That’s obvious nonsense, but here’s the important point: the crazy volatility of the economic data around COVID and in the base effects post-COVID create a fog of war that means it will be late 2021, and maybe even into 2022, before it will be clear to everyone that inflation is really settling down at a level higher than it was pre-COVID. Before then, the stock and bond markets are likely to discount worse price/rate conditions, which if anything will trigger even looser policy from the central bank.

In other words, by the time the Fed decides that cooling off price increases is more important than goosing the economy or the stock market, we will be very far down the road of squandering the Volcker Dividend. Behave accordingly.

Categories: Uncategorized Tags: ,

Once Again, You Ain’t Getting No Coke

April 27, 2021 5 comments

For a long time, I’ve held the opinion that the notion of “anchored inflation expectations” was an absurdity. For one thing, we have no good way to measure inflation expectations: market-based measures don’t reflect consumer expectations, and survey measures are nonsense that mostly reflect an availability bias (i.e., changes in small, frequently-purchased items, especially gasoline, have a much larger impact than large, infrequently-purchased items). There are lots of other biases in inflation perception, some of which I enumerated and discussed in a scholarly-ish article almost a decade ago.

It isn’t that I think that people don’t have inflation expectations, or that they are ‘wrong’ in some sense. It is just that the notion that they are “anchored” is something that is completely unmeasurable and so hypothetical. But many economists believe that hypothesis is necessary to help explain the break in inflation models around 1992-1993. I think there are better explanations for that break, which don’t require assuming a can opener.

However, recently I have started to reconsider whether there is a way in which behaviors concerning inflation are at least sticky. This is not to say that I think this necessarily has a role in inflation modeling (importantly, because there’s no good way to measure it), but I have definitely seen anecdotally some behaviors that can only be explained by figuring that consumers and producers become at least conditioned to expect low and non-volatile inflation. (Note, if I’m right about it being a conditioned response rather than an anchoring with respect to “strong central bank messaging,” it is useless in explaining the 1992-93 inflation model break because my hypothesis is that it takes a long time to happen).

My thoughts derive from some direct observations I have of actual producer/supplier behavior, from customers of mine and their suppliers, over the last couple of years but especially in response to the latest spike in raw materials prices. When I first began this sort of risk and pricing consulting a few years ago, I was struck at the attitude that one of my customers seemed to have – the customer behaved as if it was a commodity producer facing extremely elastic demand curves, such that they were very convinced that if they raised prices at all, they would lose a huge amount of their business to suppliers in China and India. Their customers of course reinforced this notion by responding to questions about price by saying that “lower prices would be good.”[1] But their product was both higher quality and shorter lead time than that of the competition; yet, they priced it as if only price mattered to their customers. The important point, though, is that they were conditioned to believe that any increase in price would destroy their business.

Their attitude wasn’t unique. Until recently you could see that behavior all over. To a surprising degree, diners with printed menus (with pictures!) have tended in recent years to have prices pretty much hard-coded and printed onto the menu. Your local barber probably changed prices every five years, at most. And every change was usually accompanied by an explanation to the customer about the need for higher prices for one reason or another. It is a strange dynamic, very different from what you see in an inflationary regime, such as in this classic scene from the movie Caddyshack (released in 1980):

Tony D’Annunzio: Give me a Coke.

Danny Noonan: One Coke.

[gives Tony a bottle of Coke and 50 cents]

Tony D’Annunzio: Hey wait a minute. That’s only 50 cents.

Danny Noonan: Yeah, well, Lou raised the price of Coke. He’s been losing at the track.

Tony D’Annunzio: Well I ain’t paying no 50 cents for no Coke.

Danny Noonan: Oh, then you ain’t getting no Coke!

Instead, in this era of low and stable inflation it looks and feels like suppliers have learned “anchored” behaviors. “I can’t raise prices; all of my customers will leave.”

Fast forward to the COVID crisis.

Input costs for many producers have skyrocketed. For example, the price of polypropylene has roughly tripled since the lows last summer. Yes, at least part of that is temporary. Up until about six months ago, when movements in input costs induced changes in profitability for producers they would hold the line on prices, lest they lose a bunch of business, and watch their margins decline. Ultimately, when input costs retraced, they would enjoy wider margins again. Price changes were artificially muted because the supply chain dampened price fluctuations. The producer absorbed those costs because of the perceived elasticity of end product demand.

However, the volatility of input prices recently has been such that producers couldn’t absorb all of the costs into margin and still remain viable. Some of the suppliers and competitors to the client I mentioned above did indeed hold prices as long as they could, before eventually passing them on with great apologies. I advised my client, though, to pass cost increases through immediately. Some in management wanted to label the increase a “surcharge,” but that again is an apologetic way to adjust prices – and one you do need to justify. Instead, they jacked up their prices to maintain their margins, and braced for the worst.

And lo and behold…nothing happened. Some customers wanted an ‘explanation’ for why the price of the Coke went up, and some customers complained that the Coke was cheaper elsewhere. Ultimately, my client did just as much business after the price increase as they did before the price increase.

What they learned, and what lots of suppliers, restauranteurs, and others are learning, is that demand is not as elastic as they had thought; that everyone wants a lower price but they’ll pay for the value of the product if they need the product. That, with more money in the system, raising prices a little doesn’t hurt business very much at all. If you need a Coke, you’ll pay the fifty cents for a Coke even if you wish it was still forty cents (and part of the reason you will pay without much complaint is because you just got $1,600 from the government for no reason at all).

Watching this behavior is what makes me wonder about the anchoring of inflation expectations. Again, I think of this as a conditioned behavioral response. By the same token, though, people can unlearn these conditioned responses. We are all conditioned now to put on a mask when going into a restaurant, but we will (hopefully) unlearn that behavior and the new conditioning will be to not put on a mask when entering a restaurant. That’s what’s happening now, I think, to suppliers in many industries. I think they’re all surprised, but I also think they’ll remember. It’s just one of many reasons I think that regardless of the path inflation takes over the next decade, it will likely be both higher on average and more volatile as well. Take away the “anchor” and the ship tosses about more, and moves with the tides. I don’t really know of a good way to model this, and I am also fairly confident that the Fed will not recognize that the anchor has been slipped (which means bad things in expectations-augmented Phillips Curve models!) for a while. To be clear, I don’t think the lack of policy response to the un-anchoring matters much because I don’t think the Fed had very much to do with the conditioning in the first place and expectations won’t become “re-anchored” merely because of the central bank’s messaging. I guess I don’t really think the central bank’s messaging means as much to consumers as they think it does! In any event, it takes time for conditioning to take hold, but less time I think for the conditioning to be broken.

[1] One of my first recommendations was that they stop asking this question. What do you expect customers to say, that they want higher prices? The question is whether they will not buy your product at a higher price, and asking their opinion on that is a really bad way to find out the answer.

Categories: Uncategorized

Summary of My Post-CPI Tweets (April 2021)

April 13, 2021 2 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!

  • Good Morning #CPI observers! Prepare for what is potentially the most entertaining #inflation figure in a while.
  • Before I get started, let me first note that I’ll be a guest on ( with @OJRenick at around 10:20ET this morning. Tune in!
  • Today’s walk-up is a little different. I usually try and focus mostly on the y/y numbers because the m/m numbers are an accumulation of random distributions around 280 other numbers. That is a lot of noise compared to signal and so I don’t like to forecast monthlies.
  • However, on a y/y basis the noise tends to cancel so it’s a clearer reading. Median CPI is even better because it lessens the impact of the tails.
  • This month, however, and for the next few months the y/y number is a distraction. We KNOW it’s going to jump a lot because the comparisons to March, April, and May 2020 are super easy. So instead, we want to focus on what happens to the monthlies.
  • I warned about this back in February in “The Risk of Confusing Inflation Frames.” And now…here we are.
  • So looking back at the last couple of months, we see that the core CPI figures were soft. Last month, core CPI (but not median CPI!) was soft because of surprising movements in goods, outside of housing. It had been goods pressing core inflation higher so that was surprising.
  • Turns out that some of that was (probably) due to the fact that the weather prevented the BLS from surveying certain prices. So we’d expect a little catch-up from last month’s +0.10% core, just as a null hypothesis.
  • Some of the places we are pretty sure to see strength are in autos, apparel, and the travel categories. Used car prices are nuts. But in the bigger picture, there are a lot of shortages out there and they all push prices the same way.
  • I talked about some of those shortages in my article at the end of March. How Many ‘Shortage’ Anecdotes Equal Data?
  • There are shortages in autos (due to semiconductors as well as lower fleet sales into the used car channel), packaging, cotton, containers, rental cars, Uber drivers, other goods…and shelter.
  • In shelter, rents have been artificially soft because of the eviction moratorium, which has made realized rents decelerate while asking rents are rising rapidly with home prices. That divergence is unusual and it’s due to the eviction moratorium.
  • The Biden Administration just extended that moratorium (was due to expire end of March) so that catch-up will come later. However there are SOME signs that rents are improving anyway. I’ll be looking for that. Rents were not as soft last month as they had been recently.
  • The economist consensus is for a core CPI m/m of about 0.2%. That seems low to me with all of the potential upside disturbances, and has got to mean that economists are expecting further shelter weakness. I don’t.
  • The market doesn’t either. Interbank trading of the (headline) price number implies about 0.1% higher than the economists expect. Most of that in core presumably. I would not be surprised in the slightest at +0.3% core.
  • We will see. Remember, the Fed doesn’t really care – and they’re working hard to tell you that you shouldn’t either. Eventually, the market will win. But not for a while. It will be late 2021 before the dust clears on the base effects.
  • So keep an eye on those underlying pressures and don’t get distracted by the y/y fog of war. I will talk today in terms of y/y figures, out of habit, but rest assured I’m watching the small ball too.
  • Thanks for coming along today on this crazy ride. Good luck! 6 minutes to print.
  • OK, core came in at 0.34% m/m, so quite a bit higher than estimates. y/y rose to 1.646%…so ALMOST rounded to a 2-tenth miss on the y/y figure.
  • Note in that chart, they’re not y/y. There’s no base effects there. In fairness, we probably should combine the last two figures, and get something like 0.22% per month, but that’s still faster than the Fed would like. Except they don’t care.
  • So Core Goods jumped back up to 1.70% y/y, where it had been 2 months ago before dropping to 1.3% y/y last month. Collection issues. Core Services up to 1.6%.
  • Primary rents +0.15%; OER +0.23%. Not as soft as a couple of months ago, but not overly strong either. Lodging Away from Home was +3.84% m/m, which pushed the Housing category to a +0.34% m/m rise…same as core, weirdly.
  • Apparel fell again. That’s a bit odd. Apparel had been doing well partly because cotton imports from part of China were being held up at the ports…maybe that’s lessening now. Anyway Apparel isn’t a big piece.
  • Pharmaceuticals: +0.08%. Doctors’ Services: +0.28%. Hospital Services +0.63%. First time I can remember them all three being positive in a while! Softness in Pharma is still surprising to me.
  • Doctors’ Services highest in years (y/y).
  • Hospital Services, despite this month’s jump…not so much.
  • Back to used cars. Part of what is happening here is that rental fleets shrunk last year so they are providing fewer cars to the used car markets. Part is the semiconductor shortage making new cars expensive. But Black Book says…this has a lot further to go in months ahead.
  • Ah. Core CPI ex Shelter jumped up to 1.61% y/y. Yeah, I know I said y/y. But that was at 1.7% last February BEFORE the COVID slide. Arguably it means price pressures are higher now than before COVID, and CPI is being held down by rents.
  • This isn’t from the CPI report but a reminder of what is happening in rents. If a landlord is unsure of being able to collect the rent, it goes in a zero. Doesn’t take many zeroes to lower measured rent. And the number of zeroes is higher when the gov’t says you can’t evict.
  • Other COVID categories: Airfares +0.44% m/m (fell 5% last month!), Lodging away from home I already mentioned +3.8% (-2.3% last month). Motor Vehicle Insurance +0.85% m/m.
  • New Cars, interestingly, was flat. That’s odd – there’s clearly a shortage of semiconductors so maybe this is more a situation of you can’t get ’em so the price doesn’t change? I’d expect that to rise going forward.
  • Car and truck RENTAL: +13.4% (SA) m/m. Here’s the m/m and y/y, which is now up to +31%. If you can’t buy ’em, you can try to rent ’em. Remember how I said fleets are smaller?
  • Now, Median CPI giveth and Median CPI taketh away. Hard to tell because median category will probably be a regional OER, but m/m will be probably 0.2-0.22%. Median y/y won’t change much b/c base effects were mainly from a few small categories with large moves.
  • That warrants further comment: the fact that we didn’t see a GENERAL deceleration in prices, but a very focused one, should make you wonder about output gap models. Most of the economy wasn’t in deflation. Hotels and airfares were though!
  • Only two core categories with more than a 10% annualized decline this month: Women & Girls’ Apparel (-28%), and Infants’ and Toddlers’ Apparel (-22%).
  • On the gainer side, tho: Car/Truck Rental as noted, Jewelry/Watches (+80.7% ann’lz), Lodging AFH (57%), Motor Vehicle Insurance (+47%), Men’s/Boys Apparel (+35%…hey!!), Misc Personal Svcs (+16%), Motor Vehicle Maintenance & Repair (+12%).
  • Core goods & Core services. Both rose, and remain atop one another. How long can goods stay elevated? Port traffic is improving, slowly. But materials prices remain stubbornly high and global trade remains fractious.
  • ok, gotta wrap it up and get to makeup for my appearance on @TDANetwork at 10:20. KIDDING, no makeup. You can dress a monkey in silk but it’s still a monkey. Anyway, I’ll do the four-pieces and then conclude. Will put out the diffusion indices later.
  • Piece 1: Food & Energy. No surprises here: it was expected to jump as gasoline prices continue to recover.
  • Piece 2: Core Goods. Back to the highs.
  • Core services less Rent of Shelter. This still remains bizarre to me. But medical finally showed some life this month and there’s sign of pressures in the PPI there so maybe it’s coming. Hard to see an uptrend here though unless you turn it upside-down.
  • Finally, Rent of Shelter. It seems it may be done going down, and there’s a lot of catch-up to do when the moratorium ends. But the last 2 months of rents have been more normal.
  • So at this hour, 10-year breakevens are +1bp and stocks are flat. Because the Fed doesn’t care, and the punch bowl remains. I guess that’s about the summary here. The base effects are going to obfuscate whatever is really happening underneath.
  • BUT, what is happening underneath (per the chart of core-ex-shelter) appears to be price pressures that are certainly no smaller than pre-COVID. Are they temporary? How will we know? If the Fed says they are, and are wrong…bad.
  • If the Fed says the pressures are NOT transitory, and are wrong, and over-tighten, that’s also bad – but for employment. And here’s the thing, this Fed has said repeatedly that full Employment is their main goal. So errors are designed into the system to be inflation-enhancing.

Here’s the summary of the main points today. Ex-housing core inflation is back at the level it was prior to COVID. Housing is artificially depressed because of the way the BLS accounts for rents (which is reasonable, since someone who isn’t paying has certainly decreased his cost of living), and asking rents tell a totally different story. But since measured rents are soft, it means that core isn’t low right now because of COVID categories: it’s low right now because of one thing, really, and that’s rents. If realized rents converge upward to asking rents, you can tack another 0.7%, 0.8%, 0.9% or so onto core CPI.

Inflation is already higher than it “should” be coming off the greatest global economic contraction since the Black Death. And that’s without consumers being truly unleashed. But the Fed has adopted an asymmetric policy stance, because they very publicly feel that the risk of higher inflation is something they ‘have the tools to manage’, whereas they believe they have some sort of moral obligation to make sure everyone is employed. I don’t want to draw too many parallels to prior hyperinflations because that’s not what I’m looking for, but the current asymmetric stance is very odd for any policymaker who learned history and knows that one of the reasons that Weimar Germany printed so many marks was because they believed having everyone employed and paid was absolutely crucial, and so they ran massive deficits and printed money to pay for them.

This is why the Bundesbank has always been willing, ever since, to rein in inflation even if it meant short-term pain in labor markets. They remember that the best route to maximum employment in the long run is to maintain a stable pricing environment. As recently as the 1990s, the Fed (Greenspan at the time) would regularly say that. It is no longer the core belief of the FRB.

The Fed believes they have the tools to rein in inflation, the knowledge about how to calibrate them, and the will to use them, but at least for the next 6 months they will wave their hands vaguely at ‘base effects.’ After that, if inflation is higher than they would like once the base effects are past, they’ll vaguely wave their hands and say ‘average inflation targeting.’ It it going to be a very long time before central bankers willingly hike rates without the market forcing them to do it. And before that, there may very well be a showdown where the Fed decides to defend the longer-term yield environment and implements Yield Curve Control. These actions and possible actions have very different implications for stocks and bonds depending on the path, especially with equities pricing in a goldilocks environment. Get ready for a bumpy year.

How Many ‘Shortage’ Anecdotes Equal Data?

March 30, 2021 3 comments

There is a growing list of categories of prices which are seeing abnormal price pressures. At least, they are abnormal by the standards of the last quarter-century! A couple of months ago, in “The Risk of Confusing Inflation Frames,” I wrote about some of the effects we might soon be seeing, and of the risk that some of the known-but-temporary effects will obfuscate more serious underlying issues.

In April, we will get the CPI for March; this will be the first CPI release to have ridiculously easy comparisons against the year-ago month. March 2020 was -0.2% on core CPI, and I suspect the consensus estimate for March 2021 will be something like +0.2%; this implies the y/y core inflation number will jump from 1.3% to around 1.7%, depending on rounding. But as I said, that disguises some of the important underlying pressures that may also start to appear with this number. There is an old saying that the plural of “anecdote” isn’t “data,” but eventually there must be a crossover point where the preponderance of independent anecdotes begins to approach the informational value of data, right? Well, here is a short list of some recent anecdotes and reports of shortages.

There has become an acute shortage of semiconductor chips, which has impacted automobile production (and will that increase prices for what is available?). There is a shortage of shipping containers, causing widespread increases in freight costs affecting a wide variety of goods. Packaging materials, which are also a part of the price of a great many goods, are also shooting higher in price. Worker shortages at various skill levels were reported in the most-recent Beige Book. There is a shortage of Uber and Lyft drivers.

There are other effects that have shown up but I misapprehended the significance of them at the time. Apparel prices have risen at an annualized 9% pace over the last four months. I’d attributed that to shipping, but there is more to it than that. In January US Customs issued a Withhold/Release Order (WRO) on cotton and tomato products coming from the Xinjiang region of China, where forced labor is employed; the order calls for the stoppage of freight with any amount of cotton (or tomatoes, but there is not much tomato in apparel) that originates from that region – even if it is only the thread on the hem. While this and the other effects on apparel are probably temporary, we don’t really know how temporary.

Importantly, we should add to these shortages a growing shortage of housing. The inventory of homes available for sale just hit an all-time low (the National Association of Realtors started keeping track in 1982).

And, as a result, the increase in the median sales price of existing homes just reached an all-time high spread over core CPI (home price increases sometimes have been higher, though it is unusual. For example, in May 1979 the year-over-year increase in the median home price was 16.9%. But core inflation was 9.4% at the time, so the real increase in home prices was only 7.5%).

I have written elsewhere about the fact that there is large divergence right now between what the BLS indicates the effective inflation in the cost of housing is, and what a measurement of asking rents suggest it should be. The significant chart is reproduced below – and the short story is that the divergence dates to the imposition of the COVID-related eviction moratorium. This has decreased the amount of rent that landlords actually expect to receive on average, which lowers effective rents even though every other measure of the true (free market) cost of shelter would be, is ratcheting higher at rates seldom if ever seen before.

Now, this moratorium was due to expire at the end of March, but the CDC just extended it until June (which may be one reason that TIPS breakevens have hit some minor resistance). That’s a little unfortunate since it means that the moratorium will expire right about the time that the CPI is enjoying favorable comparisons versus 2020. The understating of rent and owners’-equivalent rent inflation, since those are a huge portion of the consumption basket, has an outsized effect on CPI. I want to be fair here to the BLS: in an important sense, the CPI data on rents is not wrong because in fact if a tenant pays less because of the moratorium, then that tenant’s cost of living really did go down. Even though in a free market without such a moratorium his cost of living would have been higher, that’s not the question the BLS is trying to answer. The cost of living is lower in such a case. Of course, that’s temporary, and so when the moratorium is lifted we can expect the BLS will also faithfully report the catch-up. Which means that in the summer, when we would have expected y/y CPI to start to decline again as it faces more difficult comparisons to 2020…it may not, because rents will start to catch up. That’s going to toast the marshmallows of a lot of investors.

Now, there’s one more facet of the cost-of-shelter question and that’s whether home prices have risen too far, too fast and so it’s home prices and asking rents that will have to decline, rather than effective rents re-accelerating. This is a reasonable question. It is true that the ratio of home prices relative to incomes is getting back to levels that in the late 2000s indicated a bubble was getting ready to pop (see chart). For many, many years median home prices relative to median incomes was fairly stable at around 3.4x. Some increase makes sense since homes have been getting bigger, but it does give the appearance of being overextended.

However, last week in Money Illusion and Boiling Frogs I argued that the nominal value of certain real assets might be usefully compared to the level of the money supply as a way of assessing their real value. Comparing the equity market to M2 made the former look less frothy, and the argument is that maybe equity investors aren’t suffering from “money illusion” in the same way that consumers might be (so far). But the same cannot be said for the housing market. The chart below (Source: Bloomberg) divides the home price index (from the FHFA) by M2. While home prices relative to incomes look high, home prices relative to the stock of money look quite low. It is interesting how the QE of the early 2010s shows up as a one-time shift in this ratio, followed by a period of stability, isn’t it? It suggests that maybe home prices didn’t fully adjust to the new money-stock reality after the bubble’s burst in 2008 and the subsequent QE. And maybe such a one-time shift happens again now.

But it might also be the case that the current rapid escalation of home prices is the market’s attempt to get the real value of the housing stock to reflect the rapidly increasing value of the money stock. If that’s the case, then it also suggests that median wages probably will eventually follow. The last people to respond to money illusion generally are the people selling their labor.

I don’t know if this is the ‘right’ answer, and my purpose in these articles isn’t to give the ‘right’ answer. I just want to ask the right questions…and I feel like these are the right questions.

Categories: China, CPI, Housing, Wages Tags: ,

Money Illusion and Boiling Frogs

March 23, 2021 6 comments

“Twice a day we are all forced to await the quotation of the Zurich bourse. Every fresh drop in its value [of Austrian kronen to Swiss franc) is followed by a wave of rising prices … The confidence of Austrian citizens in the currency administration of the State is shaken to its foundation. The State which is perpetually printing new banknotes deceives us with the face value … A housewife who has had no experience of the horrors of currency depreciation has no idea what a blessing stable money is, and how glorious it is to be able to buy with the note in one’s purse the article one had intended to buy at the price one had intended to pay.” – account of Frau Eisenmenger, recounted in When Money Dies (Adam Fergusson).

“Speculation on the stock exchange has spread to all ranks of the population and shares rise like air balloons to limitless heights … My banker congratulates me on every new rise, but he does not dispel the secret uneasiness which my growing wealth arouses in me … it already amounts to millions.” – Ibid.

These two passages come from the contemporaneous observations of an Austrian living through the early stages of the hyperinflation that followed WWI in that country. I don’t for a minute mean to suggest that the global economies are on the verge of hyperinflation, but I present these as an apt illustration of a concept called money illusion. In the first passage, the writer makes plain that the kronen is buying less and less, in terms of real goods, every day. Similarly, it buys less and less in terms of equity shares. The former, we tend to regard as a negative, and the latter as a positive, even though they are both related in this case to the same phenomenon: the unit of measurement is losing its value, so that it buys less real stuff as time passes. Isn’t that interesting? For someone who is continually investing in the equity market – I’m looking at you, millennials – higher prices should strike us as a bad thing just as higher car prices strike us as a bad thing.

I don’t mention that, though, to suggest that equities are a great place to hide out from inflation. In fact, they’re a pretty lousy place: as inflation rises the multiple paid on earnings declines so that even if nominal earnings are rising with inflation equity market prices can’t keep up. That’s not as bad as holding paper money and watching it go to zero, but it ends up being about the same when the inflation gets serious enough that the market itself collapses – as it did in each example of monetary hyperinflation (Germany, Austria, Zimbabwe, etc) that we have seen to date. But again, it isn’t my purpose today to warn about the dangers of treating equities like real assets when multiples are at nosebleed highs.

The interesting part is the money illusion. The writer in the passages above is uneasy, because while she is making millions she understands that those millions are losing value almost as fast (and ultimately, faster) than she can make them. But for a while the higher and higher prints of the market, the rising value of one’s home, and the accelerating increase in wages makes people feel wealthier. And wealthier people are happier and tend to spend more of the marginal wealth, when that wealth is real. But in this case the wealth is an illusion, because that additional wealth buys (at best) the same amount it did previously.

In classical economics, we would call spending more in this circumstance – despite having a similar claim to wealth in real terms – irrational. Although we use dollars to translate our labor into the things we want to buy, we all understand that we are really trading our labor for those things – it’s just that we need a medium of exchange because no one wants to directly exchange groceries for inflation-focused asset management services. More’s the pity. So homo economicus would regard his increasing millions in the market and not feel any wealthier as he knows the units of account are growing weaker. The money dropped into his bank account through a universal direct stimulus also wouldn’t be treated as actual wealth, since if we handed everyone a trillion dollars then obviously we all wouldn’t be living like trillionaires because the people who sell goods and services would adjust their prices (if they did not, then those vendors are voluntarily decreasing their own claim to the real wealth, by accepting smaller real payments in return for the same amount of goods). Wealth is just a claim on the national product. If everybody’s nominal wealth rises, but the nation is not able to produce more units of real output, then in aggregate we clearly are not wealthier because the pie is the same size. (Now, if you hand everyone a trillion dollars except for one guy, then that guy is poorer and everyone else slightly richer. Ergo, direct cash payments to the poor are clearly a way to distribute actual wealth, especially if those who don’t receive those payments also face higher taxes. So fiscal policy here definitely shuffles the deck of the wealthy. It just doesn’t make us wealthier in aggregate.)

The question of how people behave when they see additional income that comes from a greater money supply, rather than from additional productivity/output, is crucially important in monetarism. In the quantity equation of exchange, MV≡PQ, an increase in the quantity of money and in the velocity of money (MV), which is the total nominal amount of expenditures, necessarily equals the real output times the price level of that output (PQ). The amount that is spent equals the amount that is bought. But how the right side divides between P and Q is very, very important. If there is no money illusion, then an increase in the quantity of money will primarily increase prices while output will remain stable. Shopkeepers are unwilling to part with their wares for a smaller piece of the pie in real terms. On the other hand, if money illusion is rife then producers respond to consumers flush with cash by providing as many goods and services as they can; they view the masses as having more actual wealth to spend and so output increases and prices don’t rise as much.

Unfortunately, it seems that money illusion operates primarily when the quantities involved are small, or narrowly distributed. When incremental money creation is widely distributed and significant in size, then (as the second quote at the start of this article suggests) consumers, suppliers, and investors eventually figure it out. When that happens, a change in M is almost fully reflected in a change in P, as over time it usually is anyway. So the secret of recovering from a negative economic shock by expansionary monetary policy is to boil the frog slowly.

No one involved in current policy circles is interested in boiling the frog slowly. And that means it’s not going to end well.

In this context, the current bubbly stock market looks decidedly better. The chart below shows the S&P 500 divided by M2 (and multiplied by 100 because sometimes I don’t like looking at decimals on my y-axis). Now, the S&P 500 level isn’t the purest look at the total value of the equity market, but you get the general idea here – stocks have outrun the growth rate in the money supply, even over the last year, but the new records we are hitting are mostly on money vapor.

Summary of My Post-CPI Tweets (March 2021)

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!

  • Another #CPI morning as spring is getting ready to spring here in the northeast. And with spring, more activity.
  • Today’s #inflation figure will be the last one to be compared to pre-COVID year-agos. The easy comps start next month. So, while consensus today is for +0.2% on core, that will still not move core much since last Feb it was +0.21%.
  • Headline will jump a bit, because gasoline has been rising, but the real headlines if any will be below the hood. Last month core was flat, due to soft housing and a somewhat surprising decline in used cars and pharmaceuticals.
  • I expect we will see the used cars number reverse this month (Black Book was strong), and with the end of lockdowns might see some strength in the covid categories. Pharma price hikes ought to eventually show up. But they’ve been confounding me.
  • Global supply chains are a disaster and raw materials and packaging prices are spiking – the Texas freeze shut-down did NOT help polypropylene prices! – so goods prices ought to continue to rise. Eye on apparel as the canary there.
  • The rent story is a passing one. But probably not yet, which means OER and Primary Rents should still look a little soggy. Asking rents are jumping, but measured rents are not – because of the eviction moratorium. If you’re not paying rent, it’s not a cost of living!!
  • In this quarterly chart, you can see the divergence between asking and realized rents. The divergence began in Q3…which is when the eviction moratorium was enacted. That’s not coincidental.
  • In the more-recent COVID relief bill, the eviction moratorium was not extended past March 31st, which was a bit of a surprise. That could still change, but when the moratorium eventually expires I am pretty sure we’ll see a rapid catch-up of rents. But not today’s story yet.
  • My calculations are that if the end of the eviction moratorium caused effective rents to catch up to asking rents, the effect on OER and Primary Rents would add something like 0.9% to core CPI.  (!) So that’s 2021’s following wind to prices.
  • As always, I want to be sure to remind you that the Fed does not care about inflation any more. Someday they will, but not yet. They’ve even stopped reporting weekly M2! They believe they have the tools to stop inflation so they’re not worried. Ergo, you’re on your own.
  • Although not exactly. We’re here to help. If you have interest in how to hedge/invest in the inflationary period approaching, visit
  • And for a summary of today’s series of tweets, you can check later at
  • Thanks for coming with me on this #CPI journey this morning. Buckle in.
  • Core looks like 0.10% flat, dropping y/y to 1.28%. That will be the low for…probably 10 years.
  • Even the +0.1% was higher than the last couple of months. But the easy comps start next month. Then some hard ones. But by the time we get to the hard comps, rents should be catching back up. Worth looking at my “conflicting frames” piece on the blog.
  • Used Cars and trucks surprisingly fell again, -0.91% m/m. That’s at odds with the private surveys, but there’s sometimes a wiggle before they catch up.
  • Apparel dropped -0.74% m/m. Also odd. Pharma PLUNGED -0.75% m/m. As a result, the core goods y/y figure dropped to 1.3% from 1.7%! That’s the story.
  • Rents were actually okay! OER was +0.27% and Primary Rents +0.20%. Really, today’s story in some ways is the opposite of what I expected. Rents solid, goods prices soft.
  • Really odd stuff today. Airfares -5.1% m/m, despite the heaviest air traffic in a year. Lodging Away from Home -2.3%, ditto. Although some of that might be a weather effect. Still anti-anecdotal.
  • Doctor’s services, though, jumped +2.01% m/m! To 5.1% y/y, highest in a while.
  • Hospital services remained a bit soft. Still, the overall Medical Care subcategory accelerated slightly to 2.00% y/y from 1.95% y/y, despite the drop in Pharma, thanks to docs.
  • So Core ex-housing dropped, to 1.16% from 1.25%. But for weird reasons, not services but goods!
  • Core goods and services back together after core goods had rocketed ahead. Again, this is super weird. Shipping costs are through the roof. Packaging and raw materials prices are having moves like we’ve never seen. And goods prices are declining?
  • sorry…decelerating. Let me be precise.
  • Biggest monthly declines in core: Jewelry (-29.9% annualized), Lodging Away from Home (-24.4%), Public Transportation (?) (-24.0%), Men’s/Boys’ Apparel -23.6%, Infants’/Toddlers’ Apparel -21.6%, Tenants’/Household Insurance -13.5%, Used Cars/Trucks -10.3%.
  • The decline in insurance makes sense. Insurance companies are having to give rebates because their loss ratios were too good (that is, they didn’t have to pay out as much as underwriting had expected). So that will be a CPI decline. I get that. Only 0.4% of CPI though.
  • Largest core increases: Car/Truck Rental (+135% annualized), and that’s it for >10% annualized.
  • Pharma y/y. Difficult supply chain for APIs and more announced price hikes in January than is normal. And prices are falling. That’s a conundrum.
  • This is the divergence I mentioned in private surveys vs CPI for used cars and trucks. I could believe it cresting at a lower level but the latest zig higher suggested we have another zag in CPI. Next month, maybe.
  • Brilliant catch. Although lockdowns are lifting, the BLS had trouble doing some collections. More likely weather, but blamed on Covid because we blame everything on Covid. But that explains a lot of weird moves. Good catch @TOzgokmen
  • Well, that makes next month even more interesting. Because the rent numbers aren’t likely to have been much impacted by weather, but physical goods prices?
  • And again, like I said the other surprise was that rents did not continue their recent trend of softness. Y/y on OER was flat. There’s a lot of catch-up ahead.
  • One thing which has changed in the last year which isn’t likely to change back very soon is the VOLATILITY in the monthly CPI figures – not just the core or headline, but the subcomponents. That will persist for a while.
  • OK, four pieces charts. Food and Energy relatively normal.
  • Core goods – slightly off the boil but will be interesting for sure to see how much of this was due to “collection problems” at BLS.
  • This is where there’s real weakness, but it’s airfares, hospital services…though doctor’s services added a bit this month. Insurance rebates likely pressured this in February. Again lots of volatility.
  • And then Rent of Shelter, normally the least volatile. This month, rents were actually pretty normal but lodging away from home dragged further. I do think that hotel rates are unlikely to keep sliding. This might also be a collection issue.
  • Think that’s going to do it for today. The bottom line is that rents were stronger-than-expected, lots of other things weaker, but collection issues make it easy to be skeptical that goods prices are suddenly decelerating. Next month we’ll get hopefully a cleaner picture. BUT…
  • …BUT we will also get the beginning of the severe base effects. In three months, core CPI will be near or above 3%. We all know it, but it will be interesting to see if markets get nervous anyway. Thanks for tuning in. Stop by !
  • FWIW, looks to me like median CPI ought to be more like +0.26% compared to core +0.10%. My confidence in that is lower than usual because of something quirky with my spreadsheet, but it highlights that the core was dragged down by large declines from small categories.

The best observation of the day wasn’t mine. The problem with pulling in data automatically, rather than reading the report, is you will miss the footnotes! And the footnote pointed out by @TOzgokmen was a very important one. It slaps much larger-than-normal error bars around what are already more volatile-than-normal data. I suspect that this was not likely to have a big effect on rent data collection, but more likely on goods and services where specific outlets were likely to be closed by the bad weather. I may be wrong about that, but it does go a long way to helping understand the weird fact that rents were solid (instead of weak as expected) and goods prices were weak (instead of strong as expected). One never should put too much weight on any one month’s figure, but this diminishes the anecdotal value even more. On to next month.

Categories: CPI, Tweet Summary

Some Thoughts on Gold, Real Yields, and Inflation

February 23, 2021 6 comments

TIPS-style inflation-linked bonds (more properly known as Canadian-style) pay a fixed coupon on a principal amount that varies with the price level. In this way, the real value of the principal is protected (you always get back an amount of principal that’s indexed to the price level, floored in the case of TIPS at the original nominal value), and the real value of the coupon is protected since a constant percentage of a principal that is varying with the price level is also varying with the price level. This clever construction means that “inflation-linked” bonds can be thought of as simply bonds that pay fixed amounts in real space.

I have illustrated this in the past with a picture of a hypothetical “cake bond,” which pays in units of pastry. The coupons are all constant-sized cupcakes (although the dollar value of those cupcakes will change over time), and you get a known-sized cake at the end (although the dollar value of that cake might be a lot higher). That’s exactly what a TIPS bond is essentially accomplishing, although instead of cupcakes you get a coupon called money, which you can exchange for a cupcake. This is a useful characteristic of money, that it can be exchanged for cupcakes.

The beauty of this construction is that these real values can be discounted using real yields, and all of the usual bond mathematics work just perfectly without having to assume any particular inflation rate. So you can always find the nominal price of a TIPS bond if you know the real price…but you don’t need the nominal price or a nominal yield to calculate its real value. In real space, it’s fully specified. The only thing which changes the real price of a real bond is the real yield.

All TIPS have coupons. Many of them have quite small coupons, just like Treasuries, but they all have coupons. So in the cake bond, they’re paying very small constant cupcakes, but still a stream of cupcakes. What if, though, the coupon was zero? Then you’d simply have a promise that at some future date, you’d get a certain amount of cake (or, equivalently, enough money to buy that certain amount of cake).

Of course, it doesn’t have to be cake. It can be anything whose price over a long period of time varies more or less in line with the price level. Such as, for example, gold. Over a very long period of time, the price of gold is pretty convincingly linked to the price level, and since there is miniscule variation in the industrial demand for gold or the production of new gold in response to price – it turns out to look very much like a long-duration zero-coupon real bond.

And that, mathematically, is where we start to run into problems with a zero-coupon perpetuity, especially with yields around zero.

[If you’re not a bond geek you might want to skip this section.] The definition of Macaulay duration is the present-value-weighted average time periods to maturity. But if there is only one “payment,” and it is received “never,” then the Macaulay duration is the uncomfortable ∞. That’s not particularly helpful. Nor is the mathematical definition of Modified duration, which is Macaulay Duration / (1+r), since we have infinity in the numerator. Note to self: a TIPS’ modified duration at a very low coupon and a negative real yield can actually be longer than the Macaulay duration, and in fact in theory can be longer than the maturity of the bond. Mind blown.  Anyway, this is why the concept of ‘value’ in commodities is elusive. With no cash flows, what is present value? How do you discount corn? Yield means something different in agriculture…

This means that we are more or less stuck evaluating the empirical duration of gold, but without a real strong mathematical intuition. But what we think we know is that gold acts like a real bond (a zero coupon TIPS bond that pays in units of gold), which means that the real price of gold ought to be closely related to real yields. And, in fact, we find this to be true. The chart below relates the real price of gold versus the level of 10-year real yields since TIPS were issued in 1997. The gold price is deflated by the CPI relative to the current CPI (so that the current price is the current price, and former prices seem higher than they were in nominal space).

When we run this as a regression, we get a coefficient that suggests a 1% change in real yields produces a 16.6% change in the real price of gold (a higher yield leads to a lower gold price), with a strong r-squared of 0.82. This is consistent with our intuition that gold should act as a fairly long-duration TIPS bond. Of course, this regression only covers a period of low inflation generally; when we do the same thing for different regimes we find that the real gold price is not quite as well-behaved – after all, consider that real gold prices were very high in the early 1980s, along with real yields. If gold is a real bond, then this doesn’t make a lot of sense; it implies the real yield of gold was very low at the same time that real yields of dollars were very high.

Although perhaps that isn’t as nonsensical as it seems. For, back in 1980, inflation-linked bonds didn’t exist and it may be that gold traded at a large premium because it was one of the few ways to get protection against price level changes. Would it be so surprising in that environment for gold to trade at a very low “gold real yield” when the alternative wasn’t investible? It turns out that during the period up until 1997, the real price of gold was also positively related to the trailing inflation rate. That sounds like it makes sense, but it really doesn’t. We are already deflating the price of gold by inflation – why would a bond that is already immunized (in theory) against price level changes also respond to inflation? It shouldn’t.

And yet, that too is less nonsensical as it seems. We see a similar effect in TIPS today. Big inflation numbers shouldn’t move TIPS higher; rather, they should move nominal bonds lower. TIPS are immunized against inflation! And yet, TIPS most definitely respond when the CPI prints surprise.

(This is a type of money illusion, by which I mean that we are all trained to think in nominal space and not real space. So we think of higher inflation leading to TIPS paying out “more money”, which means they should be worth more, right? Except that the additional amount of dollars they are paying out is exactly offset by the decline in the value of the unit of payment. So inflation does nothing to the real return of TIPS. Meanwhile, your fixed payment in nominal bonds is worth less, since the unit of payment is declining in value. Although this is obviously so, this ‘error’ and others like it – e.g. Modigliani’s insistence that equity multiples should not vary with inflation since they are paying a stream of real income – have been documented for a half century.)

For now, then, we can think of gold as having a very large real duration, along with a price-level duration of roughly one (that is just saying that the concept of a real price of gold is meaningful). Which means that higher inflation is actually potentially dangerous for gold, given low current real yields, if inflation causes yields (including real yields) to rise, and also means that gold bugs should cheer along with stock market bulls for yield curve control in that circumstance. Inflation indeed makes strange bedfellows.

Summary of My Post-CPI Tweets (February 2021)

February 10, 2021 Leave a comment

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!

  • But landlords have been collecting less rent, and expecting less rent, and so in the BLS calculation this shows up as less growth in rents. But it’s also cyclical.
  • It does look to me like rent collections stayed soft in January but it’s hard to tell a priori. Anyway that’s the story with rents and we’ll watch that.
  • Outside of rents, it’s a different story. On the services side, still soft especially in medical. And that still confounds me. How is medical inflation so low with a medical crisis on our hands? Head-scratcher.
  • On the goods side, we have pressure in pharma coming from price hikes from some major manufacturers in Jan (more than usual seasonal), and we have a GENERAL CRISIS on the supply side.
  • Shipping rates have skyrocketed. Raw goods prices have been rising rapidly.
  • It’s weird to say keep an eye on apparel, because it’s a small weight and has rarely been anything but soft for years. But apparel uses fabric and lots of fabric uses resin. And resin has tripled in price over the last couple of months. And most apparel is imported.
  • Anyway, core goods should stay robust.
  • What that means for overall core CPI is hard to say. As I wrote recently (and it’s worth reading), there are a lot of  conflicting frames right now:
  • The ‘fog of war’ will make interpreting this number very hard for the next 6-8 months. Which means policymakers will easily ignore it no matter what it does, even though the #Fed doesn’t care about inflation.
  • But if YOU care, and have interests in how to hedge/invest in the inflationary period approaching, visit
  • That’s all for now. Good luck. The consensus estimate is +0.17% on core, keeping the y/y at 1.5% (rounded down). I will look at ex-housing and think there’s some upside there. We’ll see.
  • Well this breakdown will be fun. Core CPI flat (waiting on BBG to post the actual number so we can see how flat).
  • OK, 0.03% on Core. Y/y 1.40%.
  • Apparel +2.21% m/m. Like I said, that’s only 2.8% but all of the supply issues converge on that category. Apparel is still -2.57% y/y.
  • Primary Rents +0.11% for second month in a row. OER +0.14% for the second month in a row. Neither is sustainable when home prices are spiking. Y/Y is 2.05% and 2.01% respectively.
  • Lodging Away from Home, a “COVID Category” -1.88% m/m. So I think we can see Shelter was a big softee.
  • Other COVID categories: airfares -3.18% after -2.46% last month; Used Cars & Trucks -0.89% after -0.90% last month. But Motor Vehicle Insurance +1.13% after +1.42% last month.
  • In Medical: Medicinal Drugs -0.25% m/m after -0.24%. That makes little sense. Although seasonally we expect price hikes in January, there were many more price hikes this year than in a typical year.
  • This number is weird all over in that many m/m changes are almost identical to last month’s changes.
  • Doctor’s Services +1.55%, Hospital Services +0.27% m/m. That’s good to see. I mean, I support doctors.
  • So overall, core services dropped from 1.6% y/y to 1.3% y/y (!) while core goods stayed at 1.7% y/y. I rather expected the latter to rise, especially with the apparel jump, so will have to dig deep on that one.
  • So core CPI ex-shelter dropped from 1.45% y/y to 1.25% y/y.
  • Let’s see…biggest declines m/m (in core) were Lodging Away from Home (-20% annualized), Public Transport (-18%) (?), Car and Truck Rental (-12.2%), Misc Personal Services (-11.4%) and Used Cars and Trucks (-10.2%). Lots of mobility stuff there!
  • Biggest core gainers: Jewelry & watches (+62% annualized), Women’s/Girls Apparel (+44%), Tobacco/Smoking (+24%), Motor Vehicle Insurance (+21%), Footwear (+18.8%), Men’s/Boys apparel (+19%). Lots of imports/manufacturing there!
  • Because of the weakness in rents, Median CPI might actually be negative this month. That’s rare! Last year when core CPI was negative three months in a row, median never went below +0.12% m/m.
  • So, again, I’m not really worried about rent going to zero here. What we’re measuring is an accelerating underlying trend in asking rents plus a cyclical underlying trend in delinquencies. The latter will fade.
  • Of course, I could be wrong. Maybe home prices will collapse. But the divergence doesn’t make a lot of sense. These are substitutes!
  • I guess at the end of the day (I hate that term) this report is only surprising in magnitudes.I expected rent might be soft, just surprised at how soft. Expected apparel to jump; it did. I guess Pharma prices were surprising. The rel strength of goods v svcs wasn’t surprising.
  • Meanwhile, back in the market…10y breakevens don’t like this report; they’re down 1.75bps. But not sure anything here will change minds.
  • After all, the market is already pricing in very low core inflation for the next few years. And 10y inflation isn’t exactly trading at a premium. You’re not overpaying for the chance that inflation has a long-tail outcome to the upside.
  • Four pieces. First CPI pie piece: Food & Energy.
  • Second piece, and the ongoing story, is core goods inflation. Now above core services, with or without shelter.
  • Core services less rent of shelter. Here is where the mobility stuff is dragging us down. One hopes this comes back once mobility comes back.
  • And piece 4, what will be endlessly debated: rent of shelter, including lodging away from home. Be careful comparing to the GFC – that was, after all, a housing crisis with collapsing home prices. Made perfect sense then. Makes very little sense now; I don’t see this persisting.
  • I think it’s worth touting my own article again, The Risk of Confusing Inflation Frames. There are lots of crosscurrents here, ‘fog of war’ stuff, will make it hard to discern true trend.
  • Rent collections soggy, resin prices up several hundred percent. But meanwhile, there is this. The fog is going to obfuscate any underlying upward pressure on the price level. But I’m really confident that if you increase the global money supply 20%, you don’t get less inflation.
  • One more comment on those lines. Next month’s comp on core CPI is +0.22% from Feb 2020. And that’s the last pre-covid comp, which means it will then be a long time before we have a clean picture. In between there may be a state shift that’s hard to see. Be careful.
  • That’s all for today. Thanks for following and retweeting etc. A summary will be up on  in a little while (linked too from ) and will make its way around to other sites thereafter. Have a good day!

I don’t have a lot to add to this that I haven’t already said in the “Frames” piece. There are a lot of crosscurrents here and the comforting thing this month is that they’re the crosscurrents we expected to see! I was surprised at how soft the number was, but if you’d given me the rents numbers I would not have been. One thing I forgot to mention as a driver of apparel isn’t just resin and freight, but also cotton which has been rallying hard for a while too. But this is playing to form.

The question about whether we should be measuring asking rents or actual paid rents is interesting. The CPI is supposed to measure the average prices of what consumers on average consume. And the average rent is clearly declining if more people are paying zero. But since most people aren’t paying zero, the change in the median rent is a better indicator of what most renters will see. Over a full cycle, the differences will smooth out because once eviction moratoria are removed and Americans are mostly back to work, the number of zero renters will decline. But for now, this just helps the conspiracy theorists argue why the BLS is saucing the number to make it low. However, I don’t think it’s wrong or intentionally misleading.

We have one more ‘pre-covid’ comp to see…and for most of the rest of the year after that, we’ll have to place our bets with blindfolds on.

Categories: Uncategorized Tags: ,

The Risk of Confusing Inflation Frames

February 4, 2021 8 comments

People who look at and talk about inflation are always having to move between multiple frames. There is the macro versus the micro, the theoretical versus experiential, and of course the short term, medium term, and long term. I spend a lot of time talking about the macroeconomic backdrop (27% money growth, weak velocity that should be recovering), and mostly address the short-term effects when I do the monthly CPI analysis on Twitter (and summarized here, for example this one from last month). And occasionally I do a one-off piece about more lasting effects (e.g. inventories).

But I rarely tie these things together, except quarterly for clients in our Quarterly Inflation Outlook. Right now, though, this is an exquisitely confusing time where all of these frames are colliding and making it difficult to make a simple, clear argument about where inflation is headed and when. So in this column I want to briefly touch on a number of these effects and tie the story together.

Short-term Effects

There are a bunch of short-term effects, or ones that are at least mostly short-term. We recognize that these are unusual movements in costs and prices, and expect them to pass in either a defined period (e.g. base effects) or over some reasonably near-term horizon. This makes them fairly easy to dismiss, and in fact these are not reasons to be fearful of inflation. They will affect CPI, and therefore they will affect how TIPS carry, but they should not change your view of what medium-to-long-term inflation looks like.

  1. Base effects – We know that last March, April, and May’s CPI reports were incredibly weak, as things like airfare and hotels and used cars absolutely collapsed. Core CPI declined -0.10% in March 2020, -0.45% in April 2020, and -0.06% in May 2020. These were followed by rebounds in some of those categories and in others, with June, July, and August core CPI at +0.24%, +0.62%, and +0.39%. What this means is that if core CPI comes in at 0.20% per month from here, then year/year core CPI will rise to 1.85% in April (when March 2020 rolls off), 2.52% in May, and 2.78% in June. But then it would fall to 2.32% in August (when July 2020 rolls off) and 2.13% in September. You’re supposed to look through base effects like that, and economists will. The Fed will say they’re not concerned, because the rise is mainly base effects – even if other things are going on too. Behaviorally, we know that some investors will react because they fear what they don’t know that is behind the curtain. And that’s not entirely wrong. But in any event this isn’t a reason to be concerned about long-term inflation.
  2. Measurement things, like rents – Quite apart from the question of whether COVID has caused inflation (or disinflation) is the question of what COVID has done to the measurement of inflation. For example, in the early months of the pandemic the BLS made an effort to not try too hard to get doctors and hospitals to respond to their surveys. Not only were many surveyed procedures not actually happening, but also the doctors and hospitals were clearly in crisis and the BLS figured that the last thing they needed was to respond to surveys, so the measurement of medical care data was sketchy at least early on in the pandemic. And there were many other establishments that were simply closed and could not be sampled. Most of those issues are past, and the echo of them will be past once the March-August period is out of the data. But there are some that persist and the timing of the resolution of which remains uncertain. The most important of these is the measurement of rents, both primary rents (“Rent of Primary Residence”) and the related Owners’-Equivalent Rent. In measuring rent, the BLS adjusts the quoted “asking” rent on an apartment unit by the landlord’s assessment of what proportion of the rent will eventually be collected. So, even if a renter is late on the rent, a landlord who expects to eventually expects to receive 100% of the rent due will cause that unit to be recorded at the full rent.

During the pandemic, of course, many renters lost their incomes and many others recognized that eviction moratoria made it feasible to defer rent payments and conserve cash. As a consequence, measured rents have been decelerating as landlords are decreasing their expectations of eventual receipt, even as asking rents have been rising rapidly along with home prices. The chart below (Source: Pantheon Macroeconomics, from the Daily Shot) illustrates this point. The divergence is explained by the increase in expected renter defaults – and it is temporary. Indeed, if the federal government succeeds in dropping more cash into people’s bank accounts, it will likely help decrease those defaults and we could see a quick catch-up. (That’s actually a near-term upward risk to core inflation, in fact). But in any event this isn’t a reason to be concerned about long-run inflation or disinflation…although the boom in home prices, perhaps, is.

  1. Shipping Containers – Another item that is related to COVID is that shipping costs are skyrocketing. Partly, this is because shipping containers are in the wrong places (a problem which eventually solves itself); partly, it is because the stock of shipping containers is too small to handle the sudden surge in demand as businesses reopen and not only re-build inventories but also build them beyond what they were pre-COVID (see my article about inventories for why). Deutsche Bank had a note out yesterday opining that while this spike in shipping costs – see the chart of the Shanghei (Export) Containerized Freight Index, source Bloomberg, below – will eventually ebb, it may not go down to its long-term average. But, still, the majority of this spike in costs, which is felt up and down the supply chain and drives higher near-term inflation for everything from apparel to pharmaceuticals, will ebb and isn’t a reason to be concerned about long-run inflation.
  1. Raw Materials – The same picture we see in the Shipping Containers chart is evident in lots of other raw materials markets. I’m not speaking here as much about the large commodities complexes like Copper, Lead, Oil, and so on but about certain less-widely followed but no less important markets. One you may have seen is steel (see chart, below, of front Hot Rolled Steel futures), which have nearly tripled since the summer and are about 30% above 2018’s highs with no end apparent.

Closer to my heart, and one you’re less likely to have seen, is the chart of resin futures. This is polymer grade propylene, which is a precursor to polypropylene. PP is used in all sorts of applications, from clothing and other fabrics to packaging (soda bottles!) of all kinds. And North American supplies of PP are under what can only be called severe pressure. Front PGP has more than quadrupled since the spring, and is at multi-year highs (if you can find an offer at all). It’s up 142% since mid-December! And PP is up even more, as producer margins have widened. Folks who want to track this and related markets might start by visiting theplasticsexchange. The reasons for this spike are part technical, although caused by the sudden re-start of the global economies, and will eventually pass. As with shipping, it may not go back to what was “normal,” but in any case movements like this, or those with steel or other raw materials, are not reasons to be concerned about long-run inflation. However, they likely will affect CPI prints as these are inputs into all sorts of goods.

That is a non-exhaustive list of some of the short-term effects that are directly or indirectly related to the stop-start of the COVID economy. They will pass, but they add a tremendous amount of sturm und drang to the price system and can confuse the medium and longer-term impacts.

Medium-term Effects

Some of the medium-term things that are happening, and that matter, and that will last, will be missed. Here are a few on my list:

  1. Pharmaceutical prices – One of the really fascinating things we have seen over the last few years has been the slow deceleration in inflation of medical care commodities, specifically drugs. The chart below (source Bloomberg) shows the y/y change in the CPI for Medicinal Drugs. In late 2019, after slipping into deflation, drug prices appeared to find a footing and to be recovering. But even before COVID, this jump was starting to ebb and in the most-recent 12 months pharmaceuticals prices experienced their largest decline in decades. Why?

One reason this happened is because the Trump Administration threatened drug companies with a “Most Favored Nation” clause. This means that the drug companies would not be allowed to sell their products in the United States at a higher price than the lowest price they charged overseas. The Trump Administration said that this would cause massive decreases in drug costs; this clearly wasn’t true (for reasons I discussed here last August) but it would tend to cause drug prices to decline in the US at least a little, especially relative to other countries’ costs. Faced with this, drug companies played nice…until Mr. Biden won the Presidency, in at least small part because some of the large vaccine developers slow-rolled their vaccine announcement until after the election. In January, they started moving prices higher again. This may hit the CPI as early as this month. But unlike with the short-term effects listed above, this is not a response to COVID or its ebbing, and it isn’t something that is likely to change. The Biden Administration is much less antagonistic towards drug companies than the Trump Administration was. And by the way, it isn’t just the drug companies that fall in this category. (Insert snarky comment about Trump here.)

  1. I mentioned earlier my article about how inventory management is going to change as a result of COVID. Indeed, the fact that it is already changing is one reason that the supply/demand imbalance is so bad in the short run: as I have already said, companies are building back inventories and adding additional safety stock, and that is stressing production of all sorts of goods. That was a short-term effect but the more-lasting effect is that carrying larger inventories is itself more expensive. Inventory carrying costs increase the costs of goods sold (which is the main reason managers have been pushing them down for decades). Carry more inventory, prices go up more. I don’t think this trend will ebb.
  2. Another trend I’ve seen directly, and am comfortable generalizing, is a movement among manufacturers towards shortening supply chains. The problems with production during COVID, along with the aforementioned shipping tie-ups, argues for shorter supply chains and diversified country sources (don’t get everything from India, for example, in case India as a whole shuts down). Also, shortening supply chains means that inventories (see #2) can be a little lower (or rather, safer at any given level of inventory) since one of the drivers of inventory size is lead time. Customers seem willing, at least today, to pay up to get suppliers in the same hemisphere and even more to get them in the same country. Every purchasing manager noticed that in the depths of the COVID shutdown many countries toyed with the idea of completely closing borders; some countries required container ships to ‘quarantine’ offshore for a time before they could unload. No one expects another COVID, but the -19 version reminded everyone of how the fragility of the supply chain increases with distance. Because in this country, shorter supply chains imply higher costs (since production is still generally cheaper overseas, though that differential has shrunk a lot), this is a short-term level adjustment followed by a lasting upward trend pressure on pricing. It’s essentially a partial reversal of the globalization trend, which reversal had already begun in little ways under the Trump Administration.

Granted, much of this is manufacturing-focused and most of the consumption basket (thanks mostly to rents) is services. But for many years it had been goods inflation holding down overall inflation, until recently. In the last CPI report, Core Goods inflation moved above Core Services inflation for the first time in a long, long time. That looks more like the inflation we remember from the ‘70s and ‘80s, with a much broader set of services and goods inflating.

Macro-level Effects

The last frame I want to touch on is the macro, top-down inflation concern. I won’t spend much time arguing whether output-gap models are working…if they were, then we would be in heavy deflation right now and there would be no signs of inflation anywhere, so clearly that’s the wrong model…and merely point briefly to the now-well-documented surge in M2 money supply growth (see chart, source Bloomberg), which is currently 27% y/y in the US, 11% y/y in Europe, 14% y/y in the UK, and even 9.2% in Japan. The increase in the transactional money supply in the US is twice as large as anything we have ever seen in this country, aside perhaps from the very early days when “not worth a Continental” became a term of opprobrium. Some people have argued that since money growth in 2008-9 didn’t produce much inflation, we oughtn’t worry about it this time either. But the last crisis really was different, as it was a banking crisis  (I wrote about this almost a year ago).

So, unless central banks have been doing it all wrong for a hundred years, the bare intuition is that this much money supply growth probably won’t be a non-event. Money velocity, in the short term, plunged because (a) mechanically, cash dropped into bank accounts by a generous government takes some time to spend, and (b) understandably, the demand for precautionary cash balances got super high during COVID. Both of these are passing issues, and it takes some heroic assumptions to argue why money velocity should continue to decline. Not merely stay low: if money growth continues at the 27% pace of the last year or even just the 13%-16% pace of the last quarter, even stable money velocity would produce much higher prices.

Over time, the relationship of money to GDP is a great proxy for the price level. That model has been powerful for a hundred years, and it makes sense: increasing the money supply 25% doesn’t increase wealth 25%. The amount of things you can buy with that money doesn’t change very much. So the value of the measuring stick, the dollar itself, must be weakening since 25% more dollars buys the same amount of stuff. To be sure, that’s only if people spend the new dollars as fast as they spent the old dollars, so if there’s a permanent change in velocity this won’t be true. But it needs to be a permanent change in velocity, and outside of lowering interest rates we don’t have a great way to induce permanently lower velocity.

[As an aside, the same reasoning applies to asset markets rather than consumables. Because the real output of businesses, and the stock of physical assets, don’t change very fast, a large increase in money must increase the nominal price of those things (or, more accurately, decrease the value of the measuring stick). But how to account for a decline of the value of the dollar in purchasing financial assets, but no big decline in the value of the dollar for purchasing goods and services? This implies a change in the exchange rate between real goods and financial assets. That is, a person can exchange a Tesla for fewer shares of TSLA. But unless markets are permanently valued at higher multiples when the economy is flooded with cash (and there’s no sign that has happened before in the long sweep of history with episodes of rising money supply), eventually the price of shares must decline or the price of consumption goods rises, or both. Essentially, money illusion is operating in one sphere, but not in the other, and I think that’s unsustainable. Maybe I’ll write more about this another time.]

On the macro front, the alarm bells should be ringing very loudly.

So in the three frames above we have some effects that are easy to look through, and to ignore as temporary. We have some effects that are more subtle, but long-lasting. And we have some effects that are potentially huge, and haven’t come to the fore yet at least in the consumption basket. On the whole, the signs are compelling that inflation is very, very likely to rise in a way that is not just temporary. But, because these frames are confusing, and because the Fed (and others) will easily dismiss some of the one-off effects as temporary COVID effects – which they are – this is actually an acutely dangerous time for investors. The fog of war, provided by these short-term effects, will obfuscate some of the longer-term effects and ensure that policymaker response is late, halting, and inadequate. Markets, though, will be reacting in what some will call an exaggerated reaction. Indeed, some already believe that the rise of 10-year breakevens to near-two-year highs, at 2.17% today, is an overreaction.

I don’t think it is. We are going to see core inflation rise on base effects and one-offs, then decline on base effects, but probably not as much as people expect right now. That’s when the fog will begin to clear, and we will see inflation accelerating from a level that’s already higher than it is now. By the time the fog of war clears in late 2021 or early 2022, it will be late to start planning for inflation. Maybe not too late, but late. By the time everyone agrees inflation is a problem, the price of inflation protection will have moved a lot.

The Optionality of Inventories

January 21, 2021 2 comments

I was speaking with a good friend of mine, who was reflecting optimistically on the possible positives to come out of the COVID crisis. The economic system may, thanks to 2020, become less fragile as we are collectively realizing that certain aspects of our system have become very vulnerable to breakage with serious attendant consequences. (Being more of a cynic, I should note that I don’t think this antifragility extends to financial market pricing, certainly at the moment.) For example, he noted, most meat processing in our country is done by a very small number of processors, so when COVID forces a shutdown it can mean…no meat. Most of the saline bags, he told me, are made in Puerto Rico. Of course, we all now know that most of the active pharmaceutical ingredients (APIs) come from one country, China.

Years ago, we had this problem when OPEC controlled the vast majority of the world’s oil. This is less of a problem today, because the market worked on it: high prices created an incentive for innovation in the field of energy extraction. Now there are lots of sources of oil, although OPEC still controls a plurality of it. But the system is less fragile, for sure.

As an inflation guy, I am regularly intrigued by the ways that the world has become more fragile with respect to inflation over time, as the threat of inflation has receded into the misty depths of memory. Insurance companies, for example, have only a sketchy institutional memory (and generally only near the top of the organization where the old folks are) of how the inflation of the late ‘70s eviscerated their financial condition. In 2021, we find ourselves at a point in history where it has been nearly 30 years since we have seen a core CPI reading above 3%. And people will run around as if their hair is on fire when we get it again, even though from the perspective of 1985 that would have seemed a funny problem.

But I’m actually not here to talk about inflation but rather another old habit that we’ve “evolved” away from in the C-suites of American industry, and that’s carrying inventory. Now, carrying an inventory balance is one way to reduce a firm’s exposure to inflation, so I’m not entirely ignoring the inflation angle here; the grander point though is that carrying inventory is insurance against lots of things. To name just a few:

  • your supplier shutting down because of some disease or some authoritarian lockdown measure
  • sudden increases in tariffs on raw goods, or embargos
  • a sudden surge in demand for your finished goods because some other supplier was unable to provide
  • transportation issues and bottlenecks slowing the receipt of raw goods, such as a shortage of containers at the ports or a closure of border traffic
  • large but temporary spikes in the cost of freight, as a result of same

Inventory protects against a multitude of sources of volatility, that is. Of course, this protection comes at a cost, since inventory is a use of capital and capital costs money. Now, being an old option trader (and not merely a trader of old options) that says to me that holding inventory is very much like a financial option: a countable and defined cost, that is paid no matter what your inventory turns are, and an occasional highly significant and non-linear payoff at random times, when you need it.

Owning options is neither a good nor a bad thing, inherently. Paying too much for options that have value only very infrequently is a bad thing, but even in that case if the bad thing is a very bad thing, then you’re willing to ‘overpay’ relative to the actuarial value of the option. We do this all the time with various casualty insurances (we obviously overpay relative to the actuarial likelihood of our home catching on fire or being burgled, since if we paid the ‘fair’ price then the insurance company wouldn’t be able to exist), because the negative value to us of a large loss is not proportional to the negative value of the small cost of the insurance premium…even if that premium is ‘too large.’

So it is interesting, then, that “just-in-time” inventory management, and in general the focus on reducing inventory levels, has progressed to such a level as to be almost fetishistic. And I would argue the main reason this has happened is that the episodes of loss, where the ‘inventory option’ would be ‘in the money’ have been fairly infrequent, as we have improved the supply chain architecture over the years.

But this has clearly changed, and we are seeing manufacturing enterprises – not to mention homeowners, as I stockpile soup against the possibility of another COVID-like lockdown – build precautionary inventories of inputs, and BTB enterprises increasing finished goods inventories. Because lots of these folks have been burned. It only takes one fire in your neighborhood to sell a lot of fire insurance.

And by the way, it makes perfect sense that companies should be retreating from lean-inventory models. Capital is super cheap right now; literally the cheapest in history. Carrying inventory is therefore not only an option with a bigger chance of paying off than it used to, but it’s also a really cheap option.

Here are some other option theorems in the inventory context:

  1. Options have more value, the more volatility there is. The a priori cost of the option varies with implied volatility and the ex post value of the option is related to realized volatility. Therefore, the inventory option is more valuable now, as we have greater economic volatility.
  2. Corollary: higher expected future volatility should raise the sticker price of an option. In the case of inventory, the price of the option is related to the cost of capital. Ergo, more volatile economic outcomes should raise the cost of capital. So far, they haven’t, which means the inventory option is probably irrationally cheap.
  3. Some older option trader once told me “don’t be a weenie and sell a teenie.” That is, taking in a small amount of money to sell ‘lottery tickets’ that are very unlikely to hit is still a bad long-term decision because being short one lottery ticket that hits can end the game. Similarly, it makes no sense not to carry large inventories of inexpensive items. Think thread, or fasteners. “For want of a nail, the horseshoe was lost….” Or APIs. Or soup.

That’s all I have to say about real business options, except for the obligatory (for this column) observation: inventory is not just an option, but also a hedge against future price changes. When inflation is low and stable, this hedge has little value and can work against you as well as for you. When inflation is rising, though, the incentive increases to invest more in inventories that will be worth more (once converted to finish goods, or sold to a customer) the longer the inventory is held.

Categories: Uncategorized
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