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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.

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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

Summary of My Post-CPI Tweets (January 2021)

January 13, 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!

  • Welcome to #CPI Day 2021! We get the last of 2020’s CPI figures today.
  • There’s always volatility in year-end figures, and this one is no exception. Last month, in fact, was pretty weird. In the Nov CPI we had soft housing, very strong Apparel. Broad softness sprinkled with some large moves in small categories. My write-up: Summary of My Post-CPI Tweets (December 2020)
  • As a result, while core CPI was higher-than-expected, Median inflation (which is a steadier measure) was soft. However, skewness on the upside is DIFFERENT from the way we’ve seen it for a while and I’ll be interested to see if that remains.
  • Economists’ consensus is that Core is gonna soften – the m/m core CPI consensus is around 0.12%. I think that’s mostly a call on rents, which have been softening.
  • But here’s the thing – rents haven’t really been softening much outside of big cities. What has been changing is that landlords have been expecting less rent due to financially-stressed tenants. This shows up in CPI as softening average rent growth.
  • And that could change, although probably not until next month. Payments looked soft in December. But rent tracker indices have payments a bit better this month, and they should be: there was just another Federal money drop.
  • Next month or two, we should see a rebound in rents. And in the long run, we definitely will because home prices are jumping and these two can’t diverge forever.
  • Away from Shelter, dislocations in the supply chain remain and part of the trick over the next 6 months is going to be teasing out the COVID effects from the long-term effects. Freight costs have risen steeply and there are goods shortages in places b/c of container shortages!
  • Another category I’m watching that has been weak for a while: Medicinal Drugs. Interestingly, this month (again, probably starts to hit Jan CPI when it is released next month) some major pharma manufacturers announced price increases.
  • Not a huge surprise: pharma prices had been suppressed when President Trump was threatening to introduce Most Favored Nation rules (saying companies can’t charge Americans more than other countries). Pharma played nice. CPI-Medicinal Drugs is negative y/y!
  • I wrote about that here: Drug Prices and Most-Favored-Nation Clauses: Considerations back in August. But the Biden Administration won’t be doing that. Ergo, it’s safe to raise prices again. And they have. We’ll see how much – starting next month.
  • That’s all for the walk-up. Expect volatility! I will probably focus on the ex-shelter number. BTW, be aware that monthly comps get super easy after this month, for a few months. Core CPI will be over 2.5% y/y, probably, by April & push 3% in May. Then the comps get much harder.
  • Do remember, as I constantly remind: the #Fed doesn’t care one bit about inflation. But if YOU do, and have interests in how to hedge/invest in the inflationary period approaching, visit
  • And one more note: I will be on Bloomberg TV with @adsteel and @GuyJohnsonTV at 10:10ET this morning. And my interview with @MetreSteven on @RealVision just dropped this morning. A lot happening in inflation today!! Good luck…
  • Core CPI was +0.09%, a touch softer than expected. Y/Y at 1.62%.

  • Seems like Dec is always weak…even accounting for the seasonals! Let’s see. Primary rents rose 0.10%, y/y declined further to 2.28% from 2.45%. As I said, that will start changing soon. OER was +0.14%, y/y down to 2.17% from 2.28%.
  • Apparel took another big jump, +1.36% m/m. That’s part of the general strength in core goods. Core goods at 1.7% y/y, up from 1% just three months ago!
  • Check THIS out. Core goods inflation above core services inflation for the first time in years. Since the GFC, actually. A lot of that is supply chain folks. But a lot of it is people buying products with government money drops.

  • That rise in core goods happened even with CPI-Used Cars and Trucks -1.15% on the month, second weak month in a row. Looks like the used car prices in the CPI aren’t going to catch up with the private surveys on the upside, as they didn’t on the downside.

  • Airfares slipped -2.29% after +3.49% last month. Lodging Away from Home flat vs +3.93% last month. Motor Vehicle Insurance though continued to rebound, +1.42% after +1.23% last month. Those are my main “covid categories.”
  • In Medical Care, which was down for the second month in a row: Medicinal Drugs -0.24% (y/y down to -2.13%!), Doctors’ Services -0.02% (y/y to 1.74%), Hospital Services +0.30% (y/y 2.99%).
  • I’ve said it before and I’ll say it again. It’s hard to measure medical care, but these are just silly numbers. I doubt doctors are charging less when their costs have gone up enormously. But perhaps they’re charging CONSUMERS less, and we’re measuring consumer prices? Hmm.
  • CPI for Medicinal Drugs, y/y. Come on, man.

  • Core inflation ex-shelter was roughly unchanged this month, +1.45% y/y. Was +1.46% last month. It hasn’t been much higher than 1.7% since 2012.
  • So only two categories had large negative changes: Car and Truck Rental, -49.9% annualized, and Used Cars and Trucks, -12.96%. The latter coming down from a high level. But long list of >10% gainers again:
  • >10% annualized: Jewelry and Watches (39.5%), Men’s/Boys Apparel (+31.8%), Women’s/Girls Apparel (+18.3%), Car Insurance (+17.9%), Misc Personal Goods (+15.5%), Personal Care Goods (+12.9%), Tobacco/smoking (+12.9%), Misc Personal Svcs (+10.8%).
  • Those are just non-food and energy. Also >10% annualized increases in Dairy, Nonalcoholic Beverages, Fuel Oil, and Motor Fuel. But we know those are volatile. I include them in case anyone says “the government ignores milk.”
  • Anyway, Median should be soft again but not as soft as core this month. Median category will be a housing regional so it’s just a guess but I’m saying +0.13% m/m, 2.23% y/y. Core will actually pass over Median in a few months, I think, due to base effects.
  • College Tuition and Fees: +0.74% y/y vs +0.58%. I’ve talked elsewhere about how there’s a quality change here that the BLS knows about but is ignoring for now b/c should reverse: online college ain’t same as in-person college.
  • University costs themselves are up a lot. Talked at length to a university CFO consultant yesterday and they believe many of these costs will remain BUT there are some really interesting applications of virtual education that I can’t fit in here. 🙂
  • Circling back, just want to put the Apparel jump into context. Here is the Apparel price level index. So acceleration in 2011 (after years of nothing), slow deflation, crash into COVID, and just recovering some pricing power. Will be interesting to see how far it extends.

  • Update to our OER model. And honestly, everyone’s model looks something like this – lagged effect of home price rises is a big contributor, as are incomes, to where rents should go. But we’re looking at measured rents ADJUSTED for non-collection. That’s the key.

  • Here’s a fun one. 10-year inflation swaps are about to cross above current median inflation. That hasn’t happened in a long time. You would think the forward should be above, at least because tails tend to be to the upside, but they almost never are. At least, recently.

  • Distribution of y/y price changes by bottom-level category. Big spike is OER of course. But a really wide dispersion otherwise. Chaos.

  • Four-Pieces charts and then I’ll wrap up. Piece 1: Food & Energy.

  • Piece 2: Core Goods. Wheee! Honestly this overshoots our models so I think at least some of it are dislocations. But some of it is real, too much money pushing too few goods. And some is the recently-weak USD, so if you get a much stronger dollar (@MetreSteven) it could change.

  • Piece 3: Core Services less Rent of Shelter. This is the conundrum. I can’t imagine doctors services and hospital services stay depressed in this world. Other services may (office cleaning if there are no offices), but that’s also a consumption basket change. Stay tuned here.

  • Piece 4, Rent of Shelter. I think this will start to reverse as early as next month when the next gov’t checks go out. And the Biden Administration promises more. So delinquencies should decline, raising measured rents.

  • And that’s all for today. I’ll post a summary of these tweets in a bit. Remember to look up my interview on @RealVision, tune in to @BloombergTV at 10:10 to see me there, and visit if you need an inflation nerd!

Recent inflation prints have been held down by soft rents, and that continued this month. A lot of this is artificial: when landlords expect to collect less rent…which is not unreasonable during a recession…then this shows up as a decline in collected rents. But when/if those renters get more current, it shows up as a reacceleration in rents. That’s what I expect will happen, and it could happen soon since more Federal largesse is on its way. It’s an upside risk for the next few months. Although, in another sense, it isn’t really a risk: it’s what we should be expecting to see, given what is happening in home prices.

Rents are the main part of core services inflation. Because of the softness in rents and the softness in medical care services – which is a real head-scratcher – core services inflation fell below core goods inflation this month for the first time in a very long time. Now, normally you don’t see goods inflation in the middle of a recession, but then again normally Washington DC isn’t throwing thousands of dollars into the account of every family. Too much money: check. And supply chains are stressed. Too few goods: check. No surprise we’re seeing goods inflation.

So really, the wiggles in inflation we have seen over the last year are not particularly surprising in themselves, and it’s easy to explain them by falling back on the excuse du jour: “COVID.” Certainly, a lot of the chaotic pricing environment is due to Covid and the related disruption in our economic system. But the question is, what will happen on the other side? We have had massive money growth, with declining velocity until last quarter. Will velocity continue to decline? I am skeptical of that. Precautionary cash balances are higher than they ought to be, given where rates are, because people are nervous and when you are nervous you keep more in reserve. But this won’t be true forever. And we know that, behaviorally, the velocity of “found money”/windfalls is higher than the velocity of earned money, and moreover people are less price-sensitive when they spend a windfall. So I expect that as things go back to normal, inflation will rise – and probably a lot.

This is the test! Modern Monetary Theory holds you can print all you want, with no consequences, subject to certain not-really-binding constraints. The last person who offered me free wealth with no risk was a Nigerian prince, and I didn’t believe him either. I will say though that if MMT works, then we’ve been doing monetary policy wrong for a hundred years (but then, we also leached people to cure them, for hundreds of years) and all of our historical explanations are wrong – and someone will have to explain why in the past, the price level always followed the GDP-adjusted money supply.

Now, over the next four or five months it will be much easier to believe the inflation story. While core inflation was +0.24% last January and +0.22% last February, it was -0.10% in March, -0.45% in April, and -0.06% in May. By mid-year, that is, we will be around 2.8% core CPI y/y (if we just get 0.2% per month) before the comps turn much more difficult. Even though this is fully known, and even though it will therefore be a violation of the Efficient Markets Hypothesis, it will not stop people from becoming alarmed and for the markets to respond accordingly! So buckle in – at the very least, the first half of 2021 will be extraordinarily interesting. 

Summary of My Post-CPI Tweets (December 2020)

December 10, 2020 3 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!

  • Once again, it is #CPI Day! As the summer shutdown continues to recede (even as a winter shutdown potentially looms), the data is starting to clear up a little.
  • There are still huge dislocations, though, in the global supply chain and we’re seeing anecdotal evidence of that all over the place. Check out the price of polymer grade propylene if you don’t believe me. PGP1 Comdty on Bloomberg.
  • Container shortages are also causing price and quantity ripples in global trade. And of course, huge amounts of money chasing these fewer goods. y/y M2 is +25% in the US. 10% in Europe. 9% in Japan.
  • Often, I go into the CPI report with just a vague sense of looking at the whole number and then breaking it down. This month, I have a little different plan of attack.
  • The word of the day today is “compartmentalize.” There is housing, and then there is ex-housing. Housing is one thing. There seems to be near-term pressure on rents even outside of the big cities, as delinquencies are at last rising (as many have long predicted).
  • Measured rental inflation is lower (even if quoted rents aren’t) to the extent that landlords don’t expect to collect the full rent, so that’s a downward effect.
  • But longer-term, housing is doing just fine – home price changes, in fact, are accelerating – so I am not concerned that rental deflation will stay around very long.
  • For a discussion of housing, see my post from october 23 here:
  • So shelter will probably be soft though we’re due for a bounce in Lodging Away from Home. But outside of shelter, the “non-sticky” is what I really want to see. As I mentioned, there are supply chain problems out there and it’s affecting prices because it affects supply.
  • Used Cars might have some more upside, though the early-summer surge looked to be past when that subcomponent declined slightly last month. But the surveys of used car prices are headed back up.
  • Last month, overall core CPI was weak largely because Medical Care tanked. That was the real outlier. I’m keenly interested to see if it rebounds. It’s implausible to think that medical care prices aren’t inflating much.
  • Broadly, consensus this month is for 0.1% on core and just a smidge over 1.5% y/y. No real opinion there – as I said, I’m compartmentalizing. I want to see ex-shelter.
  • Do remember, as I constantly remind: the #Fed doesn’t care one bit about inflation. But if YOU do, and have interests in how to hedge/invest in the inflationary period approaching, visit
  • There’s a growing tide of stories about inflation, both anecdotal ones and stories of the “smart people worried” variety. And I’m seeing lots of interest in new product development in inflation space, and working on several with customers. 2021 will be busy.
  • OK, let’s see what the BLS has in store for us this month. Good luck. And in case I forget to say it later, Happy Holidays. Now let’s light this candle!!
  • Core CPI +0.22%, higher than expected. y/y at 1.647%…rounded to 1.6%, but almost ticked up to 1.7%. But remember: let’s compartmentalize. See the breakdown.
  • Just a quick glance tells me this will be interesting. Used Cars, a usual suspect when we’re above consensus, wasn’t it. -1.28% m/m, which means next month probably it adds. And rents were soft.
  • Owners’ Equivalent Rent was +0.03% m/m, dropping the y/y to 2.28% from 2.50%! That’s a huge drop. Primary Rents +0.04%, y/y foes to 2.45% from 2.67%. Also huge. All of that temporary though.
  • Lodging Away from Home did rebound as expected: +3.93% on the month. So total housing was 0.27% m/m, even though the big pieces belly-flopped.
  • And Medical Care was down again, -0.13% m/m. So what was UP??
  • Well, airfares were +3.5% m/m. Motor Vehicle Insurance rebounded 1.2% m/m after falling last month.
  • Core Goods inflation rose to 1.4% y/y. Core services was flat at 1.7%. You’re looking at supply chain and classic too-much-money-chasing-too-few-goods.
  • Core ex-shelter rose to 1.47%, reversing the deceleration from last month. Still not terribly high, but heading the wrong way.
  • Shelter, and core ex-shelter. Outside of shelter, there’s no sign that covid is causing anything that looks like deflation or even disinflation.
  • Apparel was +0.92% on the month, which is a whopper and a part of the ‘how is this happening’ story, even though it’s only 2.8% of the CPI.
  • Biggest declines on the month were jewelry and watches (-14.5% annualized) and used cars and trucks (-14.4% annualized). But there’s a long list of categories annualizing over 10%:
  • Motor Vehicle Insurance (13.8%), Footwear (17.6%), Men’s/Boys Apparel (28.5%), Misc Personal Goods (+31.9%), Public Transportation (+34.4%), Infants’/Toddlers’ Apparel (+51.3%), Lodging AFH (+58.9%), Car/Truck Rental (+66.8%).
  • So here’s the thing. Because there were small categories with BIG rises and big categories with small declines, the “average” CPI is exaggerated. Median CPI in fact should be very soft, maybe even +0.04% this month. And Median y/y should fall, pretty sharply even.
  • To be sure, if the skewness goes from being on the downside where it’s been for years, to being on the upside – that’s partly what inflation looks like. More on this later when I show distribution stuff.
  • Appliances inflation, part of that core goods component, continues to accelerate. CPI for Major Appliances is now +17.2% y/y, which you probably know if you’ve been remodeling.
  • The overall Housing subcomponent inflation rose to 2.00% y/y from 1.95%. But that’s despite big drops in primary and owners’ equivalent rent. BECAUSE of things like appliances, tools, housekeeping supplies, furniture…all up.
  • As noted, a big part of the “small categories, big changes” came from apparel subcategories. But here’s the overall apparel category. Not exactly terrifying (this is price level, not inflation). The price of clothing is back to roughly what it was in the late 1980s.
  • Totally have skipped over medical care so far. At least we saw increases in some categories although it remains…improbably soft. Medicinal Drugs -0.19% m/m. Doctors’ Services +0.13% m/m. Hospital Services +0.33% m/m. I still don’t buy it.
  • Skipping back to rents – the decline is getting to the implausible level. Again, this isn’t really quoted rents – this is being caused by rent delinquencies.
  • It’s really, really important to remember that home prices don’t follow rents, rents follow home prices (usually). With home prices shooting higher, rents will not keep decelerating. These are substitutes. Over time they move together.
  • So, this distribution is starting to look different. Tails are starting to extend to the high side while the big middle is temporarily moving left b/c of rents.
  • But having the long tail on the upside, which will cause median CPI to eventually be BELOW core instead of above it as it has been for years, is part of what inflation looks like. Kernels popping.
  • I’m going to do the four-pieces charts, then the perceived inflation index, then wrap up.
  • I see we have a number of new joiners this month so to set up the “four pieces” charts: this is just one way of slicing the data into reasonable categories so that each piece is around one quarter of CPI. Food & Energy, Core Goods, Core Services ex-Shelter, and Shelter.
  • Piece 1: Food & Energy. About 20% of CPI.
  • Piece 2, core goods, also about 20%. Talked about this earlier. This is supply chain disruption, and money chasing goods. Appliances. Furniture. But not medicines, weirdly.
  • Core services less Rent of Shelter – weak, as Medical Care Services is weirdly soft. I really don’t understand this. Some of it is auto insurance, which is soft because people aren’t driving as much, but this just seems odd.
  • Rent of Shelter, 1/3 of CPI and a plurality of core CPI. This is where you’ll see really strident arguments on both sides over the next month. But remember, it’s largely about delinquencies. If there’s another stimulus and folks get current on rent, this will reverse.
  • Perceived inflation still running about 1.1% above core inflation.
  • So to wrap up: Core surprised to the upside, because of large changes in small categories like apparel, furniture, and appliances. This means median CPI, which we pay more attention to, will be softer this month.
  • Compartmentalizing: rents continue to be soft, but I don’t think they’ll stay that way. Core goods are clearly pushing higher in a way they haven’t for years, and everyone sees this especially during the shopping season. People don’t shop for services for Christmas.
  • Core services, even ex-shelter, remain curiously weak. Softness in medical care remains a conundrum to me.
  • Bottom line is that this upside surprise isn’t as alarming as it could be, in the same way last month’s downside surprise wasn’t really helpful to deflationistas. But the kernels popping to the high side is an interesting phenomenon that is becoming more common.
  • That might be related to the COVID economy, or it might be a shift to an inflationary price dynamic from the disinflationary price dynamic we’ve seen for decades, where the middle is steady but we get occasional downside tails from price-cutting.
  • Time will tell. However, there is nothing here to make Fed governors wake up early to catch the next CPI. They don’t care about inflation, and it will be a while before it gets on their radar screens. By the end of 2021, maybe.
  • Thanks for tuning in. I will post a summary of this string of tweets at in a half hour or so. Please stop by and peruse the blog, or better yet come by and drop me a note so we can talk about how to work together. Happy holidays!

This was a really different CPI in a number of ways. For one thing, Apparel actually contributed to the upside. The number of core goods categories – small ones – showing large price increases is really unusual, and fascinating. Some of this is clearly temporary: the global supply of shipping containers is all in the wrong places, and there aren’t enough of them anyway, and this is causing sharp increases in shipping costs, delays in shipping, and therefore shortage in end product markets. This would ordinarily be merely inconvenient, but pressing against that shortage of many sorts of consumer goods is a large increase in the amount of money. When helicopters drop a few thousand dollars in everyone’s pocket and many of them run out to spend it, but the shelves are sparse – you get price increases. I am not sure this is as temporary as we want to think. In the initial helicopter drop, a lot of that money was saved at least temporarily, and money velocity fell. But that was partly because we were all shut-ins; we’re also finding out it was partly because there weren’t enough products to buy. I think we’re going to continue to see that money come gradually out of savings and into spending, and I am not sure the global supply chain can keep up yet.

We aren’t yet seeing the broad inflationary pressures. Obviously, rents are soggy but core services in general are weak. I don’t think that will persist; I wonder how much is due to the hangover from the lockdowns. But the lengthening of the upside tails is one characteristic of an inflationary process. I wrote about this recently in “Are the Inflation Kernels Starting to Pop?” and that’s worth a quick read. It has been a long time since we have seen a true inflationary process even when we’ve seen occasional accelerations in inflation itself, so we tend to forget. When inflation is rising at 4%, it doesn’t mean the price of everything we buy is going up at a uniform 4% per year. What actually happens is that prices are sticky, then they jump. This happens for a number of reasons, such a “menu costs” (the cost of reprinting menus, back when that was a thing), and the fact that you have to explain to customers why prices are changing so you do it as infrequently as possible. So what happens is that the price of a particular item goes up 0%, then 0%, then 12%. When that happens, median inflation is below core inflation, because the long upside tails pull up the average. When instead we are in a disinflationary environment, prices go up 2%, then 2%, then get a price cut of 6%. In that case, median inflation will be above core inflation, because the long downside tails pull down the average.

So even though core CPI has been below median for a generation, that isn’t guaranteed. In fact, it’s a possible indicator. Look at the following chart. For years, median CPI had been below core, during an inflationary period. In 1994-5, the positions reversed and they’ve been that way basically ever since.

Obviously, core CPI is still below median CPI. But when the Cleveland Fed reports it today, Median CPI is going to decelerate quite a bit. I don’t think Median is going to keep going down – I think it, and core, are going to go up from here and probably for quite a long time. My point though is that these long tails to the upside are interesting, and worth noting. And if Core CPI crosses above Median over the next few months and quarters, then look out.

Summary of My Post-CPI Tweets (November 2020)

November 12, 2020 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!

  • Welcome to #CPI Day! And to my monthly yammering on the figure.
  • Once again, economists are looking for a soft number today. There is a very strong confidence in the economics community (and in some among the punditry) that the disinflation/deflation wave is JUST ABOUT HERE! So every month they expect it to arrive. So far, not.
  • There is as yet no evidence for such a thing as deflation in the data. Outside of housing, in fact, inflation seems to be broadening.
  • For a discussion of housing, see my post from october 23 here: For a discussion of some of the evidence of broadening, my article here:
  • So the “consensus” forecasts this month are for 0.1% on core, and 1.7% y/y. Actually Bloomberg says consensus is 0.2% on core, but that’s not consistent with a consensus of 1.7% on core.
  • Bottom line is that getting core to drop to 1.6% is going to be hard because in October 2019, core only rose 0.115%. And Core CPI last month almost rounded to 1.8%. So you need a really weak number, almost flat in fact, to get rounding down to 1.6% y/y on core.
  • (Bloomberg has 42 respondents to the m/m number and 67 respondents to the y/y number…which is why their figures on the consensus for the m/m number and the y/y number are inconsistent).
  • A rise to 1.8% on core CPI is much more likely…a mere 0.15% m/m would do it. As a reminder, the last 4 core CPI figures were +0.24%, +0.62%, +0.39%, and +0.19%.
  • On the granularity of today’s number: another huge 0.4%-0.6% surprise seems unlikely. We’ve gotten most of the upside catch-up to Used Cars vs the private surveys…so that could go either way and is not a slam-dunk add as it has been. Other covid categories remain subdued.
  • The big question in recent months, and really the only DOWNWARD pressure in major categories, has been in rents. Last month, OER rose only 0.06%, and primary rents only 0.12%.
  • That doesn’t look like it’s asking rents, which are plummeting in the cities and rising outside of the cities. Landlords might be saying they expect to collect less rent going forward, which would pressure rents lower…
  • …but actual rents being paid are on par with where they were a year ago so eventually reality should catch up with that concern.
  • Mortgage delinquencies, in fact, declined this month – that’s not part of CPI, but an anecdote that the payments crisis in rental housing is exaggerated I think. Much worse in office rents though! Work from home is killing office complexes but that’s not in the CPI.
  • I’m also still looking for the anecdotal pressures we are seeing in medical care, which haven’t yet showed up.
  • Do remember of course that the #Fed doesn’t care one bit about inflation. But if you do, and have interests in how to hedge/invest in the inflationary period approaching, visit and drop us a line.
  • And one more thing: I’m scheduled to be on @TDANetwork tomorrow with @NPetallides at about 5:20ET. We’ll be talking about investing to hedge inflation. And probably other inflation stuff. Tune in!
  • OK, buckle up that chinstrap for a little BLS data roller derby. The game is housing, versus everything except housing. I think a better chance for a high surprise than a low surprise. See you on the other side in about 7 minutes.
  • Well…nope! m/m core CPI only +0.01%, so y/y declines to 1.63%. Big surprise to me. A modest surprise to the consensus. Let’s see what happened there.
  • Another big decline in Lodging Away from Home, -3.2% m/m…after it has already fallen so far. That’s part of this. Big drop in Medical, more on that in a moment.
  • Overall, interestingly, Core Goods rose to 1.2% y/y from 1.0% (and 0.4% two months ago), but Core Services fell to 1.7% from 1.9% (and 2.2% two months ago).
  • Core goods. This is super interesting…hasn’t been this far away from deflation since 2012.
  • Apparel also took another dump, -1.16% m/m. Used Cars was down slightly, -0.08% m/m. As previously noted, the big spike in private surveys was already in CPI.
  • One more covid category that’s surprising: airfares, +6.3% m/m after -2% last month. It’s seasonally time for airfares to rise but this means they rose even more. Then again, they’d fallen so far that was easier. Still surprising.
  • Now to housing: Primary rents rose 0.16% m/m, more than last month’s 0.12% but the y/y still slowed to 2.67%. Owners’ Equivalent Rent was +0.22% vs 0.06% last month, holding the y/y steady at 2.50%. These numbers make lots more sense.
  • So not really housing pushing down vs ex-housing pushing up…housing was stable, only a touch soft; and some categories were strong. But some were really weak and oddly so. Medical for example.
  • Here is the Medical Care CPI subindex, y/y. It absolutely tanked this month. Pharma fell into deflation y/y. Doctors’ Services fell to 1.87% y/y from 2.09%. Hospital Services were -0.58% m/m!
  • THAT is the story of this month’s CPI, I think. I should note there isn’t a lot of reason to think that PRICES should be DECLINING in health care as COSTS rise precipitously.
  • This could be a compositional issue: the costs of telehealth are lower than for doctor visits, so even though the costs of medical procedures in-hospital are rising a lot, the smaller decline in a wider spending item may be dominating.
  • Health Insurance costs are dropping sharply on a y/y basis, down to +10.2% from +14.1% last month. Still high obviously but the wave is receding. Reminder that health insurance in the CPI doesn’t measure insurance policies but the implied profitability.
  • It has been my expectation for a while that the rise in health insurance inflation, b/c of how it’s measured, might be catching inflation that hadn’t been caught yet – hard to believe insurer profitability soared like that. But so far, haven’t seen that in the rest of medical.
  • That said, data collection issues in medical care right now might have something to do with this. The BLS isn’t currently hammering health care workers to respond to its surveys/calls, for obvious reasons.
  • Motor Vehicle insurance, to change topics here, was also weak again. People aren’t driving so much so insurance companies are cutting prices and/or rebating a lot (generally required by insurance boards in a lot of states when claims are less than expected).
  • Here is car insurance y/y. It’s actually 1.7% of CPI, so it matters.
  • Month’s biggest declining categories in core (annualized chg): Infants’ and Toddler’s Apparel (-34%), Lodging AFH (-32%), Men/Boy’s Apparel (-30.6%), Jewelry/Watches (-24.5%), Motor Vehicle Ins (-24%), Women’s/Girls Apparel (-10.6%).
  • Biggest increases: Car/Truck Rental (+136%), Public Transportation (+36.5%), Footwear (+14.6%).
  • Early peek at Median…my guess is +0.16% m/m, which would make the y/y 2.46% (2.51% last month). Not exactly deflation, but certainly off the highs. Don’t get used to it.
  • The “Inflation Angst” index, which is our calculation of “perceived” inflation minus core inflation, declined slightly this month.
  • Four Pieces charts. First piece: Food & Energy
  • Core Goods. This is a story, and a little surprising if this continues. This includes Medicinal Drugs, by the way, which is in deflation – so very curious. Supply-side constraints meeting big cash infusions to consumers: you don’t buy more services, you buy more stuff.
  • Third piece, core services less rent of shelter. Big drop, mainly due to medical care. Again, I think that is the real big story and surprise this month. I have a SUPER hard time believing that hospitals and doctors are going to be cutting prices in a COVID world. Even post.
  • Last chart before I wrap up: since I recently wrote about the broadening of inflation here’s a tiny update to the Enduring Investments Inflation Diffusion Index (EIIDI). Declined modestly to -16 this month.
  • OK, summing up…this month’s number was broadly tame, with the notable exception of medical care. Housing, other than Lodging Away from Home, was stable. Airfares showed a surprising increase. But the big story, and the one that I have trouble believing, was medical care.
  • Disinflationistas should probably not take a lot of comfort in this number, but surely neither can inflationistas. So whatever -ista you are, ista unexciting number fer ya.
  • Going forward – we still have this little issue of a massive increase in the transactional  money supply. There’s no way to make it go away easily. Uncertainty will keep cash balances high and velocity low – but any recovery in confidence could unleash the spending beast.
  • We are already seeing that in core goods. Now, if the Fed and Treasury somehow get religion, the inflation surge might be only modest, 4%ish next year is my guess. But we just elected people who believe in MMT, assuming Biden/Harris counts are confirmed by the states.
  • Not that the monetary authorities were behaving particularly responsibly in 2020, but if the MMT crowd gets traction things could get super ugly. Thankfully, not today’s problem. Right now breakevens are down a few bps, but  still way cheap to where I think they’re going.
  • That’s all for now. Thanks for tuning in. Remember I’ll be on @TDANetwork tomorrow evening, 5:20pm ET or so! And stop by if you wonder what it is we do.

This was a long one this month, so I won’t add a whole lot to what I wrote above, and what I wrote recently about housing. Maybe I need to do one on Medical Care, but that’s a fairly inscrutable index that’s hard to model especially at times like this when there are lots of moving parts. But the bottom line for medical care is – it’s becoming lots more costly to practice. As I mentioned, there might be savings in the transition of more routine monitoring care to televisits from in-person visits, but I’m not sure how much of that is permanent: an important part of even a routine checkup is looking for things that the patient might not be able to observe directly, e.g. glandular swelling. Moreover, everything else that is in-person has become lots more costly to do, and this is likely to remain the case even after COVID is long gone (to say nothing of the fact that hospitals are going to need to recoup lots of revenue lost on elective surgeries over the duration of the pandemic). So I don’t know exactly what is going on there, but it’s really hard for me to imagine that medical care is getting vastly cheaper.

Now, in pharmaceuticals (“Medicinal Drugs”) the answer is a little less clear. Back in August I wrote about what the President’s push to make Pharma companies accept “Most-Favored Nation” clauses would mean for domestic drug prices. My conclusion in part was “I suspect that most pharmaceutical companies will end up lowering prices a little bit in the US and in other countries where prices are similar, and only selling them in countries that now pay a very low price to the extent that those foreign countries and/or international charities subsidize those purchases.” So maybe that’s part of what is happening here. If it is, then we can expect that to change pretty rapidly under a President Biden, who seems bent on reversing by executive action pretty much everything that President Trump did over the last four years. (I suspect that this might have something to do with the timing of Pfizer’s vaccine announcement, after the election!) But in any event, I think it’s unlikely that we are about to enter a period of sustained deflation in the price of drugs. And outside of that, this month was fairly normal on the inflation front. To be sure, that means inflation was lower than it was in July and August, but it also isn’t really at zero.

Categories: CPI, Tweet Summary

Are the Inflation Kernels Starting to Pop?

October 27, 2020 2 comments

On Friday, I wrote about the outlook for housing inflation, which is a big part of the overall (and especially core) CPI. If you missed that piece, you can find it here. As a quick update: today, the FHFA House Price Index was reported +1.5% for August, versus expectations for +0.7%, and the S&P CoreLogic neé Case-Shiller 20-City Home Price Index was reported at +5.18% y/y versus expectations for +4.20%. So, as I noted in that piece – the signs for home prices remain very supportive, and that suggests that rents are unlikely to continue to decelerate for very long.

I focused first on housing because that is the largest and most-ponderous category of the Consumer Price Index. Today I want to turn more broadly and look at everything else, collectively. Because I think there are some reasons to think that not just housing, but the inflation process itself, is starting to look more buoyant.

Although we are somewhat conditioned to think of inflation as a smooth process, with all prices sort of rising/accelerating as one, that’s not how inflation happens. Thinking about the process this way – as a rising tide that gradually increases the price of everything – means that we have a predisposition to look at each individual price change and see if we can identify the “reason” for the price change; if we can find one, then that must not be inflation but rather a one-off event. Used cars CPI is a great case study: over the last few months, the CPI for Used Cars and Trucks has spiked and is now rising at about 10% y/y (see chart, source BLS).

Is that inflation? Well, to some observers it is just a one-off effect. For example, an argument by Twitter user @thestalwart in response to this spike in prices was:

Now, this ‘assumes a can opener’ because there hasn’t yet been a sudden and widespread move to the suburbs; moreover, to the extent that commuting is way down shouldn’t that mean a bigger supply of used autos? What about the car rental fleet shrinkage with business and leisure travel way down? Rental is a large source of used cars. Nonetheless, it is surely true that in each market where inflation (or disinflation) happens, you can point to movements of supply and demand in nominal space…that’s just Econ 101. In other words, there is always an explanation to be had beyond “everyone just raised prices because there’s inflation.” And inflation doesn’t happen in a uniform way. I like to say that it is like microwave popcorn: not all kernels pop at the same time, but eventually the bag is full. For each kernel, you can look at local conditions that determined exactly when that kernel will pop (“this one was moister than others, so that’s why it popped”). But the overall cause is “heat.”

So waiting until that time when you have prices rising for no apparent reason is just waiting for Godot. There’s always an excuse.

Recently, there has been evidence that the “heat” is rising. Anecdotally, the Wall Street Journal had a story a few days ago entitled “Why You Might Have Trouble Getting the Refrigerator, Can of Paint or Car You Want,” with the subtitle “Factories rush to keep up as Americans spend on their houses and vehicles.” Again, the story is that there are various bottlenecks on the supply side but the simple explanation is that there’s a lot of people trying to buy and not enough goods to sell. That’s actually the classic definition of inflation: “too much money chasing too few goods.”

Anecdotes are fun, but let’s try to look at this a little more analytically. Enduring Investments has developed an inflation diffusion index, derived from BLS data, which gives a different look at the breadth of inflation. It doesn’t take a weighted average, like Core CPI, and it doesn’t take the midpoint of the consumption basket like Median CPI. Instead, it looks at the number of categories that are seeing prices increasing faster or slower than 2%, weighted equally in their category and with each of the eight major categories getting 1/8th of the overall weight. As a price index, this is absurd – why would you weight Owner’s Equivalent Rent only slightly more than Full Service Meals and Snacks when consumers spend vastly more on shelter? But as an indicator of breadth, it makes some sense: there are, after all, a lot more different sorts of goods that fall under the category “Full Service Meals and Snacks,” and we make purchase decisions in that category more frequently than we make decisions on rents as well. So, in terms of the proportion of decisions made that are seeing higher price acceleration, arguably the index for meals and snacks should be higher. (There is nothing magic here, just an attempt to get a better view of inflation breadth. There are other ways to look at the same thing).

Over time, as the chart shows, the Enduring Investments Inflation Diffusion Index tends to move with median inflation. But interestingly, in the post-Global Financial Crisis period these two have diverged, with the diffusion index in negative territory more normally associated historically with crisis or recession periods. This helps explain why there has been little investor interest in buying inflation protection even though the Median CPI has been rising fairly steadily for seven years! But that may be changing: the EIIDI has been in the single digits negative for three of the past four months, and the 12-month average is the highest it has been since the end of 2013.

For a while, the story of inflation in the US has been that shelter inflation was strong, some other services were seeing some inflation, but the vast majority of goods were seeing stable to declining prices. This is changing. Shelter has been softening – although as I noted last week I don’t think that will continue – but we are seeing pressures percolate more widely. The corns are starting to pop more frequently. Keep an eye on that bag!

Categories: Uncategorized

The Outlook for Housing Inflation from Here, Oct 2020

October 23, 2020 5 comments

In the last couple of CPI reports, two trends have started to become apparent. One is that inflation is broadening, in that more categories are seeing accelerating inflation. The second is that shelter, the largest and slowest-moving subcategory, has been decelerating.

Is there an inflationary process going on, then? Or are we in a disinflationary or even deflationary period? The answer to this question depends a little bit on what we think the inflation process is, and a little bit on figuring out what is really happening in housing.

I originally wrote this as one long piece, but decided rather to split it into two. So today I’m going to talk about why I think the shelter component of CPI is probably not about to enter into an inflation-dampening slide; on Monday or Tuesday I’ll discuss the inflation process itself and the broadening of inflation.

I have long said that if you’re going to predict core deflation, you’d better have a reason to expect deflation in housing. And if you’re going to predict accelerating core inflation, you’d better have a reason to expect acceleration in housing. Shelter is the 800-pound elephant in CPI; it moves slowly and ponderously and if it sits in one place, you’re not going to move the broad index very far. And the story for the better part of two decades in inflation is largely this: shelter inflation has been consistent and in the 2%-4% range; everything else in core has been fairly consistent but lower.[1]

The exception, of course, was in 2009-10, when the housing implosion dragged down rents in a short but deep dip. But if you’ll look at the following chart, which splits core into Shelter and ex-Shelter components, you’ll see that nothing else really looked like deflation was in the offing. Indeed, if you take out shelter, core inflation barely slowed in the aftermath of the Global Financial Crisis (Keynesians, take note).

To get a real inflationary outcome, then, we’ll need two things. One of these is that shelter needs to not decline, but rather accelerate. And the other is that non-shelter inflation needs to pick up. None of this needs to happen tomorrow, but it needs to happen. So, when Keynesians see Shelter declining markedly, they become gleeful because it sure doesn’t look like the enormous deficit spending and explosive money growth is doing anything to cause inflation.

Not so fast! Let’s take a deeper look first. The three main components of Shelter are (a) Owner’s Equivalent Rent, which is ~73% of Shelter; (b) Rent of Primary Residence – that is, apartment renters – which is ~24% of Shelter; and (c) Lodging Away from Home, which is about 2.8% of Shelter. (The difference is rounding and a little bit of “Tenants’ and household insurance.”) The chart below shows the y/y changes in these three pieces, unweighted.

Clearly, Lodging Away from Home provides a ton of volatility, and that massive decline – and not much of a bounce – has deducted about a third of a percent from the year/year growth rate of the broad Shelter CPI index. Lodging Away from Home is clearly and directly impacted by a lack of travel, so to get a better idea of the general shelter trends let’s strip that away. The two main categories, then:

Not surprisingly, Primary Rents and OER track each other very well. This makes some people very angry. Some mathematically-challenged inflation-conspiracy “alternative stats” sites claim that the Bureau of Labor Statistics changed to the rental-equivalence method of computing shelter costs to “hide” the real inflation, which they say is really 5-6% per year higher than what is reported. This is obvious nonsense, and I hate to always have to debunk it because it’s so easy to do. The reason that the US uses rental-equivalence is that you can think of a house as providing two things to the owner: an investment, and a place to live. It’s important to separate these two functions of a house, and so the BLS reasons that the “place to live” part is in competition with other ways you can get a place to live without the “investment” part: in other words, a rental. This gets confusing at times when home values are rising faster or slower than rents. This happens because although the “owner’s equivalent rent” part of a home is in competition with “rent of primary residence” – and so these two series move together as the chart above shows – the investment value of the house has no analog if you’re a renter. So when home prices and rents diverge, it is best to think of the divergence being caused by the investment portion.

Incidentally, you can understand this equivalence by reflecting on the fact that these two situations have equivalent financial outcomes: (1) live in your owned home and (2) rent your owned home to someone and use that income to rent someone else’s owned home. In both cases you are living in a house, and get investment returns related to home prices. But in the second one you’re clearly paying rent, and you also own a home that earns you the change in home prices plus a stream of rental payments, even though the two rental streams in this case (the one you’re paying, and the one you’re receiving from your tenant) happen to cancel. That’s essentially what is happening, then, in (1) and it’s the reason the BLS looks at housing in that way.

So, how much difference does it make over time to use rents, rather than home prices, to measure the cost of “shelter services”? The chart below shows the median price of an existing home, compared with OER. Note that prior to the bubble era, rents and prices moved pretty close in lock-step…through the late 1990s, there was no difference – certainly not 5-6% per year! And even with the wild swings induced by the ‘environment of abundant liquidity’, median home prices have risen ~4.2% per year since 1982, compared with ~3.2% for OER. One whole percent per year, which means the dastardly BLS has understated Shelter costs by 0.7% per year, and overall CPI by roughly 0.2% per year! Oh, and as lately as 2013 the difference was exactly zero percent per year. This seems like a conspiracy theory in search of a conspiracy.

Back to the story we came here to discuss. Why are rents decelerating, and is there reason to think that will continue?

In some parts of the country, notably in dense metropolitan areas where taxes and violence are rising, rents have not only slowed their rise but are actually in decline as renters can easily pick up and rent elsewhere. But elsewhere, rents are showing normal trends. The following picture, sourced from, illustrates this phenomenon. New York, as President Trump recently noted, really is becoming a ghost town and rents are falling briskly in L.A., San Francisco, Boston, Washington, Minneapolis, Seattle, and Chicago and more mildly in Portland, Denver, Chicago, Houston, Dallas, and Philly. But they’re rising in lots of other places.

Also, rents in the CPI aren’t ‘asking rents.’ They are based on a survey of landlords, who report the rents they have actually received in the latest month plus any amounts they expect to receive in arrears. So if someone has paid rent to the landlord, that rent is included…but someone who is behind on the rent isn’t treated a zero. Instead, the landlord reports what amount of rent he/she expects to eventually receive. At times like the one we are currently living in, this can matter. While the government grants early in the year actually kept incomes surprisingly robust despite the lock-downs, those streams of money are drying up and with it, the potentially ability of some renters to make the rent. If landlords give a grace period to the renter, that doesn’t show up as a rent decline. But if the renter sneaks out the back window like George Thorogood,[2] it will. Nevertheless, at the moment the number of renters making full or partial payments is not too far below par, according to the NMHC Rent Tracker. However, if after a “blue wave” election the Congress declared a “rental holiday,” there would be a massive decline in the BLS rental figures. I give that a very low probability of happening, but it’s a risk to be aware of.

Overall, then, rents are softening mostly in the big cities and this is being reflected in Owners’ Equivalent Rent as well (for a good if wonky explanation of how the BLS measures Owners’ Equivalent Rent, see this publication on the BLS website). But how confident are we that this will continue? Notably, exactly the opposite thing is happening in home prices. Just this week, the National Association of Realtors reported that the median price paid in Existing Home Sales rose 15.4% over last year – the fastest rise since 2005.

That’s remarkable, and I must say unexpected. Some will say that this is a sign of a wave of people moving to the suburbs; maybe that’s true. But while 10-20% per year home price appreciation going forward seems unlikely, it is also unlikely that home prices are going to fall very much since the inventory of homes available for sale is near the lowest level in many, many years; historically, low inventories lead home price appreciation by about 12 months.

Although rents are decelerating, at least looking backwards, I find it very hard to believe that can be sustained. Apartment rental and home ownership are, after all, substitutes to some degree, and while they sometimes diverge for a time rents almost always eventually follow prices. In the Global Financial Crisis, for example, the drop and eventual recovery in home prices led OER by about 18 months, which is why it was pretty easy at the time to know that October 2010 was going to be the low in core CPI, plus or minus a month or two.

Now, lagging home prices is one way to get rents, and as you can see it doesn’t really suggest that a collapse in OER is imminent. But at Enduring Investments we also use an income-based model since one might reasonably suspect that when people’s incomes decline they are less likely to be willing and able to pay high primary rents, and over time if the amount that people spend on shelter is reasonably stable then the rise in nominal incomes is likely to parallel the rise in nominal rents. And although it doesn’t fit the contours of rents as well as one based on home prices, the implication of that model is very interesting, thanks to the big jump in incomes due to government transfer payments.

If you look at home buyer traffic, and what’s happening to home prices, it doesn’t seem a big stretch to suggest that at least some of that is resulting from the income replacement schemes that have left some people actually better off than before the crisis. The income model actually suggests we could see a decent acceleration in rents in the latter half of 2021.

When we put our various models together, we get a more stable picture that suggests the recent dip in rents is overdone and not likely to be the start of a significant slide lower (again, assuming no rental holiday!); in fact, the 800-pound gorilla might begin moving north soon.

That’s all for today on housing. On Monday or Tuesday, I’ll have a much shorter piece discussing the broadening of price pressures, and how that factors into the outlook. Thanks for reading. Be sure to stop by Enduring Investments if you would like to start a dialogue on this topic and how we can help you manage inflation risks.

[1] And for the better part of this last decade, I’ve been writing periodic updates about housing inflation, which you can find on my blog in the “Housing” category at What’s amazing is how many times I say “recently, there has been some alarm about OER” or “some people have been saying housing inflation is about to head lower.” Seems a recurring theme!

[2] “So I go in my room, pack up my things and I go/ I slip on out the back door, down the streets I go/She a-howlin’ about the front rent/She’ll be lucky to get any back rent/She ain’t gonna get none of it.” – One Bourbon, One Scotch, One Beer as sung by George Thorogood & The Destroyers.

Categories: Housing

Summary of My Post-CPI Tweets (October 2020)

October 13, 2020 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!

  • Another COVID-era #CPI report coming up this morning. After two big upside surprises versus economic forecasts, the forecasts this month are …lower.
  • Last month, economists were looking for a “strong” 0.2%, something 0.21%-0.24%, and got close to 0.39%. That was a month after the 0.62% print.
  • This month, the forecasts are for 0.2% on core, but a 1.7% y/y. We can look at the year-ago number and figure out that to keep 1.7% from rounding to 1.8%, core can’t be 0.21% or higher. So economists are clearly expecting a “soft” 0.2% on core.
  • …something closer to what was normal before COVID. I’m still not sure we get normal.
  • The “COVID categories” (hotels, airfares, etc) still haven’t fully recovered, and despite the recent bump in used car CPI it’s still well behind private surveys which continue to accelerate. Never know if that will happen THIS month but still looks like some room there.
  • We’re also starting to see reports of pressure in medical care, which so far hasn’t made it into the CPI in a significant way. And the weakness in the dollar since spring will eventually help apparel a little.
  • Now, we still have some near-term downside risk from housing, but more and more any weakness there (and it has been a touch soft, which makes the upside surprises even more surprising) looks transitory.
  • We’ve all seen the reports of plummeting rents. But those are in cities, and it turns out that a lot of renters don’t live in cities. Outside of cities, rents don’t appear to be under pressure.
  • If renters are being more delinquent such that landlords expect to collect less, this would pressure the measurement of rent inflation – but the NMHC tracker says the share paying rent through Oct 6 is the same level as in 2019.
  • Meanwhile, there are signs from the housing market that there is actually upside risk ahead – I really meant to write a column this month on the housing indicators but just didn’t get to it.
  • For example, one important longer-term driver of rents and OER and home prices is incomes, and incomes are very strong right now thanks to federal income replacement. Will they be this strong in 4 months? Probably not, but presently these incomes are driving housing outcomes.
  • All that said, OER and primary rents have been a little weak recently and my gut is bracing for something even softer. But there’s no analysis there, just a concern. Even a little housing softness could produce a ‘soft’ 0.2%.
  • Rents are really the only ‘normal’ thing that can drag this number lower. But this is the COVID era, and nothing is normal, so there can always be weird one-offs, in both directions. With M2 rising at 24% per year, these are more likely to be on the positive side.
  • All of these one-offs on the high side are what inflation looks like, after all. Inflation is like microwave popcorn. The kernels go off one at a time, and each has a micro “explanation.” But eventually the bag is full, and the MACRO explanation was “heat.”
  • Outside of rents, inflation is broadening, quickening, and deepening. It surprises me that it has happened so early…I thought it would take until 2021…but if we get a third surprise today then we’ll have to start thinking it’s here already.
  • Do remember of course that the #Fed doesn’t care one bit about inflation. But if you do, and have interests in how to hedge/invest in the inflationary period approaching, visit and drop me a line. Good luck today.
  • Well, soft 0.2% it is. +0.19% on core CPI.
  • y/y on core at 1.73%, so basically unchanged from last month.
  • OK, so used cars was +6.7% m/m, even more than last month’s jump. Core goods, partly as a result, went from 0.4% y/y to 1.0% y/y. But core services plunged from 2.2% to 1.9%. And where?
  • Yep, OER was only +0.06% m/m, which pushed the y/y down to 2.49% from 2.69%. Primary rents +0.12% m/m, so y/y fell to 2.72% from 2.95%. My gut was right – there was (near-term) downward pressure there.
  • Lodging away from home, which had been recovering, slipped back some last month -0.38% m/m. I guess the end of the summer vacation season means it’s all business travelers, and not many of those.
  • Apparel fell, -0.45% m/m, despite weaker dollar. But the real surprise might be medical care, which FELL despite lots of evidence that prices are increasing. Need some charts here.
  • Physicians’ services -0.29% m/m. Really? Talk to any doctors who are doing price cuts recently?
  • Amazing that we were able to get an 0.2% even with housing so soft (and again, the bigger indicators on housing are pointing higher). Core inflation ex-housing rose to 1.50% y/y. Disinflationary pulse from COVID basically over already.
  • College tuition and fees fell to 0.71% y/y from 1.31%. This is clearly a quality effect that isn’t being captured by a quality adjustment, and the BLS knows it but can’t figure an easy fix for what is a 1-year problem. Remote-learning isn’t worth the same as in-person.
  • Tuition had been under pressure anyway because endowment returns had been fantastic for a while, but this dip is because colleges can’t charge the same for e-college.
  • Motor vehicle insurance continues to be a drag on services inflation. People are just not driving as much, and insurance companies are rebating premiums. Biggest 1m declines this month were Infants/Toddlers Apparel (-36% annualized) and Motor Vehicle Insurance (-35%).
  • The surprising part of that might be the fact that Motor Vehicle Insurance has a 1.7% weight in the CPI. That seems like a lot, but we only notice it once a year when we get the renewal.
  • Biggest core gainers this month were Motor Vehicle Fees (+10% annualized 1m change) – governments gotta make it somewhere! – Public transportation, jewelry, car & truck rental, used cars, leased cars, miscellaneous personal goods.
  • Health insurance is also finally coming off the boil.
  • m/m decline in health insurance (NSA) is largest in a long long time.
  • …I guess that decline in health insurance is because people aren’t going to the doctor for minor maladies as much? But of course remember health insurance in the CPI is a residual, not a direct measurement of premiums.
  • So here is OER versus our ensemble model. This month I REALLY have to do a column on housing, because the right side of this graph has been revising HIGHER while the spot numbers have been surprising lower. There are big reasons to think rents are NOT about to decline hard.
  • Forgot to mention one of the covid categories: airfares were -2.0% m/m after +1.2% last month.
  • The jump in used car CPI was, as I noted up top, not really surprising. But it looks like we’ve squeezed most of that lemon (no car pun intended) unless the private surveys keep accelerating.
  • So, despite an as-expected number, bond breakevens have plunged 3.5bps since the print. Investors are conditioned to not ever take inflation breakevens much above 2% or swaps above 2.5%, no matter the outlook. That’s a gonna hurt.
  • Sorry for the break – calculations. Here’s a fun one. It’s our measure of perceived inflation minus core inflation (consider it “inflation angst”), versus the subsequent return to gold.
  • Four pieces: Food & Energy, trendless.
  • Core goods, impressive. Although a lot of that is used cars. Pharmaceuticals pretty soft, import prices not worrisome yet. Apparel soft. So this might be best we can expect from this piece, about 20% of the CPI.
  • Core services less rent of shelter. Settled back a bit, although as noted I’m skeptical that medical care costs are about to go into retreat…
  • And finally, rent of shelter. A lot of this deceleration is hotels, but as noted earlier rents are definitely soft and that’s the big story this month.
  • So, to sum up: housing inflation looks soft, but forward-looking indicators there are pretty solid as long as incomes don’t collapse again (they’ll decelerate and maybe even decline, just need them to not collapse). Outside of housing, there’s broadening of price pressures.
  • Yes, core goods exaggerates where those pressures are at the moment, but they are definitely there. And with money supply rolling 24% y/y, it’s going to persist. The question for Keynesians is: where is the deflation, man? We never even got close!
  • Thanks for tuning in. Have a great day.

Later this month, I definitely need to talk more about housing. Since housing is always the biggest and slowest piece of consumption, any argument about meaningful disinflation or inflation must include a discussion about housing. Right now, when there isn’t an overall inflationary or disinflationary trend, the slow waves in rents are really the main driver of core, and everything else is noise around that trend. When we get into a more-extended inflationary or disinflationary trend, then housing will likely follow the overall underlying trend. This hasn’t happened, though, in decades – which is why most models of rental inflation now tend to be built on a nominal frame rather than in real terms. But I digress.

Most of the main rebound of the “Covid” categories seems to be over. While those categories – apparel, airfares, lodging away from home, food away from home – still sport prices below their pre-Covid levels, it may be that they just don’t come all the way back any time soon. Ergo, the potential for upside surprises from those categories, going forward, is lessened. Similarly, I’m not sure we have a lot more upside to used car prices, as CPI has mostly caught up to the private surveys (of course, used car prices might still go higher, but at least the CPI has caught up to what we already knew). So, again, we come back to rents. Will rents continue to decelerate? The headlines suggest an implosion of the rental property market. But in the meantime, the median price of existing home sales was recently reported as +11.4% y/y, the biggest jump since 2013 (and back then, we were still rebounding from the financial crisis). Home prices and rents cannot diverge for long; they are substitutes.

And with the money supply spiraling higher at an all-time record pace, it is hard to imagine that hard assets like homes will see prices decline, or even level off. Think about it this way: if you have an exchange rate between apples and bananas, say 1:1, and suddenly there is a bumper crop of bananas, then you’d expect the price of bananas fall relative to apples. Right now there is a bumper crop of money, and so it’s reasonable to expect the price of money to fall relative to the price of real assets like houses (each dollar buys fewer houses). Of course, what that means is that the price of houses, in dollar terms, ought to keep rising.

If that happens, then the recent softening of rents is likely to be temporary. That’s the next phase of the inflation puzzle – looking for the rebound in rents.

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