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The Era of Bizarro Bill Gross is Beginning

February 2, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.


It’s hard to believe that 10-year yields in the US have doubled in the last 18 months. It’s the last 50bps, taking us from 2.35% to 2.84% since December, that has received the most attention but 10yr Treasury rates have literally spanned the width of the nearly 40-year-old channel over that 18 months (see chart, source Bloomberg).

Such a long-term chart needs to be done in log scale, of course, because a 200bp move is more significant when rates are at 2% than when they are at 10%. I have been following this channel for literally my entire working career (more than a quarter-century now), and only once has it seriously threatened the top of that channel. Actually, that was in 2006-07, which helped precipitate the last bear market in stocks. Before that, the last serious test was at the end of 1999, which helped precipitate that bear market.

You get the idea.

The crazy technicians will note that a break above about 3.03%, in addition to penetrating this channel, would also validate a double bottom from the last five years or so. Conveniently, both patterns would project 10-year rates to, um, about 6%. But don’t worry, that would take years.

Let’s suppose it takes 10 years. And let’s suppose that velocity does what it does and follows interest rates higher. The regression below (source: Bloomberg) shows my favorite: velocity as a function of 5y Treasury rates. Rates around 5% or 6% would give you an eyeball M2 velocity of 2.1.

So, let’s go to the calculator on our website, and see what happens if money velocity goes to 2.1 over the next decade, but real growth averages a sparkling 3%.

Looking down the “2.1” column for velocity, we can see that if we want to get roughly 2% inflation – approximately what the market is assuming – then we need to have money growth of only 1% per annum for a decade. That is, the money supply needs to basically stop growing now. The only problem with that is that there are trillions in excess reserves in the banking system in the US, and trillions upon trillions more on the balance sheets of other central banks, and not only does the Fed not plan to remove all of those reserves but rather to maintain a permanently larger balance sheet, but other central banks are still pumping reserves in. So, you can see the problem. If money growth is only 3%, then you’re looking at average inflation over the next decade of 3.9% per annum. By the way, average money growth in the US since the early 1980s has been 5.9% (see chart, source Bloomberg). Moreover, it has been below 3% only during the recessions of the early 1990s and the global financial crisis, and never for more than a couple of years at a time.

The bottom line is that rising interest rates and more importantly rising money velocity create a very unfortunate backdrop for inflation, and this is what creates the trending nature of inflation and the concomitant ‘long tails’: higher rates create higher velocity, which creates higher inflation, which cause higher rates. Etc. The converse has been true for nearly 40 years – a happy 40 years for monetary policymakers. Yes, I know, there are a lot of “ifs” above. But notice what I am not saying. I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities. And if interest rates were to head much higher, we would get such a response in equities that would provoke soothing tones from central bankers. So tactically, I wouldn’t expect yields to go a lot higher from here in a straight shot.

I am also not saying that money velocity is going to gap higher, and I am not saying that inflation is about to spring to 4% (in fact, just the other day I said that it will likely be mainly the optics on inflation that are bad this year because some one-off events are rolling out of the data). Just as with interest rates, this cycle will take a long time to unwind even if, as I suspect, we have finally started that unwind. We’re going to have good months and bad months in the bond market. But the general direction will be to yields that are somewhat higher in each subsequent selloff. And some Bizarro Bill Gross will be the new Bond King by riding yields higher rather than riding them lower.

I am also told that mortgage convexity risk, which in the past has taken rallies and selloffs in fixed-income and made them more extreme, is less of a problem than it used to be, since the Fed holds most mortgages and servicing rights have been sold from entities that would hedge extensions to those who “just want yield” (unclear how this latter group responds to the same yield, at longer maturities). On the other hand, the Volcker Rule has gutted a lot of the liquidity provision function on Wall Street, so if you have a million to sell you’re okay; if you have a yard (a billion) then best of luck.

I will note that real yields are still lower (10year TIPS yields 0.70%) than they reached at the highs in 2016, which were lower than they got to in 2015, which were lower than they hit in 2013. The increase in interest rates is not coming from a surge in belief about rising real growth. The increase is coming from a surge in concern about the backdrop for inflation. For nominal interest rates to go much higher, real yields will have to start contributing more to the selloff. So I think we are probably closer to the end of the bond selloff, than to the beginning…at least, this leg of it.

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Summary of My Post-CPI Tweets (Jan 2018 – Dec figure)

January 12, 2018 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • 22 minutes until CPI. Not sure I am looking forward to this one. The little birds are all whispering that this is supposed to be high, and that concerns me.
  • Not the economists: consensus forecast is for a reasonably high 0.24% on m/m core. But we drop off 0.22% from last December so the y/y won’t move much from 1.7% if that’s the print we get.
  • Yes – there are lots of reasons this COULD be higher. Chief among them is the divergence between surveys of used car prices and the BLS cars index. Cars are 6.4% of CPI, so it matters. But PPI showed weakness in vehicles for another month. (I usually ignore PPI, though).
  • ..it’s December, which means it’s crazy-seasonal-adjustment month. December is the only month of the year where you can confidently reject the hypothesis that there’s no seasonal (on headline CPI), as prices tend to fall. But there’s also a lot of volatility.
  • Rents have come back to model, and home prices continue to rise, so decent chance that housing starts to contribute again here soon.
  • What I fear is that some of the forecasts for a “surprise” higher are coming from the fact that the inflation markets have been rallying, so people are afraid “someone knows something.” Economists don’t ignore markets. But in this case I think it’s just year-end reassessment.
  • …let’s face it, inflation bonds are cheap. About 50bps cheap at the 10-year point by my model. Commodities are cheap. And everything else is expensive. I don’t have to believe inflation is coming to swap out of stocks into commodities.
  • Of note – inflation swaps have been rising in every major market recently. So there definitely is an undercurrent of inflation concern.
  • Don’t fade the whispers! +0.3% on core. Actually 0.277%. But enough to put y/y up to 1.77%, rolling it to 1.8% rounded.
  • Wow, 2 yr Tsy above 2% for the first time since September 2008!
  • Last 12 CPIs. Try hard not to see an uptrend here. It’s an illusion caused by the low mid-year figures. But that said, this is highest in a while.

  • Let’s see…Housing up slightly, Transportation up, no change in medical care (talking major subgroups here)…will be interesting to see where the wiggle is.
  • Core services 2.6% vs 2.5% and core goods -0.7% vs -0.9% y/y. That’s the least goods deflation since last July. But it’s still deflation.
  • Pulling in the micro data now. The BLS series is so rich. But while the sheet is calculating this is a good time to remind everyone that these figures are for DECEMBER so try hard not to get too excited. The breakdown will be more important to tell us if this is ‘real.’
  • If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. Very good piece. “What happened to inflation? And What happens if it comes back?” https://www.gmo.com/docs/default-source/research-and-commentary/strategies/gmo-quarterly-letters/what-happened-to-inflation-.pdf?sfvrsn=5
  • One more item of context before we dive deeper: Median CPI is at 2.3%. So we should be expecting something right around 0.2% per month if there’s no trend. The uptick from 1.7% to 1.8% is just catching up, mostly.
  • OK on the breakdown. New and Used cars, 8% of core CPI, rose to -0.33% from -1.05%. As expected, and that’s a big part of the surprise.
  • I say “surprise,” but it really oughtn’t be a surprise. Remember that Hurricane Harvey had a similar effect to Cash for Clunkers in terms of the number of cars removed from the road. The private car prices indices were showing this. BLS has a lot of catching up yet.

  • Just lost power. Anyway. Wasn’t just used cars. Used cars went from -2.1% to -0.99% but new went from -1.08% to -0.53%
  • Owners Equivalent Rent went to 3.175% from 3.124%, and primary rents from 3.675% to 3.689%. So housing back on track.
  • Medical Care broadly went to 1.78% from 1.68%. Pharma went 1.87% to 2.37%. Other components pretty stable (in medical). Medicinal drugs (pharma) is about one fifth of medical care subindex.
  • Wireless telephone services again steady. The jump will be fun when the plunge washes out. Right now it’s -10.19% y/y vs -10.24%.
  • Wish I could post my chart of distributions of price changes. Left tail starting to move rightward a bit. Hopefully get power back soon. This is all on backup power to my pc. [Editors’ Note – I added it later, see below]
  • Well, looks like power isn’t coming back on quickly. I will have to come back later with the median CPI estimate etc. Got most of the details out though.
  • Bottom line is that the components we expected to start converging, did. Housing behaved. Medical care behaved. And so we moved towards the real middle of the distribution, around 2.3% or so presently.
  • This shouldn’t be taken as an acceleration in inflation. This is just one (flawed) number converging with the better ones. Core inflation is going to head higher, but this isn’t convincing evidence that it is yet doing so.
  • Having said that, in a couple of months the y/y comps start to get better so the inflation story will have much better OPTICS. And it’s optics these days, more than fundamentals, that drive markets. So don’t jump off the commodities or tips bandwagon. That trend will continue.
  • Power’s back on! Of note is that Median CPI printed at 0.29%, the highest level since July 2008 (sound familiar? That was also true two months ago when it was 0.27%). So y/y up to 2.44% now.
  • Yeah, I know I said don’t think of this was an uptrend. And it’s not; it’s an unwind of one-offs. But still, that’s gotta look scary.

  • Better late than never. Here’s what I meant about the distribution moving right. Those two bars on the left were one bar before today. So you can see those components – largely cars and cell phones – are dragging down core relative to median.

  • The rally in breakevens shouldn’t be terribly surprising – this chart shows it’s just keeping pace (and not even) with the turn back higher in median CPI.

  • The market is NOT AT ALL ahead of itself in this sense.

This was certainly not the easiest time I have had with a CPI report, but that’s mostly because the power grid in this country is as brittle as glass. The story was actually not as much about screwy seasonal as I was concerned about. Actually, it was a fairly humdrum report in many ways, and that’s what is scary if you’re thinking we are in a “lowflation” period. The chart of Median CPI is interesting. Core inflation had risen mostly because car prices are starting to catch up with private measures of car prices – what remains in the gap between the red line and the blue line in the “Manheim” chart would add about 0.5% to core CPI – and housing stopped decelerating. But then Median CPI, which doesn’t care about the New and Used car prices since those are outliers, rose at the highest rate (m/m) in nearly a decade, and the Median-Core spread actually widened slightly this month. That means more core acceleration is ahead.

I mentioned that in a few months the year-ago comparisons will start getting easier. This month, we got 0.28% from core CPI versus 0.22% last year. But in Jan 2017, core CPI was +0.31%. That will be a hard comp to beat. But after that, Feb 2017 was +0.21%, March was -0.12%, April was +0.07%, May was +0.06%, June was +0.12%, and July was +0.11%. At the time, we mused “is the natural run rate for core really 0.5%/annum?” which was what those five months were averaging. That seemed very unlikely. Median CPI told us that wasn’t the case. Now, if core CPI merely averages a monthly 0.17% print from now until July, the y/y figure will be up at 2.20%. And if it’s 0.2% per month, in July we will be sitting at 2.42%.

I don’t think you want to fade those optics, even if you think we’re only going to get 0.15%. Perhaps the next month or two, because of the more-difficult comps, will take some wind out of the sails of the inflation bulls and offer better entry points. But the direction of travel looks fairly clear for the next six months or so. And that also means that the direction of travel for monetary policy is also likely set, to be at least as aggressive as the market is pricing. And, perhaps, the direction of travel for equity prices isn’t quite as clear as it currently seems.

And it bears repeating that this is going to be the case even if inflation is not actually in an uptrend, but just maintaining its current run rate around 0.2% per month (commensurate with median CPI at 2.4%/yr). If inflation is in fact turning higher – and there are some signs of that, though not as widespread as everyone seems to suddenly think – then it could be a lot uglier in 2018. As I said again above: don’t jump off the commodities or TIPS bandwagon yet. But…you might want to trim some of that nominal bond exposure!

Some Abbreviated but Important Thoughts on Housing

November 29, 2017 3 comments

I posted this chart yesterday to my Twitter feed (@inflation_guy, or @inflation_guyPV through PremoSocial for some additional content), but didn’t have time to write very much about it. This is the Shiller 20-City Home Price Index year/year change (Source: Bloomberg).

My observation was that when you take out the housing bubble, it looks more ominous. It’s actually really the bubble and bust, which makes the recent trend look uninteresting. This is what the chart looks like if you go further back like that.

So it actually looks calm and stable, because the axis explodes to -20% to +20%. The volatility of recent years has caused us to forget that for decades before that, the behavior of home prices was actually pretty sedate. Although residential real estate over very long time periods has only a slightly positive real return, adjusted for the maintenance and other required expenditures, that means the ratio of home prices to median income has tended to be fairly stable. We have historically valued homes as a consumption good only, which meant that the home price traded as a multiple of rents or incomes within a pretty narrow range. Here’s a chart of median home prices to median household income going back to the 1970s (Source: Bloomberg, Enduring Intellectual Properties calculations).

This is true even though there have been important tax changes along the way which changed the value of the home as a tax shelter, changes in the structure of the typical family unit, and so on. Despite that, homes were pretty stable investments – really, they were more savings vehicles than investments.

The fact that home prices are now accelerating, and are rising faster than incomes, implies several things. First, as the last chart above shows, the ‘investment value’ of the home is again inflating to levels that, in 2005-2008, proved unsustainable. The bubble in housing isn’t as bad as it was, and not as bad as stocks are now, but the combination of those two bubbles might be worse than they were when they were mostly independent (in 2000 there wasn’t a housing bubble and in 2007 the bubble in stocks wasn’t nearly as bad as in 2000 and now).

The second implication is that as home prices rise, it isn’t just the value of the investment in the home that is rising but also its cost as a consumption item. Because shelter to rent is a substitute for shelter that you own, rising home prices tends to imply that rents also accelerate. Recently, “Owner’s Equivalent Rent” has been decelerating somewhat, although only coming back to our model. But the gradual acceleration in the home price increase implies that shelter inflation is not going to continue to moderate, but rather should continue to put upward pressure on core inflation, of which 42% consists of “Rent of Shelter.”

Velocity and Rates and the Vicious Cycle Possibility

November 1, 2017 3 comments

There was a potentially important development in inflation recently, but one that was generally overlooked.

Perhaps it was mostly overlooked because it is way too early to say that a trend is developed that could cause an adverse inflation occurrence. But I think that the main reason it was overlooked is that monetary velocity is not very well understood. In particular, most people seem to think that money velocity – definitionally, the number of times a unit of money is transacted in a year, on average – is somehow tied to nervousness about the economy. So, when money velocity fell in the global financial crisis, many observers attributed that to savers stuffing dollar bills in the proverbial mattress.

There may be some role for investor/consumer uncertainty in the modeling of velocity, but at best it is a secondary or tertiary cause. The main cause of changes in velocity is simple: when the cost of holding money is high, we work hard to hold less of it, and when the cost of holding money is low, we don’t mind holding more of it. Friedman first noticed this, so it isn’t a new discovery. In monetarist speak, velocity is the “inverse of the demand for real cash balances,” and the demand for such balances depends of course on the relative cost of cash balances relative to other investments.

The chart below shows the power of this relationship. I’m using the 5-year constant maturity treasury rate, but there are obviously other investments that would get thrown into this relationship. But it’s easy to envision the effect here. When interest rates are at 6%, then money does not sit idle for very long or accumulate without limit in your bank account – you will invest those monies in, say, a 5-year CD or Treasury Note, rather than earn basically nothing in a checking account. But when interest rates are at 1%, the urge to do so isn’t as much.

What you can see in the chart is that interest rate moves tend to precede movements in money velocity, which is what we would expect from a causal relationship such as this. So the reason that money velocity plunged in the GFC wasn’t because people were scared; it was mostly because interest rates fell, taking away the incentive to invest longer-term.

Changes in money velocity, of course, tend to cause changes in inflation. MVºPQ, after all, and Q tends to be mostly exogenously determined by aggregate fiscal variables, industrial policy (what’s that?) and the like. Changes in M and changes in V tend to be reflected mainly in P over time.

Also, interest rates are affected by inflation, or more properly by the expectations of inflation. And expectations about inflation tend to follow inflation.

So, the history of the 1980s’ declining inflation can be read like this, without too much of a stretch: declining money growth under Volcker caused declining inflation initially. The decline in inflation tended to cause interest rates to decline. Declining interest rates tended to cause declines in money velocity. Declining money velocity tended to cause declines in inflation…and we were in a virtuous cycle that extended, and extended, and extended, until we were close to zero in interest rates and inflation, and money velocity was as low as it has ever been.

Now, you can see from this chart that interest rates bottomed in 2013, but really have not appreciably risen above the lows, and so money velocity hasn’t reversed its slide although since the beginning of last year the trajectory has been slowing (I suspect some nonlinearity/stickiness of this relationship near zero). But the GDP report from last Friday, combined with recent money growth and increase in the price deflator, implied that money velocity actually rose slightly.

It has nudged higher before, but not by very much. And this is why I am reluctant to make a huge deal about this being the start of something, except that this is the first time since 2008 that there has been a reasonable expectation that interest rates might continue to rise because the central bank wishes it so.

And so I don’t think it’s wrong to consider the “what if” of the next cycle. Normalization of interest rates implies normalization of velocity, and there’s just no way to get appreciably higher velocity without higher inflation. Higher inflation would probably produce higher interest rates, because however much your expectations about inflation are “anchored” they are likely to become unanchored if inflation of 3%-4% starts to print. Higher interest rates could lead to higher velocity, and we have a cocktail for the opposite of the 1980s virtuous interest rate cycle.

This speculation isn’t destiny, and a lot depends on whether interest rates start to move higher and by how much. But there is already starting to be some concern about inflation and the FRBNY’s “Underlying Inflation Gauge” has recently gone to new post-crisis highs (see Chart above, source Bloomberg), so I don’t think it is unreasonable to consider and prepare. Because the best case for the next inflation uptick is that it rises a bit and falls back. But there are elements in place that support a much worse case, and that is a feedback loop through interest rates and velocity. The chances of that outcome are considerably higher than zero.


Note: these articles are now first released on my private Twitter feed, which you can subscribe to for only $10 per month here. Subscribers also get my real-time tweet analysis on the monthly CPI report, which are not on my public feed, and I am working on adding a free chart package to the mix as well.

Summary of My Post-CPI Tweets (Oct 2017)

October 13, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • Friday the 13th and a heavy data day. What could go wrong?
  • 10y breakevens at local highs of 1.90% – but that’s the biggest spread over core CPI in several years.
  • …yet we still have 10y TIPS 50bps to fair at this level of interest rates.
  • Economist expectations are for 0.21% on core and 1.78% y/y. Interesting given how low it has been recently.
  • I don’t usually look at headline but the y/y number is forecast to jump to 2.3% from 1.9%. That will get some attention.
  • I think the market forecasts are about right for core, but there’s a wide range of upside risks. Autos are due to catch up, e.g.
  • But that’s why the forecasts make sense. 0.15% for trend plus 0.05% for expected value of risks.
  • …in turn, that means the point forecasts are not the most likely prints. They’re in between the most likely prints.
  • Core +0.13%, 1.69% y/y.
  • Breakdown will be interesting. Housing broad category went to 2.79% y/y from 2.91%. Medical Care fell to 1.56% from 1.81%.
  • Used cars/trucks went to -3.7% vs -3.8% y/y, so that rebound is still ahead of us. Surveys of car prices are up a lot, just not in BLS yet.
  • pulling in the breakdown now…core services 2.6% from 2.5%, but core goods deflation deepens to -1.0% from -0.9%.
  • Core goods deflation, however, ought soon to be rising again after the lagged effect of the dollar’s decline passes in.
  • In Housing, Primary Rents plunged to 3.78% from 3.88%. That’s huge. OER dropped to 3.18% from 3.27%. Also huge. There’s your story.
  • Core ex-housing rose to 0.58% vs 0.52% y/y, so there’s more going on here but the housing. Wow.
  • A few months ago we had y/y OER fall by more, but that was when OER was overextended.
  • Here is primary rents y/y. I guess this isn’t DRAMATIC – just quite contrary to my own expectations for a continuation of the rebound.

  • In Medical Care, Medicinal Drugs fell to 1.01% from 2.51%. Wow! But Professional Services and Hospital Services accelerated slightly.
  • Here’s CPI for pharma. Think we’ve discussed this before – likely compositional in nature, more generics thanks to worse insurance.

  • Professional services (doctors) bounced;not significant. Also somewhat compositional as old doctors quit rather than take ins. headaches.

  • College Tuition 2.08% vs 1.89%. Have I mentioned the new S&P Target Tuition Inflation Index recently? 🙂
  • Just b/c …who can get enough of wireless telecom services? Bounced, mostly base effect of course. Bottom line was that dip was a 1-off.

  • New cars also still deflating, BTW. -1.0% vs -0.68%. Obviously this will change with Houston buying loads of new cars.
  • Speaking of Houston: core CPI in Houston y/y ended June: 1.31%. For y/y ended Aug: 1.90%. But that’s actually before Harvey.
  • In Miami, 2.01% vs. 2.26% (June vs August). Have to wait a bit to get October numbers – they’ll come out in Dec.
  • Bottom line on the storms is that we haven’t seen the impact yet on CPI. Still to come.
  • My early estimate of Median CPI is 0.20%, bringing y/y up to 2.17% from 2.15%.
  • Housing and Medical Care still keeping pressure on core.

  • Interestingly, these other categories, including Food, and Energy too, all saw acceleration this month (except for other).

  • distribution of changes getting more spread out…

  • Percentage of basket over 3% hasn’t changed much, ergo median didn’t change much.

  • Does this change the Fed’s calculus? I don’t think so, especially with wages accelerating. Still waiting for one-offs to unwind.
  • The doves will argue that the unwind of a one-off is itself a one-off and we should therefore look thru and see 0.12-0.14 as the trend.
  • They’re unlikely to carry the day in Dec, even if the data don’t bounce higher. But if core stays weak the mkt will unwind the 3 in 2018.
  • 10y breakevens -3bps since the number. Market had seemed a little long but this is still too low for breakevens.
  • Four pieces. Piece 1: Food & Energy

  • Piece 2: core goods. Won’t go down forever with the dollar well off its highs.

  • Core services less ROS. A bounce. Sustainable? We’ll have to see.

  • Piece 4, Rent of Shelter. Seemingly ignoring continued rise in home prices. Back to model but weaker than I expected.

  • Last chart. here is the argument: do we cheer the weak consumer inflation or worry about higher wages?

  • Yes, wages follow inflation rather than lead…but the Fed doesn’t believe that.

Thanks to everyone who followed my new “premium” (but cheap) channel. I wrote on Wednesday about the reason for changing my Tweet storm; in a nutshell, it’s because research is starting to be priced a la carte at the major dealers and hopefully this means that quality but off-Street analysis might finally be competing on an even footing rather than competing with “free.” If you think there’s value in what I do, I’d appreciate a follow. If not…well, if the market tells me that what I’m producing isn’t worth anything, then I’ll stop producing it of course!

But in the meantime, here is the story of CPI this month. A continuing regression of rents and OER to model levels held core down to recent-trend levels. But there are many one-off and temporary effects that are due to be reversed, and relationships that suggest certain components are due to catch up to underlying realities. For example, here is the picture of Used Cars and Trucks CPI, compared to the Manheim Used Vehicle Value Index 4 months prior.

According to the relationship between these series over the last decade, CPI for Used Cars and Trucks should be growing about 5% faster than it is presently, and rise another 3-4% in the next few months. New and Used Motor Vehicles inflation is about 8% of core CPI, so this effect alone could add 0.7% to core CPI! Or, put another way, right now core CPI is about 0.4% lower than it would be if the CPI was measuring the actual price of vehicles the same way that Manheim does it. That’s a big number when the entire core CPI is only 1.7%.

The continued, and actually extended weakness in core goods is also due to reverse. I don’t mean that core goods inflation will go from -1% to +3% but only to 0.5%. But that 150bp acceleration, in one-quarter of the core CPI, would also raise core CPI by 40bps or so. To be sure, there is some double-counting since a third of core commodities is new and used vehicles, but that merely reinforces the message.

So, too, are the effects in medical. Volatility in those series should persist, which means that since they are at a low ebb there’s a better bet that the next volatile swing is to higher prices.

All of which is to say that the hawks on the Federal Reserve Board actually have it right, in a sense. Prices are headed higher, and inflation is accelerating. It would be a truly shocking development if core inflation one year from now was unchanged from the current level. Indeed, I think there is a better chance that core inflation is above 2.7% than below 1.7%. On another level, the hawks aren’t quite right though. By hiking rates before draining excess reserves, the Fed risks kicking off the vicious cycle I have mentioned before: higher rates cause higher money velocity, which causes higher inflation, which causes higher rates etc. Without control of reserves at the margin, the Fed cannot control money supply growth and so the normal offset to rising monetary velocity in a tightening cycle, slowing money growth, comes down to chance. Either way, the Fed is very likely to tighten in December, but beyond that it probably matters more who ends up in the Chairman’s seat than anything economic data.

The Mystery of Why There’s A Mystery

October 10, 2017 Leave a comment

We have an interesting week ahead, at least for an inflation guy.

Of course, the CPI statistics (released this Friday) are always interesting but with all of the chatter about the “mystery” of inflation, it should draw more than the usual level of attention. That’s especially true since the mystery will cease to be a mystery fairly soon as even flawed indicators of inflation’s central tendency, such as the core CPI, turn back higher. This is not particularly good news for many pundits, who have declared the mystery to be solved with some explanation that implies inflation will stay low.

  • “Amazon effect”
  • Globalization
  • “competition”
  • Etc

The first of these I have addressed previously back in June (“The Internet Has Not Killed, and Will Not Kill, Inflation”). The second is a real effect, but it is a real effect whose effect peaked in the early 1990s and has been waning since then. I wrote something in our quarterly in Q4 last year, which is partly summarized here.

The “competition” objection is a weird one. It seems to posit that competition was pretty lame until recently, which is pretty strange. One argument along these lines is in this article by Steve Wunsch, who considers the increase in airline fees “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition.” This is odd, since airlines were deregulated in 1978 and have in recent years become less competitive if anything with the mergers of Delta/Northwest in 2009, United/Continental in 2010, Southwest/AirTran in 2011, and US Airways/American Airlines in 2013. A flaccid antitrust response from the Justice Department has allowed quasi-monopolies to develop in some travel hubs, which has tended to push fares higher rather than lower. The chart below shows the relationship between Jet Fuel prices and the CPI for airfares (both seasonally adjusted) for the 20 years ended in 2014, along with the most-recent point from last month.

The highly-explanatory R-squared of 0.81 suggests that there is not much wiggle room in airline pricing. Airfares are, as you would expect under a competitive industry, roughly cost-plus with the main source of variance being jet fuel prices. This is true even though we would expect that spread to vary over time. As Mr. Wunsch would argue, the highly competitive nature of the industry is holding down the non-commodity price pressures in airfares.

The only problem is that if you extend this graph to include the last three years, the R-squared drops about 10 points:

In case it isn’t clear from that chart, the last three years have seen airfares increasingly above what we would expect from the level of jet fuel prices. The next chart makes that clear I hope by plotting the residual (and 12-month moving average to smooth out seasonal issues such as one that evidently happened last month) between the actual CPI-airfare and the level that would be predicted from the 1994-2014 relationship. As you can see, prices have been higher, and increasingly so, than we would have thought, until this last month or two – and I wouldn’t grab a lot of comfort from that yet.

Not only is this not “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition,” it seems to be stark evidence of inflation in ticket prices caused by a reduction in competition thanks to airline mergers.

In reading these many articles, it always is somewhat striking to me: everybody thinks their answer is “the” answer to the mystery. But most of these authors really don’t sufficiently understand how inflation works, and what the data is showing. This is apparent to those who do understand these nuances, as an author might discuss (as the one mentioned above did) an “aberration” in cell phone inflation as if the experts are stupid for expecting inflation when cell phone services only go down. The author clearly misunderstands what the “aberration” referred to even is; in this case the aberration was an enormous one-month collapse in prices that had never been seen and has not been repeated since. (For those who are curious about the aberration, and why it occurred, and why it is likely a methodology issue rather than sign of spiraling deflation in wireless services you can see my discussion of it here.)

The mystery is simple – the Fed’s models don’t work, and don’t take into account the fact that lower interest rates cause lower money velocity. They rely on a Phillips Curve effect that they think is broken because they don’t understand that the Phillips Curve relates wages and unemployment, not consumer prices and unemployment. They focus on a flawed measure like PCE rather than on something like Median CPI which, coincidentally, is a lot higher and suggests more price pressures. The mystery isn’t why inflation isn’t rising yet – the mystery is why they think there’s a mystery.

Money and Credit Growth Update

September 19, 2017 Leave a comment

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It has been a challenging few years to be a monetarist. That isn’t because monetarist predictions have failed, but rather because monetarists have had to spend a lot of time explaining why money velocity has been declining (the answer is: low interest rates) and why “printing money” hasn’t led to runaway inflation (the answer is: inert reserves don’t count, but M2 money growth has been growing between 5%-8% for the last 5 years and that would be too fast for stable prices if velocity was stable).

Money velocity declines when interest rates decline because the demand for real cash balances increases when the opportunity cost of those cash balances is low. That is, if interest rates are at 10%, then you won’t leave cash sitting around idle; it becomes a hot-potato and either gets reinvested in term loans or other assets, or spent. On the other hand if term interest rates are at 0%, then what’s the hurry? The chart below (source: Bloomberg) shows the simple relationship since the early 1990s between 5-year Treasury rates and M2 velocity. This is not a mystery – it has been a critical part of monetarist theory since the 1970s.

You can see that there is a modest conundrum, since interest rates bottomed a couple of years ago but money velocity has continued to sag. I don’t see this as a major mystery; it makes sense to me that there could be some nonlinearities in this relationship near and below the 0% level that we just don’t have enough data to resolve. These nonlinearities have certainly made forecasting more difficult and led generally to forecasts that were modestly too high compared with actual inflation outturns. Again, there’s no mystery about why the forecast misses – the mystery is why money velocity has remained low while interest rates have bounced (we believe economic policy uncertainty has led people to hold somewhat higher real cash balances than they otherwise would, but that’s just a hypothesis). At some point, higher interest rates will snap money velocity back as it gets too ‘expensive’ to leave cash balances sitting around. But this hasn’t happened yet.

Meanwhile, money growth has been slowing. It is still rising faster than 5% per annum, which means that if money velocity was stable and potential GDP growth is 2.5% then we would see the GDP Deflator rising at 2.5%. So money growth is still a bit too fast, unless money velocity is going to decline forever. But it is better at 5% than at 8%, to be sure.

Credit growth has also been slowing, as the chart below (source: Federal Reserve) shows.

Now, regardless of what you read credit growth has essentially no relation to money velocity. Obviously, credit growth has been fairly rapid – as money velocity continued to sag – and is now slowing – as money velocity has continued to sag. It is moderately better connected to M2 growth, so it tends to reinforce the notion that money growth is slowing somewhat, but people who are saying that velocity will continue to slow because banks are slowing loan growth need to explain why rapid growth didn’t lead to velocity acceleration. One-way relationships in economics are pretty rare.

I doubt very seriously that M2 growth is about to drop off a cliff. The Fed’s rate hikes and any balance sheet reduction is not going to affect money supply growth while bank reserves are still “abundant,” to use the Fed’s phrase. Banks are neither capital nor reserve-constrained at the moment, so a decline in credit growth is either coming from the supply side as banks voluntarily reduce loan growth perhaps because credit quality is diminishing, or it is demand side as borrowers are not seeing the growth opportunities that require financing. Money growth is still, and always, something to keep an eye on. But, just as changes in velocity dominated changes in money growth when velocity was falling, velocity changes will dominate changes in money growth when (if?) money velocity starts to rise. As the first chart above shows, velocity when interest rates were “normal” was around 1.8 or higher. I invite you to go to the calculator on the Enduring Investments website and play around using a starting money velocity of 1.43 to see what sort of money supply contraction is required to keep inflation low, if velocity returns to 1.80 over some period of time.

And then, realize that M2 has not declined on a y/y basis as far back as the Fed has records on FRED (about 1960). It seems unlikely to do so now. This leaves few low-inflation exit paths as long as money velocity isn’t permanently dead.

I think the decline in credit growth has implications, but they are mainly implications for growth and not for inflation. Along with the weakness that is starting to be seen in some other areas of the economy (e.g. autos, until the hurricanes caused some “forced replacement”), I think this could be seen as a harbinger of a potential recession in 2018.

Categories: Causes of Inflation Tags: ,
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