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Which June Did You Mean, Charles?

Yesterday, Chicago Fed President Charles Evans gave a speech in which he said that he probably leaned towards making the first tightening early next year, as there is “no compelling reason for us to be in a hurry to tighten financial conditions.” The Fed, he said, probably shouldn’t raise rates until there’s a “greater confidence” that inflation one-to-two years ahead will be at or above 2%. This isn’t a surprising view, as Evans is the progenitor of the “Evans Rule” that says rates should stay near zero until unemployment has fallen below 6.5% (it has) or inflation has risen above 2.5%. Yes, those bounds have been walked about; in particular the 6.5% unemployment rate is obviously no longer binding (he sees the “natural rate” as being 5% again). But the very fact that he promoted a rule that set restraints on a mere return to normal policy means that he is a dove, through and through. So, it should not be surprising that he isn’t in a hurry to tighten.

What I found amusing is the sop he threw to the bears. Fed speakers often try to do the “on the one hand, on the other hand” maneuver, but in Evans’ case his heart clearly isn’t in it. He said that “you could imagine a case being made for a rate increase in June.” Notice that he doesn’t say he could imagine a case being made! I am also unclear about which June he means. Does he mean…

(thru Apr) (thru May)
Q1 GDP Q2 GDP Median CPI M2 growth
June 2012? 2.3% 1.6% 2.4% 9.2%
June 2013? 2.7% 1.8% 2.0% 6.6%
June 2014? -2.1% 4.6% 2.2% 7.3%
June 2015? 0.2% 1.0% (e) 2.2% 5.4%

I am not sure exactly what he thinks those darn hawks are looking at, but it seems to me the case for tightening in June is getting worse every year.

Eagle-eyed readers will notice that I didn’t include the Unemployment Rate in the table above. That particular metric has been improving each year, but we know that the labor situation tends to lag the economic situation. The Unemployment Rate is a big political football, but it isn’t particularly useful for policy unless you believe in the concept of a “natural rate” with respect to accelerating unemployment in the overall economy. I don’t: low unemployment tends to increase wages, but has no discernible effect on consumer inflation. Moreover, it appears that the “natural rate” shifts quite a bit over time (6.5% down to 5% in Evans’ formulation, in only a few years’ time), making it look to me like a fairly useless concept.

Yes, of course it makes it more difficult politically to tighten when people are out of work, but since monetary policy is quite useful for affecting prices and not particularly useful for affecting growth, this should be a secondary effect at best. The Fed simply can’t help the unemployed worker, except by holding down inflation for him. In the real world, of course, the Fed Chair is not going to countenance an uptick in rates when unemployment is above 5% or so.

Let me be clear: I think the Fed ought to have tightened in 2012, 2013, or 2014, and they ought to tighten now. I don’t necessarily mean they should guide rates higher, but they should reduce the size of the mountain of reserves via any means a their disposal. But if you are going to argue one year over another year, I think it is hardest to argue that now is the time unless you are merely being guided by the old James Carville adage that the best time to plant a tree was twenty years ago, but the second-best time is right now.

One thing that Evans said that quickens my heart, as an inflation-watcher, is that the Fed “ought to allow” a chance that inflation overshoots 2% that is symmetrical to its chance of falling below it. While he is quintessentially unclear about how he would establish these probabilities – as I have just shown, he seems blissfully unaware that consumer price inflation is already above 2% – the mere fact of treating the costs of inflation misses as symmetrical is dangerous territory. The costs are not symmetrical. The costs of an inflation rate around 0% are very low; some frictions, perhaps, created by wage “stickiness” (even this possibility hasn’t been conclusively established until inflation gets convincingly below zero). The costs of an inflation rate of 4% are much higher, since inflation has historically had long “tails.” That is, once inflation goes up a little, it not infrequently rises a lot. Over the last 100 years, if you take the set of all year-on-year inflation rates above 4%, you find that about one-third of them are also above 10%. This means the costs of a loss of inflation vigilance is must greater than the costs of a loss of deflation vigilance.

Inflation Risks Behind, Beside, and Ahead

To be sure, it looks like growth slowed over the course of the difficult winter. The cause of this malaise doesn’t appear to me to be weather-related, but rather dollar-related; while currency movements don’t have large effects on inflation, they have reasonably significant effects on top-line sales when economies are sufficiently open. It is less clear that we will have similar sequential effects and that growth will be as punk in Q2 as it was in Q1. While I do think that the economy has passed its zenith for this expansion and is at increasing risk for a recession later this year into next, I don’t have much concern that we are slipping into a recession now.

Given how close the Atlanta Fed’s GDPNow tracker was to the actual Q1 GDP figure, the current forecast of that tool of 0.8% for Q2 – which would be especially disappointing following the 0.2% in Q1 that was reported last week – has drawn a lot of attention. However Tom Kenny, a senior economist at ANZ, points out that the indicator tends to start its estimate for the following quarter at something close to the prior quarter’s result, because in the absence of any hard data the best guess is that the prior trend is maintained. I am paraphrasing his remark, published in today’s “Daily Shot” (see the full comment at the end of the column here). It is a good point, and (while I think recession risks are increasing) a good reminder that it is probably too early to jump off a building about US growth.

That being said, it does not help matters that gasoline prices are rising once again. While national gasoline prices are only back up to $2.628 per gallon (see chart, source Bloomberg), that figure compares to an average of roughly $2.31 in Q1 (with a low near $2/gallon).

gasoline

It isn’t clear how much lower gasoline prices helped Q1 growth. Since lower energy prices also caused a fairly dramatic downshift in the energy production sector of the US economy, lower prices may have even been a net drag in the first quarter. Unfortunately, that doesn’t mean that higher gasoline prices now will be a net boost to the second quarter; while energy consumption responds quite rapidly to price changes, energy producers will likely prove to be much more hesitant to turn the taps back on after the serious crunch just experienced. I doubt $0.30/gallon will matter much, but if gasoline prices continue to creep higher then take note.

Inflation traders have certainly taken note of the improvement in gasoline prices, but although inflation swaps have retraced much of what they had lost late last year (see chart of 5y inflation swaps, quoted in basis points, source Bloomberg) expectations for core inflation have not recovered. Stripping out energy, swap quotes for 5-year inflation imply a core rate of around 1.65% compounded – approximately the same as it was in January.

5ycpiswaps

And that brings us to the most interesting chart of all. The chart below (source: Bloomberg) shows the year/year change in the Employment Cost Index (wages), in white, versus median inflation.

eciwagesvsmedian

Repeat to yourself again that wages do not lead inflation; they follow inflation. I would argue this chart shows wages are catching up for the steady inflation over the last couple of years, and for the increased health care costs that are now falling on individuals and families but are not captured terribly well by the CPI. But either way, wages are now rising at a faster rate than prices, which will not make it easy for inflation to sink lower.

Let me also show you another chart from a data release last week. This is the Case-Shiller 20-city composite year/year change. Curiously (maybe), housing prices may be in the process of re-accelerating higher after cooling off a bit last year – although home price inflation as measured by the CS-20 never fell anywhere near to where overall inflation was.

cs20

Inflation risks are clearly now moving into the danger zone. I showed a chart of a lagging inflation indicator (wages), a coincident indicator (energy), and a leading indicator (housing). All three of these are now rising at something faster than the current rate of core inflation. In my view, there is not much chance that core inflation over the next 5 years will average only 1.65%.

If Liquidity is Your Sword, Keep Swinging

April 28, 2015 9 comments

I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.

monbaseequalsstocks

But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.

m2notequalstocks

If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).

But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.

What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.

So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.

m2andstocksnow

Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.

What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.

I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.

Two Quick Items

Two relatively quick items that I want to address today; they have been in my ‘to do’ box for a while.

Negative Rates

One of the most interesting features of the fixed-income landscape today, and one that will likely serve in the future as an exam question on finance quizzes, is the increasingly widespread proliferation of negative nominal interest rates among government bond markets…and occasionally even for high-quality corporate paper.

In finance theory, this can’t happen. Because currency earns a 0% nominal interest rate, theory says that no rational person would ever accept a negative nominal interest rate. If I have $50 today, and put it in the bank, I will have $49 tomorrow. So why not just keep the $50 in my wallet? (Obviously this leads to high cash balances, which means low monetary velocity, by the way). And this is true in the absence of “other costs.”

So why are so many interest rates negative? Are individuals irrational? No: at least not so irrational that they prefer less money to more money. However, what is true at an individual level does not necessarily scale to the institutional level. An institution, such as a money fund or corporation, does not have the freedom to hold its assets in physical currency. Microsoft has $90 billion in cash and equivalents. If this were in $100 bills, it would weigh about one thousand tons. That’s a pretty big vault. And vaults cost money. Guards cost money. And, if Microsoft had this money in the vault, it would be harder to spend. It is much easier to wire $5 million than it is to send an armored car.

In the presence of those costs, Microsoft and other institutions will accept a negative interest rate. It will invest its money at a negative rate rather than build a vault.

Now, an important (if obvious) point is that cash balances are so high, and interest rates so low, because global central banks are making sure we have plenty of cash. Too much cash chasing too few investment opportunities causes rates to be low.

Walmart and Minimum Wage Increases

It has been a few weeks now, but when Walmart in February announced it was going to increase the minimum wages it plans to pay its employees (preceded by Starbucks, Aetna, and the Gap and followed by TJX and Target), I received a number of queries about what the hike was going to do to inflation. Is this the beginning of the much-feared “cost-push inflation”?

The answer is no. Wages, as I have said many times, follow inflation rather than lead it. Think about it: wouldn’t it be really weird for companies to raise wages and then raise prices, to the extent that they have control – at least with respect to timing – over both? No, whatever price increase is going to be caused by the increase in the wages Walmart expects to pay is already in the price. Walmart is not surprised by their own move to raise wages. Nor is anyone surprised by the general increase in the minimum wage, which happened in 2009.

So, while I continue to believe that inflation is rising, and will continue to rise…I don’t believe that the increase in prices is going to be any faster due to these wage increases. It does, however, increase my confidence that inflation is rising, since obviously these retailers are confident enough in the pricing environment to be able to increase wages (which are sticky – it is harder to lower them than to raise them).

Summary (and Extension!) of My Post-CPI Tweets

February 26, 2015 3 comments

Below you can find a recap and extension of my post-CPI tweets. You can follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.

  • CPI -0.7%, core +0.2%. Ignore headline. Annual revisions as well.
  • Core +0.18% to two decimals. Strong report compared to expectations.
  • Core rise also off upwardly-revised prior mo. Changing seasonal adj doesn’t affect y/y but makes the near-term contour less negative.
  • y/y core 1.64%, barely staying at 1.6% on a rounded basis.
  • Core for last 4 months now 0.18, 0.08, 0.10, 0.18. The core flirting with zero never made a lot of sense.
  • Primary rents 3.40% from 3.38% y/y, Owners’ Equiv to 2.64% from 2.61%. Small moves, right direction.
  • Overall Housing CPI fell to 2.27% from 2.52%, as a result of huge drop in Household Energy from 2.53% to -0.06%. Focus on the core part!
  • RT @boes_: As always you have to be following @inflation_guy on CPI day >>Thanks!
  • A bit surprising is that Apparel y/y rose to -1.41% from -1.99%. I thought dollar strength would keep crushing Apparel.
  • Also New & Used Motor Vehicles -0.78% from -0.89%. Also expected weakness there from US$ strength. Interesting.
  • Airline fares, recently a big source of weakness, now -2.98% y/y from -4.71% y/y.
  • 10y BEI up 4bps at the moment. And big extension tomorrow. Ouch, would hate to have bet wrong this morning.
  • Medical Care 2.64% y/y from 2.96%.
  • College tuition and fees 3.64% from 3.43%. Child care and nursery school 3.05% from 2.24%. They get you both ends.
  • Core CPI ex-[shelter] rose to 0.72% from 0.69%. Still near an 11-year low.
  • Overall, core services +2.5% (was +2.4%), core goods -0.8% (was -0.8%). The downward pressure on core is all from goods side.
  • …and goods inflation tends to be mean-reverting. It hasn’t reverted yet, and with a strong dollar it will take longer, but it will.
  • That’s why you can make book on core inflation rising.
  • At 2.64% y/y, OER is still tracking well below our model. It will continue to be a source of upward pressure this year.
  • Thank you for all the follows and re-tweets!
  • Summary: CPI & the assoc. revisions eases the appearance that core was getting wobbly. Median has been strong. Core will get there.
  • Our “inflation angst” index rose above 1.5% for the 1st time since 2011. The index measures how much higher inflation FEELS than it IS.
  • That’s surprising, and it’s partly driven by increasing volatility in the inflation subcomponents. Volatility feels like inflation.
  • RT @czwalsh: @inflation_guy @boes_ using surveys? >>no. Surveys do a poor job on inflation. See why here: http://www.palgrave-journals.com/be/journal/v47/n1/abs/be201135a.html  …
  • 10y BEI now up 5.25bps. 1y infl swaps +28bps. Hated days like this when I made these markets. Not as bad from this side.
  • Incidentally, none of this changes the Fed outlook. Median was already at target, so the Fed’s focus on core is just a way to ignore it.
  • Once core rises enough, they will find some other reason to not worry about inflation. Fed isn’t moving rates far any time soon.
  • Median CPI +0.2%. Actually slightly less, keeping the y/y at 2.2%.

What a busy and interesting CPI day. For some months, the inflation figures have been confounding as core inflation (as always, we ignore headline inflation when we are looking at trends) has consistently stayed far away from better measures of the central tendency of inflation. The chart below (source: Bloomberg), some version of which I have run quite a bit in the past, illustrates the difference between median CPI (on top), core CPI (in the middle), and core PCE (the Fed’s favorite, on the bottom).

threecpis

I often say that median is a “better measure of central tendency,” but I haven’t ever illustrated graphically why that’s the case. The following chart (source: Enduring Investments) isn’t exactly correct, but I have removed all of the food and beverages group and the main places that energy appears (motor fuel, household energy). We are left with about 70% of the index, about a third of which sports year-on-year changes of between 2.5% and 3.0%. Do you see the long tail to the left? That is the cause of the difference between core and median. About 12% of CPI, or about one-sixth of core, is deflating. And, since core is an average, that brings the average down a lot. Do you want to guide monetary policy on the basis of that 12%, or rather by the middle of the distribution? That’s not a trick question, unless you are a member of the FOMC.

cpidist

Now, let’s talk about the dollar a bit, since in my tweets I mentioned apparel and autos. Ordinarily, the connection between the dollar and inflation is very weak, and very lagged. Only for terribly large movements in the dollar would you expect to see much movement in core inflation. This is partly because the US is still a relatively closed economy compared to many other smaller economies. The recent meme that the dollar’s modest rally to this point would impress core deflation on us is just so much nonsense.

However, there are components that are sensitive to the dollar. Apparel is chief among them, mainly because very little of the apparel that we consume is actually produced in the US. It’s a very clean category in that sense. Also, we import a lot of autos from both Europe and Asia, and they compete heavily with domestic auto manufacturers. As a consequence, the connection between these categories and the dollar is much better. The chart below shows a (strange) index of New Cars + Apparel, compared to the 2-year change in the broad trade-weighted dollar, lagged by 1 year – which essentially means that the dollar change is ‘centered’ on the change in New Cars + Apparel in such a way that it is really a 6-month lag between the dollar and these items.

cpinewcarsapparel

It’s not a day-trading model, but it helps explain why these categories are seeing weakness and probably will see weakness for a while longer. And guess what: those categories account for around 7% of the “tail” in that chart above. Ergo, core will likely stay below median for a while, although I think both will resume upward movement soon.

One of the reasons I believe the upward movement will continue soon is that housing continues to be pulled higher. The chart below (source: Enduring Investments using Bloomberg data) shows a coarse way of relating various housing price indicators to the owners’ rent component of CPI.

housing

We have a more-elegant model, but this makes the point sufficiently: OER is still below where it ought to be given the movement in housing prices. And shelter is a big part of the core CPI. If shelter prices keep accelerating, it is very hard for core (and median) inflation to decline very much.

One final chart (source Enduring Investments), relating to my comment that our inflation angst index has just popped higher.

angst

This index is driven mainly by two things: the volatility of the various price changes we experience, and the dispersion of the price changes we experience. The distribution-of-price-changes chart above shows the large dispersion, which actually increased this month. Cognitively, we tend to overlook “good” price changes (declines, or smaller advances) and recall more easily the “bad”, “painful” price changes. Also, we tend to encode rapid up-and-down changes in prices as inflation, even if prices aren’t actually going anywhere much. I reference my original paper on the subject above, which explains the use of the lambda. What is interesting is the possibility that the extremely low levels of inflation concern that we have seen over the last couple of years may be changing. If it does, then wage pressures will tend to follow price pressures more quickly than they might otherwise.

Thanks for all the reads and follows today. I welcome all feedback!

Winter Is Coming

February 10, 2015 5 comments

Sometimes being a value investor, amid overvalued (and ever more so) markets, feels a bit like being a Stark in Westeros. The analogy will be lost on you if you do not follow Game of Thrones, but the Starks hold the largest of the sub-kingdoms in Westeros. This kingdom also happens to be the coldest, and the sober Starks are always reminding people that “Winter is coming.”

I should observe that winter in Westeros is a much more serious affair than it is around here; it comes at odd intervals but can last for years. So being prepared for winter is really important. However, getting people to prepare for winter during the long “summer” is very difficult.

Sound familiar? The thing to keep in mind is that the Starks are always right, eventually, and they’re the ones who come through the winter in the best shape. Such is the case with value investors. (Some people might prefer calling value investors who are bearish on stocks right now “Chicken Littles” but I prefer being compared to Ned Stark, thanks. Although both of them have been known to lose their heads on occasion.)

Fortunately, it does not appear that winter is coming to the U.S. very soon. Friday’s Employment report was strong, despite the beginnings of downsizing in the oil and gas extraction businesses. The chart below shows the Baker Hughes oil and gas rig count, which is falling at a rate every bit as fast as it did in the credit crisis.

rig count

Yet, the U.S. economy as a whole generated 267,000 new jobs last month, which was above expectations. It is unlikely that this pace will continue, since the extraction (and related industry) jobs will be a drag. But in 2008, this happened when every other industry was being squeezed, and in the current case other industries are being squeezed by the strong dollar, but only mildly so. I think this will actually serve to increase the labor force participation rate, which has been in a downtrend for a long time – because laid-off oil workers will still be in the labor force looking for work, while other jobs will be getting filled by (sometimes) discouraged workers coming off the sidelines. So we may well see the Unemployment Rate rise even as jobs growth remains reasonable, even if less robust than the most recent figures.

Winter, though, is still coming.

In the near-term, winter is coming to Europe. Unusually, it is moving from the south to the north because Greece appears to be finally heading for the denouement that has been utterly unavoidable from the beginning. I wrote this in June 2012 (and I wasn’t the only one saying such things – the only real question has been how long it would take before the Greeks decided they’d had enough of sacrifice to hold together the Eurozone for the elites):

Greece will still leave the Euro. Government or no government, austerity or no austerity – the fiscal math simply doesn’t make sense unless Europe wants to pay for Greece forever. In principle, the Greeks can dig themselves out of trouble if they work harder, retire later, pay more taxes, and receive fewer government services. I do believe that people can change, and a society can change, under pressure of crisis. Remember Rosie the Riveter? But the question is whether they can change, whether they will change, do they even want to change, if the benefit of the change flows not to Greece’s people but to the behemoth European institutions that have lent money to Greece?

If a person declares bankruptcy, and the judge declares that he must pay all of his wages for the next thirty years, after deducting enough for food and shelter, to the creditors…do you think that person is going to go looking for a 60-hour workweek?

Am I sure that Greece is going to leave the Euro in a week, or a month, or a year? Not at all. The institutional self-preservation meme is very strong and I am always amazed at how long it takes obvious imperatives to actually happen.[1] But I am quite confident that Greece will eventually leave the Euro, and it does seem as if parties on all sides of the negotiating table are coming to that conclusion as well.

One question that authorities have had to come to peace with first was whether Grexit is really Armageddon. I have argued that default and an exit from the Euro is not bad for Greece, at least when compared to a multi-year depression.

And it’s probably not even horrible for Europe, or the world at large, at least compared to the credit crisis, despite all protestations that this would be “Lehman squared.” Again, this is old news and as I lay out the reasoning here there is no reason to repeat myself.

But it won’t be a positive thing. And it is likely to bring on “winter,” economically. Helpfully, the world’s central banks not only remain in easing mode but are increasing the dovishness of their stance, with the ECB foremost among the central banks that are priming the pumps again. M2 money growth in the Eurozone was up to 4.5% y/y in December (latest data available), with the highest quarter-over-quarter growth rate (8.3%, annualized) in money since the end of 2008! Meanwhile the Fed, while it is no longer adding to reserves, is still watching the money supply grow at 6% y/y with no good way to stop it. For all the talk about the FOMC hiking rates by mid-year, I think the probable rise in the Unemployment Rate discussed above, plus the weak inflation readings (with the notable exception of Median CPI), plus the fact that all other central banks are easing and likely to continue doing so, plus the probability of turbulence in Europe, makes it very unlikely that this Committee, with a very dovish makeup, will be tightening any time soon.

The likely onset of some winter will not help hold down inflation, however. Upward pressures remain, and the fact that the ECB is now running the pumps makes higher prices more likely. Yes, we care about money supply growth in Europe: the chart below shows the M2 growth of the US and Europe combined, against core CPI in the US. The fit is actually better than with US CPI alone.

m2prices

Now, some markets are priced for winter and some are not. We think that real interest rates in Europe are far too low compared to real rates in the US, and stock prices in the US are too high compared to stock prices in Europe. The first chart below shows the spread of 10-year real rates in the US minus Europe (showing US yields are high compared to European yields); the second chart shows the ratio of the S&P 500 to the Eurostoxx 50.

realratespreadUSEU

spxeurostoxx

You can see in the latter chart that the out-performance of the S&P has proceeded since 2009, while the under-performance of US inflation-linked bonds has only happened since 2012, so these are not simply two ways of looking at the same trade. In both cases, these deviations are quite extreme. But the European economy and the US economy are not completely independent of one another; weak European growth affects US corporate entities and vice-versa, and as I suggest above the growth of European money supply tends to affect US inflation as well. We think that (institutional) investors should buy TIPS and sell European linkers, and also buy European stocks against US stocks. By doing both of these things, the exposure to currency flows or general trends in global equity market pricing is lessened. (Institutional investors interested in how we would weight such a trade should contact us.)

[1] As another example, take the shrinking of Wall Street. It was obvious after 2008 that it had to happen; only recently, however, as banks and dealers have been forced to become more and more like utilities have we started to see layoffs while stocks are rising, which is very unusual. But Wall Street defended the bloated structures of the past for more than six years!

Summary (and Extension!) of My Post-CPI Tweets

January 16, 2015 5 comments

Below is a summary and extension of my post-CPI tweets. You can follow me @inflation_guy:

  • Core CPI unchanged – which is amazing. I can’t wait to see the breakdown on this one.
  • Core 0.003%, taken out one more decimal. I thought y/y had a chance of rising to 1.8%; instead it fell to 1.61%.
  • Last Dec, core was 0.10%, so part of this may be faulty seasonal adjustment. It is December, after all.
  • Core services +2.4%, down from 2.5%. Core goods down to -0.8%, worst since mid-2007.
  • Medical Care Commodities +4.8%! Biggest increase since 1993. Oh ACA, we hardly knew ye.
  • Housing weakened, which isn’t insignificant. Primary rents 3.38% from 3.48%; OER 2.61% from 2.71%.
  • We still think housing is headed higher but that was part of the surprise. Apparel too, -2.0% y/y from -0.3% previous.
  • The apparel move is likely related to dollar strength. Most apparel isn’t made here.
  • Accelerating major groups: Food/Bev, Med Care, Rec (28.2%). Decel: Housing, Apparel, Transp, Educ/Comm, Other (71.8%)
  • Decline in apparel prices may be a story. In recent yrs Apparel had been rising after many years of dis/deflation. Weakness in Asia…
  • Apparel y/y decline was largest since 2003.
  • Core ex-housing down to 0.69%. Much lower than crisis lows. That’s where to look if you’re worried about deflation, not the headline.
  • Very interesting core goods. Our three-item proxy is Apparel (-2%), New cars (-0.1%), and Medical Care commodities (+4.8%). Figure THAT out.
  • This CPI is hard to dismiss. Hsng dip is most concerning (think it’s temporary tho), but broadening of decel categories worrisome.
  • Core ex-housing looking really soft. Now, some of that is probably energy sneaking thru…not a prob normally but for BIG moves – maybe.
  • That being said, market is pricing in 1% core for next yr, 1.25% for 2 years, 1.37% for 3 years…so infl market has overshot. A lot.
  • number of categories at least 1 std dev above deflation went from 43% to 20% in one month.
  • Now here’s something to not be worried about yet: our “relative inflation angst” index reached its highest level since 2011. Still low.

This was a wild report, full of interesting items. Let’s start with Apparel. In recent years, I have watched Apparel closely because one of my theses was that the domestic benefit from exporting production to cheap-labor countries was ending. Apparel is a nice clean category that went from normal inflation dynamics when most apparel was produced domestically (prior to 1993), to disinflation/deflation over the years where virtually all production was moved offshore, to normal inflation again once the cost savings on labor had been fully realized and so no longer a source of disinflation (at which time, costs ought to begin to track wage inflation in the exporting country, adjusted for currency moves).

apparel

While it seems that the recent decline should challenge that thesis (and that was my knee-jerk reaction), I think that perhaps it isn’t quite as clear-cut as I thought. In the past I had ignored the effect of foreign exchange movements, since (a) it didn’t matter when we were mostly domestic production and (b) over the last few years currencies have been broadly stable. I think the latest decline in apparel is almost surely related to the dollar’s strength, which unfortunately means that it isn’t as pure a test of my thesis as I had hoped. In any event, apparel is one place (one of few, in the US) where dollar strength manifests clearly in core goods prices, so this is a dollar effect.

The next chart is the chart of Medical Care Commodities (mainly pharmaceuticals). Remember when we had that quaint notion that the Affordable Care Act (Obamacare) was going to permanently reduce inflation in medical care? (Actually, we didn’t all have that quaint notion – in particular, I did not – but it was certainly a view pushed very hard by the Administration). It turns out that the decline in medical care inflation was mostly due to the effects of the sequester on Medicare payments, and now prices seem to be catching up. This is an ugly chart.

medcarecomm

Ex-medical care commodities, however, it doesn’t appear that disinflation in core commodities will be in for much of a respite unless the dollar rally is arrested.

dollarvscorecommod

And now for one of the scariest charts: core inflation ex-shelter is as low as it has been since the early 2000s, when the uptick in housing costs (like now) hid a close scrape with deflation. I think the causes of that deflationary scrape were similar to those of today, if in fact we are going to head that way: too much private debt. Although the higher level of public debt makes the answer more indeterminate, high private debt imparts a disinflationary tendency. The “deleveraging” was supposed to get rid of the disinflationary tendency by moving private debt onto the public balance sheet. It really didn’t happen, except for auto companies and some large financial institutions like Fannie Mae.

corex

The important difference between now and then is that in the early 2000s we had higher rates, higher velocity (which is correlated to rates) and no excess reserves. Today, all the Fed would need to do to arrest this tendency would be to lower the interest on excess reserves to a significant penalty rate and those excess reserves would quickly enter the money supply. Interestingly, a movement the other way – to raise interest rates – will likely also cause inflation to rise as it will raise money velocity. So I am not particularly concerned we will get into deflation even ex-housing. There are lots of ways out of that pickle. I am much more worried about overreaction. Once again, the Fed might have stumbled into the right policy: doing nothing. If you can’t be good…be lucky.

One final remark on our “inflation angst” index (not shown here): the rise in the index, which manifests itself in a perception that inflation is actually higher than reported, is driven by the increasing volatility of index components (such as airfares, gasoline, and apparel) and the increased dispersion of index components (such as apparel and medical care commodities). These both have the impact of making inflation feel higher than it actually is. It is nothing to worry about at these levels of inflation, because “higher than it actually is” still feels low. But if inflation volatility continues to pick up as the level picks up (as it eventually will), then it will feel much worse for consumers than it actually is. That’s not a 2015 story, however.

Keep in mind that the market has already discounted really bad core inflation for a long time. We are very unlikely to get such a bad outcome, unless housing collapses – which it might, since prices are getting back into bubble territory, but I don’t think it’s very likely. As a consequence, even such a bearish inflation report as this one has been followed by a rally in inflation swaps and breakevens. I think this is a wonderful time to be buying inflation. It’s hard to do in the retail market, although the Proshares UINF ETF is a reasonably clean way to be long 10-year breakevens. It is $28.80, and I expect it to be at $36 within 6-9 months. [Disclosure: Neither I nor any entity or fund owned or controlled by me owns this ETF or has any current plans to buy or sell it.] [Additional Disclosure: That would be difficult it seems. While Bloomberg says it has NAV it also seems to have been liquidated. Pity if true. But RINF, a 30-year breakeven, still exists. From $30.57, I would expect $37 over a similar period.]

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