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Summary of My Post-CPI Tweets (May 2020)

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

  • Once again CPI day, and unlike last month where expectations were very low, it seems people think they have a firmer grasp of inflation this month. Ha!
  • I suppose that’s relative, but while I think there will be some interesting stories today I wouldn’t read much into the near-term data. Some things we know will be happening just aren’t happening yet.
  • Some examples include hotels, food away from home, rent of residence, medical care…all of these have serious upward pressures going forward, but not clear today.
  • I’ll talk about these as we go today. The consensus forecast for core is -0.2%, dropping y/y core to 1.7% from 2.1%. Last April – so sweet, so long ago – was +0.198% on core so ordinarily we’d be expecting a small y/y acceleration today.
  • But remember that last month, median inflation was pretty much normal. All of the movement in core was in lodging away from home, airfares, and apparel.
  • I don’t know about apparel, but I doubt the other two have fallen as far this month. Surveys of used cars, another typical volatility source, have plunged though. Usually takes a couple months for that to come into the CPI, but with a big move like that, it might.
  • On the other hand, prices for medical care were virtually ignored in the survey for last month’s release. If they start surveying those more ambitiously, that’s going to be additive. No question in the medium-term, medical care prices are going up.
  • Rents will be very interesting. So, if someone skips a rent payment how the BLS treats it depends on whether the landlord expects to collect it eventually, some of it, or none of it.
  • Rent-skipping isn’t yet unusually prevalent, and the threat that Congress could declare a rent holiday will mean that NEW rents are definitely going to be higher (this is a new risk for a landlord). Remember it’s rents that drive housing inflation, not home prices.
  • Neither effect is likely appearing yet, but be careful of that number today. In fact, as I said up top, be careful of ALL of the numbers today!
  • In the medium-term, inflation is lots more likely than deflation because there is much more money out there chasing fewer goods and services (20% y/y rise in M2, better than 50% annualized q/q). But today?
  • And while no one will be surprised with a low number today, almost everyone would be shocked with a high number. But with a lot of volatility, a wider range of outcomes in BOTH directions becomes possible.
  • In other words, HUGE error bars on today’s number, which SHOULD mean we take it with a grain of salt and wait for a few more numbers. Markets aren’t good with that approach. OK, that’s it for the walk-up. Hold onto your hats folks. May get bumpy.
  • Core CPI fell -0.448%, meaning that it was very close to -0.5% m/m. The y/y fell to 1.44%. The chart looks like a lot of the other charts we’re seeing these days. But of course devil will be in the details.

  • Core goods -0.9% y/y from -0.2%; core services 2.2% from 2.8%.
  • CPI for used cars and trucks, coming off +0.82% last month, turned a -0.39% this month. That’s not super surprising. I suspect going forward that rental fleets will shrink (meaning more used cars) since most cars are rented from airports.

  • Lodging Away from Home again plunged, -7.1% after -6.8% last month. That’s a little surprising. In my own personal anecdotal observation, hotel prices in some places went up last month, although to be fair that’s forward. TODAY’S hotel prices are still being discounted.
  • However Primary rents were +0.20% after +0.30% last month. Y/Y slid to 3.49% from 3.67%. Owners’ Equivalent Rent was +0.17% vs 0.26% last month; y/y fell to 3.07% from 3.22%.
  • I would not expect any serious decline in rents going forward. It’s housing stock vs number of households, and if we’re trying to spread out that means MORE households if anything. Also, as noted earlier I expect landlords to raise rents to recapture ‘jubilee risk.’
  • Apparel was again down hard, -4.7% m/m. That’s not surprising to me. Transportation down -5.9% m/m, again no real surprise with gasoline. But Food & Beverages higher, up 1.40% m/m. That’s not surprising at all, if you’ve been buying groceries!
  • Still some oddness in Medical Care. Pharma was -0.13% m/m, down to +0.78% y/y from +1.30% last month. Doctors’ Services -0.08%. Both of those make little sense to me. But hospital services +0.50% m/m, pushing y/y to 5.21% from 4.37%. That part makes perfect sense!
  • Hospital Services Y/Y. Expect that one to keep going up. Overall, of the 8 major subsectors only Food & Energy, Medical Care, and Education/Communication were up m/m.

  • Core ex-housing fell to +0.6% y/y, vs +1.45% last month. That’s the lowest since…well, just 2017. The four-pieces chart is going to be interesting. As I keep saying though, the real story is in 2-3 months once things have settled and there’s actual transactions again.

  • Little pause here because some of the BLS series aren’t updated. I was looking at the -100% fall in Leased Cars and Trucks…and the BLS simply didn’t report a figure for that. Which is odd.
  • …doesn’t look like a widespread problem so we’ll continue. A quick look forward at Median – there’s going to be more of an effect this month but going to be up by roughly +0.15% depending on where the regional housing indices fall.
  • That will drop y/y median to 2.70% or so from 2.80%. You’ll see when we look at the distribution later, this is still largely a left-tail event. The middle of the distribution is shrugging slightly lower. Again, it’s early.
  • Biggest core category decliners: Car and Truck Rental, Public Transportation, Motor Vehicle Insurance, Lodging Away from Home, Motor Vehicle Fees (sensing a trend?) and some Apparel subcategories.
  • Only gainer above 10% annualized in core was Miscellaneous Personal Goods. But in food: Fresh fruits/veggies, Dairy, Other Food at Home, Processed Fruits/Veggies, Cereals/baking products, Nonalcoholic beverages, Meats/poultry/fish/eggs.
  • Gosh, I didn’t mention airfares, -12.4% m/m, -24.3% y/y. Some of that is jet fuel pass through. But it’s also definitely not going to last. Fewer seats and more inelastic travelers (business will be first ones back on planes) will mean lots higher ticket prices.
  • The airfares thing is a good thought experiment. Airlines have narrow margins. Now they take out middle seats. What happens to the fares they MUST charge? Gotta go up, a lot. Not this month though!

  • I’ll take a moment for that reminder – people tend to confuse price and quantity effects here, which is one reason everyone expects massive deflation. There is a massive drop in consumption, but that doesn’t mean a massive drop in prices.
  • Indeed, if it means that the marginal price-elastic buyer in each market is exiting long-term, it makes prices more likely to rise than to fall going forward. Producers only cut prices IF cutting prices is likely to induce more buyers. Today, they won’t.

  • 10-year breakevens are roughly unchanged from before the number. If anything, slightly higher. I think that’s telling – they’re already pricing in so little inflation that it’s getting hard to surprise them lower.
  • 10y CPI swaps, vs median CPI. Little disconnect.

  • Little delay from updating this chart. OER dropped to the lowest growth rate in a few years. But it’s not out of line with underlying fundamentals.

  • To be fair, underlying fundamentals take a while to work through housing, but lots of other places we’ve seen sudden moves. The only sudden move we have to be wary of is in rents if Congress declares a rent holiday.
  • Under BLS collection procedures, if rent isn’t collected but landlord expects to collect in the future, it goes in normally. If landlord expects a fraction, that is taken into effect. If landlord doesn’t expect to collect, then zero.
  • …which means that if Congress said “in June, no one needs to pay rent,” you’d get a zero, massive decline in rents…followed by a massive increase the next time they paid. That would totally muck up CPI altogether, and I would hope they would do some intervention pricing.
  • So that’s a major wildcard. To say nothing of the huge effect it would have on the economy. Let’s hope Congress leaves it to individual landlords to work it out with tenants, or at worst there’s a Rental Protection Program where the taxpayers pay the rent instead of the tenant.
  • OK time for four-pieces charts. For those new to this, these four pieces add up to the CPI and they’re all between 20% and 33% of the CPI.

  • Piece 1: Food and Energy. Actually could have been worse. Energy down huge, Food up huge (+1.5% m/m). But this is the volatile part. Interesting for a change as energy is reversing!

  • Piece 2, core goods. We went off script here. But partly, this is because the medicinal drugs component is lagging what intuition tells us it should be doing.

  • I said offscript for core goods. Here’s the model. We were expecting to be back around 0% over the next year, but not -1%.

  • Piece 3, core services less rent of shelter. This was in the process of moving higher before the virus. Medical Care pieces will keep going higher but airfares e.g. are under serious pressure. Again, I think that’s temporary.

  • Piece 4: rent of shelter. The most-stable piece; this would be alarming except that a whole lot of it is lodging away from home. I’ve already showed you OER. It has slowed, but it will take a collapse in home prices to get core deflation in the US. Doesn’t seem imminent.

  • Last two charts. First one shows the distribution of price changes. Most of what is happening in CPI right now is really big moves way out to the left. That’s why Median is declining slowly but Core is dropping sharply. It’s the tails.

  • And another way to look at the same thing, the weight of categories that are inflating above 3% per year. Still close to half. MOST prices aren’t falling and many aren’t even slowing. Some, indeed, are rising. This does not look like a deflationary outcome looming.

  • Overall summary – much softer figure than last month, but still pretty concentrated in the things we knew would be weak. A few minor surprises. But for us to get a real deflationary break, another big shoe needs to drop.
  • With money supply soaring and supply chains creaking, any return to normal economic activity is going to result in bidding for scarce supplies with plentiful money. You already see that in food, the one thing it’s easy to buy right now. That’s the dynamic to fear when we reopen.
  • And, lastly. I’ve made the point many times recently: inflation hedges are priced so that if you believe in deflation you should STILL bet on inflation because you don’t get any payoff if you’re right about deflation.
  • That’s all for today. Stop by our *new* website at https://enduringinvestments.com and let us know what you think. It needed a facelift! Good luck out there.

I think the key point this month is the point I made up top: we always need to be wary of one month’s data from any economic release. It’s important to remember that the release isn’t the actual situation, it’s a measurement of the actual situation and any measurement has a margin for error. All of these data need to be viewed through the lens of ‘does this change my null hypothesis of what was happening,’ and if the error bars are large enough then the answer almost always should be ‘no.’

However, markets don’t usually act like that. Although there’s not a lot of information in the economic data these days the markets act like there is. (I was, however, pleased to see the TIPS market not overreacting for a change.) Let’s look at this data for what it is: right now, the one thing we know for sure is that it’s hard to buy anything at all. Economic activity is a fraction of what it was before the lockdowns took effect – but that affects economic quantities transacted (GDP), not prices. We need to get back to something like normal business before we know where prices are going to reach equilibrium. From these levels, my answer is that in most cases the equilibrium will almost assuredly be higher. I think most consumer-to-consumer services are going to end up being a lot more labor-intensive, which is good for labor’s share of national income but bad for prices: declining productivity shows up in higher prices. And there’s lots more money out in the system. While some of this is because companies drew quickly on their bank lines lest those lines be pulled like they were in 2008-2009, a great deal of it is because the government is spending enormous sums (a lot of it helicopter money) and the Fed is financing that by buying the debt being issued. So while M2 growth probably won’t end up at 20% y/y for a long period, I think the best we can hope for is that it goes flat. That is, I think the money is here to stay.

Monetary velocity is falling, and in fact the next print or two are going to be incredibly low. Precautionary cash balances ballooned. But once the economy opens again, those precautionary balances will drop back to normal-ish and the money will still be there. It’s a cocktail for higher inflation, to be sure. The only question is how much higher.

Over the next few months, the inflation numbers will be hard to interpret. What’s temporary, and what’s permanent? Keep in mind that inflation is a rate of change. So hotel prices have plunged. Gasoline prices have plunged. But unless they continue to plunge, you don’t have deflation. You have a one-off that will wash out of the data eventually. If hotel prices retrace half of their plunge, that will be represented by a m/m increase from these levels. Airfares will end up higher than they were before the crisis, but even if they didn’t they’d likely be higher from here. The real question is whether the one-offs spread much farther than apparel/airfares/lodging away from home. So far, they’ve spread a little, but not a lot. We’re nowhere close to deflation, and I don’t think we’re going to be.

Summary of My Post-CPI Tweets (April 2020)

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

  • CPI Day! I have to be honest – with the markets closed and this number likely to not have a lot of meaning, I almost skipped doing this this morning. But, thanks to M2, lots more people are suddenly listening so…obviously CPI is starting to be important. So let’s try.
  • The consensus for today, to the extent “consensus” means anything, is for -0.3% headline and +0.1% on core. But these are even more guesses than usual.
  • The BLS stopped taking prices a couple of weeks ago. That will have less effect than if that had happened a few years ago, b/c they ‘survey’ some prices using database downloads from retailers e.g. apparel.
  • But it still means that we don’t know what they’ll do about missing prices. Normally the BLS imputes an estimated figure for an item based on similar items…but if whole groups of items or categories are missing, less clear. Do they assume zero? Prior trend?
  • I actually think that this number won’t have too many of those problems but there will be some and next month will be very odd – and some chance they don’t publish at all because they can’t get statistically significant data.
  • In the meantime…remember we are coming off of recent strong data. Core was 2.37% y/y last month, and in general has headed higher. Before this, I was expecting 2.5% core by summer. Now that will take longer! (You can imply the word “maybe” before every statement this month.)
  • Lodging Away from Home is one place we’ll surely see an effect this month, and airfares, but beyond that who knows. And we are dropping off a weak +0.16% from last March so the core y/y figure might even stay steady. Or it could drop 0.3%. Who knows.
  • What we DO know is headline inflation is going to fall and in a month or 2 will show negative changes, which will prompt “DEFLATION!” screams. But headline just follows gasoline. That’s important – it’s also the reason people think infl is related to growth. Only headline.

  • I doubt we’ll get very close to core deflation in this cycle. See my recent article Last Time Was Different for why I don’t think we’ll see similar effects. But mkts are priced for long-term disinflation and deflation.
  • Oh and of course yesterday’s M2 chart. Probably discuss that more later today. Anyway, I’d say good luck but with markets closed you can’t do anything anyway! So just “hang on” and we’ll try and figure this out over the next few months.

  • I will be back in 5 minutes with thoughts on the figures and diving as deep as I can this month.
  • Core -0.1% m/m, down to 2.1% y/y. That’s a bigger fall than expected, but with these error bars I wouldn’t be shocked. Normally missing by 0.2% on core is a big deal. More interesting is that they got headline right to within 0.1%! It ‘only’ fell -0.4% m/m in March.
  • Here are the last 12 core CPI prints. This chart is gonna look kinda wacky for a while.

  • Broadly, core goods were -0.2% y/y, a decline from flat. More amazing is core services, dropping to 2.8% y/y from 3.1%.
  • Haha, that core services number is EVEN MORE AMAZING than you think. Because it didn’t happen from Owners Equivalent Rent (+0.26% m/m, 3.22% y/y) or Primary Rents (+0.30% m/m, 3.67% y/y). Both slower y/y but basically same m/m from Feb.
  • So if rents didn’t decelerate, where do we get the big drop in core services? Lodging Away From Home was -6.79% m/m, dropping to -6.38% y/y from +0.78% last month. I should drop the second decimal.
  • BTW, good time to remember that VOLUMES of transactions don’t enter into CPI monthly. This is just a survey of prices. So if no one bought any apparel, but we have a price, that’s what gets recorded. Lodging fell because prices actually were down hard, as you probably know.
  • CPI for Used Cars and Trucks was +0.82% m/m. Some people were worried about autos but I’m not sure they should be. Big supply shock in cars because of parts supply chain. If I were a dealer I wouldn’t be marking down my existing inventory.

  • Airfares -12.6% m/m. That’s worth about 0.1% on core all by itself. So we expected big declines in airfares and Lodging Away from Home (worth about 0.06%), and got them. Core ex- those two items still had some softness, but not horrendous.
  • Core ex-housing declined from 1.70% y/y to 1.45% y/y. Again, a lot of that were those two items I just mentioned. But 1.45% core ex-housing is still higher than it was last July.
  • Now, in medical care I’m not sure how to think about any of this. Medicinal Drugs were -0.04% m/m, after -0.43% last month, pushing y/y to 1.31% from 1.85%. But lots of drugs are really hard to get right now and of course we now know most of our APIs come from China.
  • That may be a case of some shortages, because in the short term no one wants to be seen jacking up the price of drugs. Prescription drugs decelerated y/y; non-prescription accelerated.
  • Physicians’ Services +0.34% m/m vs +0.21% prior month. Hospital Services +0.40% vs -0.12%. How in the heck do you measure this when most of those doctors and services are doing one thing? And a very crucial one indeed. What’s the price of a hip replacement right now?
  • OK, biggest m/m changes down, other than fuel. Public Transportation -65% (annualized), car/truck rental -58%, Lodging Away from Home -57%, Infants/toddlers apparel -41%, womens/girls apparel -30%, footwear -29%.
  • Which makes me realize I forgot to mention Apparel was -2% m/m. That’s another 5bps off the core inflation rate.
  • There were still some increases on the month. Biggest ones other than food were Tobacco and Smoking Products (12.5% annualized), nonalcoholic beverages (+12%), and Used Cars and Trucks (+10%).
  • FWIW, the early look to me is that MEDIAN CPI will still be around 0.22% or so. That’s what long-tail negatives do to core! So while y/y Core dropped sharply, y/y median will still be around 2.8%.
  • So, coarse but…core -0.1% m/m. Add back 0.06% lodging, 0.10% airfares, 0.07% apparel and 0.07% for public transportation (cuffing it) and you get back to +0.2%. Which means that outside of those categories there wasn’t much disinflation pulse. Median will say same thing.
  • That probably more means that prices haven’t really reacted yet that that there will be zero impact of COVID-19. But I don’t think we’ll see a big impact lower on prices. At least not lasting very long.
  • Haven’t done many charts yet. But here’s one I haven’t run in a while. Distribution of y/y price changes by low-level item categories in the CPI. Look at that really long tail to the left. Take off just the last bar on the left and you get 2.37% core roughly.

  • Here’s the weight of categories over 2% y/y change, over time. Just another way of saying that we haven’t seen any big effects yet. Unknown is just how much the trouble in collecting affects this.

  • Pretty good summary and gives me more confidence in the data – they’re at least calling people! But interestingly, not so much doctors/hospitals. So asterisk by Medical Care.
  • BLS has posted this, explaining how they’re collecting prices. https://bls.gov/bls/effects-of-covid-19-pandemic-on-bls-price-indexes.htm#CPI
  • So let’s do the four-pieces charts and then wrap up. For those new to my monthly CPI tweets, these four pieces add up to CPI, each is 20%-33%, but each behaves differently from a modeler’s perspective.
  • First piece: Food and Energy. This will go much lower. As I said up top, we will be in deflation of the headline number pretty soon. But, I think, only the headline number.

  • Core goods. This declined a tiny bit, mostly apparel. I think the short-term effect here is indeterminate but might actually be higher as some goods made overseas get harder to get (ibuprofen??)

  • Here’s where the rubber meets the road. Core Services less Rent of Shelter. Was in a good trend higher and about to be worrisome. Dropped a bit, but with an asterisk on medical care.

  • Rent of Shelter – this looks alarming! And rents declining is the ONLY way you can get core deflation. But…Rent of Shelter includes lodging away from home. That’s the dip, is in that 1% of CPI. The 31% that is primary and OER, not so much.

  • That last chart calls for one more on housing. Here is OER, the biggest single piece of CPI. It’s right on model. As yet, no sign of any big effect from COVID-19 either now, or in the forecast that’s driven by housing market data.

  • End with 1 final chart. We started w/ M2 chart showing the biggest y/y rise in history. The counterpoint is “what if velocity falls.” But vel is already @ record low. To drop, you need lower int rates (from 0?), or huge long-lasting cash-hoarding.Hard to see.

  • Thanks for tuning in. I’ll collate these in a single post in the next hour or so.

So what was most amazing about today’s data? I suppose it was that, outside of the things we knew would be disasters (airfares, hotels) the effects of the virus crisis were very small. And you know, that sort of makes sense. If I’m a producer of garden rakes (I honestly just pulled that out of the air), why would I change my prices? I’m not seeing traffic, but it isn’t because my prices are too high. From a seller’s perspective, it only makes sense to lower price if lower prices will induce more business. Lowering the price of rakes isn’t going to sell more rakes. It isn’t that people have no money to buy rakes – with the government fully replacing wages of laid off workers, and covering the wage costs for small businesses so they don’t need to lay anyone off, and sending everyone a fat check besides, there’s no shortage of people with money to spend. (I know we read a lot about the tragedy of the millions being laid off, but it’s not much of a tragedy yet since they’re being paid the same as before!)

[As an aside, businesses with high fixed overhead and low variable costs – hotels are a classic example; it costs very little for the second occupied guest room – might lower prices significantly since if they can cover their variable costs then anything above that goes to covering fixed overhead. That’s what airlines did initially too, but when they realized after that knee-jerk response that they couldn’t fill the planes even if they offered free flights, they started canceling enormous numbers of flights. I’ve actually seen some of the fares that I track rise in the last week or two as the number of flights out of NYC has dwindled to very few! But it’s harder to mothball a hotel than to mothball a plane.]

The NY Fed published a really insightful article today entitled “The Coronavirus Shock Looks More like a Natural Disaster than a Cyclical Downturn.” Although they focused on the path of unemployment claims, a similar analysis can take us to the inflation question. In a natural disaster, we don’t see deflation. If anything, we tend to see inflation as some goods get harder to acquire. The amount of money available doesn’t decline, assuming the government deploys an emergency response that includes covering non-insured losses, and the amount of goods available drops. In today’s circumstance, we have more money available – as the M2 chart shows – than we did before the crisis, and if anything we will have fewer things to buy when it’s all over as supply chains will remain disrupted for a long time and a lot of production will surely be re-onshored. But you don’t need the latter point to get disturbing inflation. All you need is for the money being created to get into circulation rather than reserves (which is what is happening, which is why M2 is soaring), and for precautionary money-hoarding to be a short-term phenomenon. I believe the money will be around long after the fear has died away, because for the Fed to drain a few trillion by selling massive quantities of bonds is much, much more difficult than to add a few trillion by buying bonds that the Treasury coincidentally needs to sell more of right now.

The quality of the CPI numbers will be sketchy for a while, but I am fairly impressed that this release wasn’t as messy as I was prepared for. The inflationary outcome may well be messy, though! With 14% money growth, and little reason to expect a lasting velocity decline, it’s hard to get an innocuous inflation outcome. But markets are still offering you inflation hedges at prices that imply you win even if inflation drops a fair amount from the current level. If you don’t have those hedges, you’re making a very big bet on deflation.

Happy Easter.

Last Time Was Different

April 4, 2020 5 comments

They say that the four most dangerous words in investing/finance/economics are “This time it’s different.”

And so why worry, the thinking goes, about massive quantitative easing and profound fiscal stimulus? “After all, we did it during the Global Financial Crisis and it didn’t stoke inflation. Why would you think that it is different this time? You shouldn’t: it didn’t cause inflation last time, and it won’t this time. This time is not different.”

That line of thinking, at some level, is right. This time is not different. There is not, indeed, any reason to think we will not get the same effects from massive stimulus and monetary accommodation that we have gotten every other time similar things have happened in history. Well, almost every time. You see, it isn’t this time that is different. It is last time that was different.

In 2008-10, many observers thought that the Fed’s unlimited QE would surely stoke massive inflation. The explosion in the monetary base was taken by many (including many in the tinfoil hat brigade) as a reason that we would shortly become Zimbabwe. I wasn’t one of those, because there were some really unique circumstances about that crisis.[1]

The Global Financial Crisis (GFC hereafter) was, as the name suggests, a financial crisis. The crisis began, ended, and ran through the banks and shadow banking system which was overlevered and undercapitalized. The housing crisis, and the garden-variety recession it may have brought in normal times, was the precipitating factor…but the fall of Bear Stearns and Lehman, IndyMac, and WaMu, and the near-misses by AIG, Fannie Mae, Freddie Mac, Merrill, Goldman, Morgan Stanley, RBS (and I am missing many) were all tied to high leverage, low capital, and a fragile financial infrastructure. All of which has been exhaustively examined elsewhere and I won’t re-hash the events. But the reaction of Congress, the Administration, and especially the Federal Reserve were targeted largely to shoring up the banks and fixing the plumbing.

So the Federal Reserve took an unusual step early on and started paying Interest on Excess Reserves (IOER; it now is called simply Interest on Reserves or IOR in lots of places but I can’t break the IOER habit) as they undertook QE. That always seemed like an incredibly weird step to me if the purpose of QE was to get money into the economy: the Fed was paying banks to not lend, essentially. Notionally, what they were doing was shipping big boxes of money to banks and saying “we will pay you to not open these boxes.” Banks at the time were not only liquidity-constrained, they were capital-constrained, and so it made much more sense for them to take the riskless return from IOER rather than lending on the back of those reserves for modest incremental interest but a lot more risk. And so, M2 money supply never grew much faster than 10% y/y despite a massive increase in the Fed’s balance sheet. A 10% rate of money growth would have produced inflation, except for the precipitous fall in money velocity. As I’ve written a bunch of times (e.g. here, but if you just search for “velocity” or “real cash balances” on my blog you’ll get a wide sample), velocity is driven in the medium-term by interest rates, not by some ephemeral fear against which people hold precautionary money balances – which is why velocity plunged with interest rates during the GFC and remained low well after the GFC was over. The purpose of the QE in the Global Financial Crisis, that is, was banking-system focused rather than economy-focused. In effect, it forcibly de-levered the banks.

That was different. We hadn’t seen a general banking run in this country since the Great Depression, and while there weren’t generally lines of people waiting to take money out of their savings accounts, thanks to the promise of the FDIC, there were lines of companies looking to move deposits to safer banks or to hold Treasury Bills instead (Tbills traded to negative interest rates as a result). We had seen many recessions, some of them severe; we had seen market crashes and near-market crashes and failures of brokerage houses[2]; we even had the Savings and Loan crisis in the 1980s (and indeed, the post-mortem of that episode may have informed the Fed’s reaction to the GFC). But we never, at least since the Great Depression, had the world’s biggest banks teetering on total collapse.

I would argue then that last time was different. Of course every crisis is different in some way, and the massive GDP holiday being taken around the world right now is of course unprecedented in its rapidity if not its severity. It will likely be much more severe than the GFC but much shorter – kind of like a kick in the groin that makes you bend over but goes away in a few minutes.

But there is no banking crisis evident. Consequently the Fed’s massive balance sheet expansion, coupled with a relaxing of capital rules (e.g. see here, here and here), has immediately produced a huge spike in transactional money growth. M2 has grown at a 64% annualized rate over the last month, 25% annualized over the last 13 weeks, and 12.6% annualized over the last 52 weeks. As the chart shows, y/y money growth rates are already higher than they ever got during the GFC, larger than they got in the exceptional (but very short-term) liquidity provision after 9/11, and near the sorts of numbers we had in the early 1980s. And they’re just getting started.

Moreover, interest rates at the beginning of the GFC were higher (5y rates around 3%, depending when you look) and so there was plenty of room for rates, and hence money velocity, to decline. Right now we are already at all-time lows for M2 velocity and it is hard to imagine interest rates and velocity falling appreciably further (in the short-term there may be precautionary cash hoarding but this won’t last as long as the M2 will).  And instead of incentivizing banks to cling to their reserves, the Fed is actively using moral suasion to push banks to make loans (e.g. see here and here), and the federal government is putting money directly in the hands of consumers and small businesses. Here’s the thing: the banking system is working as intended. That’s the part that’s not at all different this time. It’s what was different last time.

As I said, there are lots of things that are unique about this crisis. But the fundamental plumbing is working, and that’s why I think that the provision of extraordinary liquidity and massive fiscal spending (essentially, the back-door Modern Monetary Theory that we all laughed about when it was mooted in the last couple of years, because it was absurd) seems to be causing the sorts of effects, and likely will cause the sort of effect on medium-term inflation, that will not be different this time.


[1] I thought that the real test would be when interest rates normalized after the crisis…which they never did. You can read about that thesis in my book, “What’s Wrong with Money,” whose predictions are now mostly moot.

[2] I especially liked “The Go-Go Years” by John Brooks, about the hard end to the 1960s. There’s a wonderful recounting in that book about how Ross Perot stepped in to save a cascading failure among stock brokerage houses.

COVID-19 in China is a Supply Shock to the World

February 25, 2020 2 comments

The reaction of much of the financial media to the virtual shutdown of large swaths of Chinese production has been interesting. The initial reaction, not terribly surprising, was to shrug and say that the COVID-19 virus epidemic would probably not amount to much in the big scheme of things, and therefore no threat to economic growth (or, Heaven forbid, the markets. The mere suggestion that stocks might decline positively gives me the vapors!) Then this chart made the rounds on Friday…

…and suddenly, it seemed that maybe there was something worth being concerned about. Equity markets had a serious slump yesterday, but I’m not here to talk about whether this means it is time to buy TSLA (after all, isn’t it always time to buy Tesla? Or so they say), but to talk about the other common belief and that is that having China shuttered for the better part of a quarter is deflationary. My tweet on the subject was, surprisingly, one of my most-engaging posts in a very long time.

The reason this distinction between “supply shock” and “demand shock” is important is that the effects on prices are very different. The first stylistic depiction below shows a demand shock; the second shows a supply shock. In the first case, demand moves from D to D’ against a stable supply curve S; in the latter case, supply moves from S to S’ against a stable demand curve D.

Note that in both cases, the quantity demanded (Q axis) declines from c to d. Both (negative) demand and supply shocks are negative for growth. However, in the case of a negative demand shock, prices fall from a to b; in the case of a negative supply shock prices rise from a to b.

Of course, in this case there are both demand and supply shocks going on. China is, after all, a huge consumption engine (although a fraction of US consumption). So the growth picture is unambiguous: Chinese growth is going to be seriously impacted by the virtual shutdown of Wuhan and the surrounding province, as well as some ports and lots of other ancillary things that outsiders are not privy to. But what about the price picture? The demand shock is pushing prices down, and the supply shock is pushing them up. Which matters more?

The answer is not so neat and clean, but it is neater and cleaner than you think. Is China’s importance to the global economy more because of its consumption, as a destination for goods and services? Or is it more because of its production, as a source of goods and services? Well, in 2018 (source: Worldbank.org) China’s exports amounted to about $2.5trillion in USD, versus imports of $2.1trillion. So, as a first cut – if China completely vanished from global trade, it would amount to a net $400bln in lost supply. It is a supply shock.

When you look deeper, there is of course more complexity. Of China’s imports, about $239bln is petroleum. So if China vanished from global trade, it would be a demand shock in petroleum of $240bln (about 13mbpd, so huge), but a bigger supply shock on everything else, of $639bln. Again, it is a supply shock, at least ex-energy.

And even deeper, the picture is really interesting and really clear. From the same Worldbank source:

China is a huge net importer of raw goods (a large part of that is energy), roughly flat on intermediate goods, and a huge net exporter of consumer and capital goods. China Inc is an apt name – as a country, she takes in raw goods, processes them, and sells them. So, if China were to suddenly vanish, we would expect to see a major demand shock in raw materials and a major supply shock in finished goods.

The effects naturally vary with the specific product. Some places we might expect to see significant price pressures are in pharmaceuticals, for example, where China is a critical source of active pharmaceutical ingredients and many drugs including about 80% of the US consumption of antibiotics. On the other hand, energy prices are under downward price pressure as are many industrial materials. Since these prices are most immediately visible (they are commodities, after all), it is natural for the knee-jerk reaction of investors to be “this is a demand shock.” Plus, as I said in the tweet, it has been a long time since we have seen a serious supply shock. But after the demand shock in raw goods (and possibly showing in PPI?), do not be surprised to see an impact on the prices of consumer goods especially if China remains shuttered for a long time. Interestingly, the inflation markets are semi-efficiently pricing this. The chart below is the 1-year inflation swap rate, after stripping out the energy effect (source: Enduring Investments). Overall it is too low – core inflation is already well above this level and likely to remain so – but the recent move has been to higher implied core inflation, not lower.

Now, if COVID-19 blossoms into a true global contagion that collapses demand in developed countries – especially in the US – then the answer is different and much more along the lines of a demand shock. But I also think that, even if this global health threat retreats, real damage has been done to the status of China as the world’s supplier. Although it is less sexy, less scary, and slower, de-globalization of trade (for example, the US repatriating pharmaceuticals production to the US, or other manufacturers pulling back supply chains to produce more in the NAFTA bloc) is also a supply shock.

Summary of My Post-CPI Tweets (February 2020)

February 13, 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 with interests in this area be sure to stop by Enduring Investments (updated site coming soon). 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.

  • Welcome to CPI day! Before we get started, note that at about 9:15ET I will be on @TDANetwork with @OJRenick to discuss the inflation figures etc. Tune in!
  • In leading up to today, let’s first remember that last month we saw a very weak +0.11% on core CPI. The drag didn’t seem to come from any one huge effect, but from a number of smaller effects.
  • The question of whether there was something odd with the holiday selling calendar, or something else, starts to be answered today (although I always admonish not to put TOO much weight on any single economic data point).
  • Consensus expectations call for +0.2% on core, but a downtick in y/y to 2.2% from 2.3%. That’s not wildly pessimistic b/c we are rolling off +0.24% from last January.
  • Next month, we have much easier comparisons on the y/y for a few months, so if we DO drop to 2.2% y/y on core today that will probably be the low for a little while. Feb 2019 was +0.11%, March was +0.15%, April was +0.14%, and May was +0.11%.
  • So this month we are looking to see if we get corrections of any of last month’s weakness. Are they one-offs? We are also going to specifically watch Medical Care, which has started to rise ominously.
  • One eye also on core goods, though this should stay under pressure from Used Cars more recent surveys have shown some life there. Possible upside surprise because low bar. Don’t expect Chinese virus effect yet, but will look for signs of it.
  • That’s all for now…good luck with the number!
  • Small upside surprise this month…core +0.24%, and y/y went up to 2.3% (2.27% actually).
  • We have changes in seasonal adjustment factors and annual and benchmark revisions to consumption weights this month…so numbers are rolling out slowly.
  • Well, core goods plunged to -0.3% y/y. A good chunk of that was because Used Cars dropped -1.2% this month, down -1.97% y/y.
  • Core services actually upticked to 3.1% y/y. So the breakdown here is going to be interesting.
  • Small bounce in Lodging Away from Home, which was -1.37% m/m last month. This month +0.18%, so no big effect. But Owners Equivalent Rent jumped +0.34% m/m, to 3.35% y/y from 3.27%. Primary Rents +0.36%, 3.76% y/y vs 3.69%. So that’s your increase in core services.
  • Medical Care +0.18% m/m, 4.5% y/y, roughly unchanged. Pharma fell -0.29% m/m after +1.25% last month, and y/y ebbed to 1.8% from 2.5%. That goes the other way on core goods. Also soft was doctors’ services, -0.38% m/m. But Hospital Services +0.75% m/m.
  • Apparel had an interesting-looking +0.66% m/m jump. But the y/y still decelerated to -1.26% from -1.12%.
  • Here is the updated Used Cars vs Black Book chart. You can see that the decline y/y is right on model. But should reverse some soon.

  • here is medicinal drugs y/y. You can see the small deceleration isn’t really a trend change.

  • Hospital Services…

  • Primary Rents…now, this and OER are worth watching. It had been looking like shelter costs were flattening out and possibly even decelerating a bit (not plunging into deflation though, never fear). This month is a wrinkle.

  • Core ex-housing 1.53% versus 1.55% y/y…so no big change there. The upward pressure on core today is mostly housing.
  • Whoops, just remembered that I hadn’t shown the last-12 months’ chart on core CPI. Note that the next 4 months are pretty easy comps. We’re going to see core CPI accelerate from 2.3%.

  • So worst (core) categories on the month were Used Cars and Trucks and Medical Care Commodities, which we’ve already discussed. Interesting. Oddly West Urban OER looks like it was down m/m although my seasonal adjustment there is a bit rough.
  • Biggest gainers: Miscellaneous Personal Goods, +41% annualized! Also jewelry, footwear, car & truck rental, and infants/toddlers’ apparel.
  • Oddly, it looks like median cpi m/m will be BELOW core…my estimate is +0.22% m/m. That’s curious – it means the long tails are more on the upside for a change.
  • Now, we care about tails. If all the tails start to shift to the high side, that’s a sign that the basic process is changing.
  • One characteristic of disinflation and lowflation…how it happens…is that prices are mostly stable with occasional price cuts. If instead we go to mostly stable prices with occasional price hikes, that’s an inflationary process. WAY too early to say that’s what’s happening.
  • Appliances (0.2% of CPI, so no big effect) took another big drop. Now -2.08% y/y. Wonder if this is a correction from tariff stuff.
  • Gotta go get ready for air. Last thing I will leave you with is this: remember the Fed has said they are going to ignore inflation for a while, until it gets significantly high for a persistent period. We aren’t there yet. Nothing to worry about from the Fed.

Because I had to go to air (thanks @OJRenick and @TDAmeritrade for another fun time) I gave a little short shrift on this CPI report. So let me make up for that a little bit. First, here’s a chart of core goods. I was surprised at the -0.3% y/y change, but it actually looks like this isn’t too far off – maybe just a little early, based on core import prices (see chart). Still, there has been a lot of volatility in the supply chain, starting with tariffs and now with novel coronavirus, with a lot of focus on the growth effects but not so much on the price effects.

It does remain astonishing to me that we haven’t seen more of a price impact from the de-globalization trends. Maybe there is some kind of ‘anchored inflation expectations’ effect? To be sure, it’s a little early to have seen the effect from the virus because ships which left before the contagion got started are still showing up at ports of entry. But I have to think that even if tariffs didn’t encourage a shortening of supply chains, this will. It does take time to approve new suppliers. Still I thought we’d see this effect already.

Let’s look at the four pieces charts. As a reminder, this is just a shorthand quartering of the consumption basket into roughly equal parts. Food & Energy is 20.5%; Core Goods is 20.1%; Rent of Shelter is 32.8%; and Core services less rent of shelter is 26.6%. From least-stable to most:

We have discussed core goods. Core Services less RoS is one that I am keeping a careful eye on – this is where medical care services falls, and those indices have been turning higher. Seeing that move above 3% would be concerning. The bottom chart shows the very stable Rents component. And here the story is that we had expected that to start rolling over a little bit – not deflating, but even backing off to 3% would be a meaningful effect. That’s what our model was calling for (see chart). But our model has started to accelerate again, so there is a real chance we might have already seen the local lows for core CPI.

I am not making that big call…I’d expected to see the local highs in the first half of 2020, and that could still happen (although with easy comps with last year, it wouldn’t be much of a retreat until later in the year). I’m no longer sure that’s going to happen. One of the reasons is that housing is proving resilient. But another reason is that liquidity is really surging, so that even with money velocity dripping lower again it is going to be hard to see prices fall. M2 growth in the US is above 7% y/y, and M2 growth in the Eurozone is over 6%. Liquidity is at least partly fungible when you have global banks, so we can’t just ignore what other central banks are doing. Over the last decade, sometimes US M2 was rising and sometimes EZ M2 was rising, but the last time we saw US>7% and EZ>6% was September 2008-May 2009. Before that, it happened in 2001-2003. So central banks are providing liquidity as if they are in crisis mode. And we’re not even in crisis mode.

That is an out-of-expectation occurrence. In other words, I did not see it coming that central banks would start really stepping on the gas when global growth was slowing, but still distinctly positive. We have really defined “crisis” down, haven’t we? And this isn’t a response to the virus – this started long before people in China started getting sick.

So, while core CPI is currently off its highs, it will be over 2.5% by summertime. Core PCE will be running up on the Fed’s 2% target, too. If the Fed maintains its easy stance even then, we will know they are completely serious about letting ‘er rip. I can’t imagine bond yields can stay at 2% in that environment.

A Generous Fed Isn’t Really the Good News it Sounds Like

October 31, 2019 14 comments

I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).

Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.

I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.

So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.

I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.

In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:

GDP = C + I + G + (X-M),

or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?

But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).

The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.

An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.


[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.

Tariffs Don’t Hurt Domestic Growth

August 28, 2019 7 comments

I really wish that economics was an educational requirement in high school. It doesn’t have to be advanced economics – just a class covering the basics of micro- and macroeconomics so that everyone has at least a basic understanding of how an economy works.

If we had that, perhaps the pernicious confusion about the impact of tariffs wouldn’t be so widespread. It has really gotten ridiculous: on virtually any news program today, as well as quite a few opinion programs (and sometimes, it is hard to tell the difference), one can hear about how “the trade war is hurting the economy and could cause a recession.” But that’s ridiculous, and betrays a fundamental misunderstanding about what tariffs and trade barriers do, and what they don’t do.

Because to the extent that people remember anything they were taught about tariffs (and here perhaps we run into the main problem – not that we weren’t taught economics, but that people didn’t think it was important enough to remember the fine points), they remember “tariffs = bad.” Therefore, when tariffs are implemented or raised, and something bad happens, the unsophisticated observer concludes “that must be because of the tariffs, because tariffs are bad.” In the category of “unsophisticated observer” here I unfortunately have to include almost all journalists, most politicians, and most alarmingly a fair number of economists and members of the Fed. Although, to be fair, I don’t think the latter two groups are making the same error as the former groups; they’re probably just confusing the short-term and the long-term or thinking globally rather than locally.

In any event, this reached a high enough level of annoyance for me that I felt the need to write this short column about the effects of tariffs. I actually wrote some of this back in June but needed to let it out again.

The effect of free trade, per Ricardo, is to enlarge the global economic pie. (Ricardo didn’t speak in terms of pie, but if he did then maybe people would understand this better.) However, in choosing free trade to enlarge the pie, each participating country surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off.

However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the US went through a period of truly sucking at automobile manufacturing, we still have the big three automakers. On the other hand, the US no longer produces any apparel to speak of. In fact, I would suggest that the only way that free trade works at all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself. Many would argue that (b) is what happened, as the US was willing to let its manufacturing be ‘hollowed out’ in order to make the world a happier place on average. Enter President Trump, who suggested that as US President, it was sort of his job to look out for US interests. And so we have tariffs and a trade war.

What is the effect of tariffs?

  1. Tariffs are good for the domestic growth of the country imposing them. There is no question about it in a static equilibrium world: if you raise the price of the overseas competitor, then your domestic product will be relatively more attractive and you will be asked to make more of it. If other countries respond, then the question of whether it is good or bad for growth depends on whether you are a net importer or exporter, and on the relative size of the Ex-Im sector of your economy. The US is a net importer, which means that even if other countries respond equally it is still a gain…but in any event, the US economy is relatively closed so retaliatory tariffs have a comparatively small effect. The effect is clearly uneven, as some industries benefit and some lose, but tariffs are a net gain to growth for the US in the short term (at least).
  2. Tariffs therefore are good for US employment. In terms of both growth and employment, recent weakness has been blamed on tariffs and the trade war. But this is nonsense. The US economy and the global economy have cycles whether or not there is a trade war, and we were long overdue for a slowdown. The fact that growth is slowing at roughly the same time tariffs have been imposed is a correlation without causality. The tariffs are supporting growth in the US, which is why Germany is in a recession and the US is not (yet). Anyone who is involved with a manufacturing enterprise is aware of this. (I work with one manufacturer which has suddenly started winning back business that had previously been lost to China in a big way).
  3. Tariffs are bad for global growth. The US-led trade war produces a shrinkage of the global pie (well, at least a slowing of its growth) even as the US slice gets relatively larger. But for countries with big export-import sectors, and for our trade partners who are net exporters to the US and have tariffs applied to their goods, this is an unalloyed negative. And as I said, more-fractious trade relationships reduce the Ricardian comparative advantage gain for the system as a whole. It’s just really important to remember that the gains accrue to the system as a whole. The question of whether a country imposing tariffs has a gain or a loss on net comes down to whether the growth of the relative slice outweighs the shrinkage of the overall pie. In the US case, it most certainly does.
  4. Trade wars are bad for inflation, everywhere. I’ve written about this at length since Trump was elected (see here for one example), and I’d speculated on the effect of slowing trade liberalization even before that. In short, the explosion of free trade agreements in the early 1990s is what allowed us to have strong growth and low inflation, even with a fairly profligate monetary policy, as a one-off that lasted for as long as trade continued to open up. That train was already slowing – partly because of the populism that helped elect Mr. Trump, and partly because the 100th free trade agreement is harder than the 10th free trade agreement – and it has gone into reverse. Going forward, the advent of the trade war era means we will have a worse tradeoff of growth and inflation for any given monetary policy. This was true anyway as the free-trade-agreement spigot slowed, but it is much more true with a hot trade war.
  5. Trade wars are bad for equity markets, including in the US. A smaller pie means smaller profits, and a worse growth/inflation tradeoff means lower growth assumptions need to be baked into equity prices going forward. Trade wars are of course especially bad for multinationals, whose exported products are the ones subject to retaliation.

In the long run, trade wars mean worse growth/inflation tradeoffs for everyone – but that doesn’t mean that every country is a net loser from tariffs. In the short run, the effect on the US of the imposition of tariffs on goods imported to the US is clearly positive. Moreover, because the pain of the trade war is asymmetric – a country that relies on exports, such as China, is hurt much more when the US imposes tariffs than the US is hurt when China does – it is not at all crazy to think that trade wars in fact are winnable in the sense of one country enlarging its slice at the expense of another country or countries’ slices. To the extent that the trade war is “won,” and the tariffs are not permanent, then they are even beneficial (to the US) in the long run! If the trade war becomes a permanent feature, it is less clear since slower global growth probably constrains the growth of the US economy too. Permanent trade frictions would also produce a higher inflation equilibrium globally.

In this context, you can see that the challenge for monetary policy is quite large. If the US economy were not weakening anyway, for reasons exogenous to trade, then the response to a trade war should be to tighten policy since tariffs lead to higher prices and stronger domestic growth. However, the US economy is weakening, and so looser policy may be called for. My worry is that the when the Federal Reserve refers to the uncertainty around trade as a reason for easing, they either misapprehend the problem or they are acting as a global central bank trying to soften the global impact of a trade war. I think a decent case can be made for looser monetary policy – but it doesn’t involve trade. (As an aside: if central bankers really think that “anchored inflation expectations” are the reason we haven’t had higher inflation, then why are they being so alarmist about the inflationary effects of tariffs? Shouldn’t they be downplaying that effect, since as long as expectations remain anchored there’s no real threat? I wonder if even they believe the malarkey about anchoring inflation expectations.)

Do I like tariffs? Well, I don’t hate them. I don’t think the real economy is the clean, frictionless world of the economic theorists; since it is not, we need to consider how real people, real industries, real companies, and real regimes behave – and play the game with an understanding that it may be partially and occasionally adversarial, rather than treating it like one big cooperative game. There are valid reasons for tariffs (I actually first enumerated one of these in 1992). I won’t make any claims about the particular skill of the Trump Administration at playing this game, but I will say that I hope they’re good at it. Because if they are, it is an unalloyed positive for my home country…whatever the pundits on TV think about the big bad tariffs.

What “Transitory Factors” Might Tell Us About Inflation

May 23, 2019 2 comments

There is a lot of buzz around inflation these days. Some people are explaining why we shouldn‘t worry and some people why we should, but regardless – it’s a topic of conversation for the first time in ages. And despite this (or rather, because of it, because I find myself very busy these days), I haven’t written in a long time despite the fact that I have a few things worth writing about. I keep trying, though.

Today I am cheating a bit and taking a column from the quarterly inflation outlook that my company (Enduring Investments) just sent to customers. But I think it is fair to include it here, because the musing was provoked by a recent exchange I had on Twitter while doing my monthly CPI analysis/tweetstorm (follow me @inflation_guy).

As readers know, I tend to focus on Median CPI, rather than Core CPI, as my forecast target variable. The reason is that price changes are rarely distributed randomly. If they were, then the choice of core or median CPI would be irrelevant because they would normally be the same, or roughly the same. But when a distribution has long tails, the ends of the distribution exert a lot of pressure on the average and so median can differ substantially from the mean simply because one tail is much longer than the other even if most of the distribution is similar.

Consider a playground see-saw and imagine that on one side of the see-saw are seated several small children. Think of the “average” of the see-saw system as the point where the see-saw balances. Well, there are lots of ways to balance the system with weight on the other side of the see-saw: a very large weight close to the fulcrum will do it. But the further away from the fulcrum one places the weight, the smaller the weight necessary to balance the scale. As Archimedes said, “give me a lever long enough, and a place to stand, and I can move the world.” The point is that an influence far from the middle of the distribution can have a very significant effect on the average because it is far away from the distribution:  the effect on the mean is (weight * distance from the mean).

Example: the mean of 98% of a distribution is 12. The remaining 2% of the distribution is 28. The weighted average is [(12 * 0.98) + (118 * .02)] / (0.98 + 0.02) = 14.12.  That little 2% caused the mean to go from 12, without the tail, to 14.12 with the tail…a movement of 17.7%! Notice that .02 * 118 = 2.12, which is the amount the mean moved. And if that tail is 228 rather than 118, the mean goes to 16.32. So you see, the length of the tail matters. In both cases, the median was 12, which I would argue is a better indicator of the “central tendency” of the distribution.

(If the distribution is approximately normal, then the tails roughly balance and so the mean and median are about the same. But many economic indicators are not normally distributed, especially ones like income or home prices which are bound by zero on one side. Thus, for many economic series the median, rather than mean, is a better measure. Even though CPI is not bound by zero, it is not normal because prices are not set in a continuous process but instead to have jump-discontinuities.)

The chart below, which I often show in my CPI tweetstorm, shows the see-saw of CPI, where I’ve broken up the index into its lowest-level components and placed those weights on a number line representing the most-recent year-over-year changes. The height of the bar indicates the amount of the basket that sits in that bucket. As you can see, nearly half of the CPI is inflating faster than 3% (which is why Median CPI is 2.8%), and the mode of the distribution is between 3.5% and 4.0%. But because of the far left tail, the mean – which is what core CPI is – is just barely over 2%. Because we have much longer left-hand tails than right-hand tails, the average is biased lower relative to median.

But is this “normal?” Some people have occasionally accused me of picking Median CPI because it tends to be higher, and so the number makes it look like there is more inflation. If the spread were constant, then it would be a bit academic which we chose as the forecast variable, and in fact Core would have a better claim since after all, as consumers purchasing that basket we are in fact paying the average price and not the median.

In fact, though, I think that the tendency of core in recent years to trade below median really is its own interesting story about how prices evolve. If we have 3% inflation, it does not mean that all prices are going up at 3% per year, 0.75% per quarter, 0.25% per month. The price of any given good doesn’t move smoothly but rather episodically, sporadically, spastically. When we are in a disinflationary period, or anyway a low-inflation period, what is happening is that those episodes involve periods of slower prices and “transitory factors” that tend to be on the downside.[1] In that sense, it may be that the Fed, and me/Enduring, both err when they try to look through ‘transitory factors’ because transitory factors may be part of the process. The argument for that perspective is similar to the argument I myself make about why “ex-items” measures make sense when you are looking at an individual company’s earnings but not when you look at the aggregate earnings of the economy. Because bad stuff, or “items,” are always happening to someone somewhere. You can throw them out of any one analysis but if you own the index, you’ll get some of those “items.” You just don’t know from where. Perhaps inflation is the same way.

However, I should point out that median inflation is not always below core. The chart below shows median and core CPI going back to 1983, which is when the Cleveland Fed’s series for Median CPI begins. Notice that from 1983 until 1993, Median CPI was generally lower than core CPI. In 1994, this changed and it has been the opposite ever since.

The year 1994 is significant because that is also the year that most models for inflation that are calibrated on pre-1994 data break down (or, conversely, it is the year prior to which a model calibrated on post-1994 data breaks down). I have written previously about this phenomenon and the fact that the Fed believes this is when inflation expectations abruptly became “anchored,” whatever that means – but *I* believe that this discontinuity is when globalization kicked into high gear with an explosion in the number of bilateral and multilateral trade agreements. It strikes me as plausible that these items are related. When markets are suddenly opened to global competition, affected markets will suddenly show slower price appreciation due to the pressure from that competition (and the replacement of high-cost domestic goods with lower-cost imports). But which market is currently being affected will not stay constant, but change over time. In other words, I think the fact that core has been persistently below median for a long time is a symptom of the globalization “dividend.”

If I am right, and if if I am also right about the arrow of globalization changing direction, then it follows that core and median might flip positions at some point over the next couple of years. And then the “transitory effects” will be mostly on the high side.


[1] It could also be indicative of a bias from the measurers that their improved methods are always looking for lower inflation – not in the “the BLS is making up this *@&$^” sense but in the sense that for lots of reasons the CPI appears to be overstated because of technical details about the functional form, the way measurement errors happen, etc. And so researchers may spend more time looking for ways that inflation is overstated. I don’t think that research bias is actually much of a problem. But I figured I ought to mention that that is one possible interpretation.

Categories: Causes of Inflation, CPI

What if ‘Excess Reserves’ Aren’t Really Excess?

March 4, 2019 2 comments

One intriguing recent suggestion I have heard recently is that the “Excess” reserves that currently populate the balance sheet of the Federal Reserve aren’t really excess after all. Historically, the quantity of reserves was managed so that banks had enough to support lending to the degree which the Fed wanted: when economic activity was too slow, the Fed would add reserves and banks would use these reserves to make loans; when economic activity was too fast, the Fed would pull back on the growth of reserves and so rein in the growth of bank lending. Thus, at least in theory the Open Markets Desk at the New York Fed could manage economic activity by regulating the supply of reserves in the system. Any given bank, if it discovered it had more reserves than it needed, could lend those reserves in the interbank market to a bank that was short. But there was no significant quantity of “excess” reserves, because holding excess reserves cost money (they didn’t pay interest) – if the system as a whole had “too many” reserves, banks tended to lend more and use them up. So, when the Fed wanted to stuff lots of reserves into the system in the aftermath of the financial crisis, and especially wanted the banks to hold the excess rather than lending it, they had to pay banks to do so and so they began to pay interest on reserves. Voila! Excess reserves appeared.

But there is some speculation that things are different now because in 2011, the Basel Committee on Banking Supervision recommended (and the Federal Reserve implemented, with time to comply but fully implemented as of 2015) a rule that all “Systematically Important Financial Institutions” (mainly, really big banks) be required to maintain a Liquidity Coverage Ratio (LCR) at a certain level. The LCR is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) by a number that represents its stress-tested 30-day net outflows. That is, the bank’s liquidity is expressed as a function of the riskiness of its business and the quantity of high-quality assets that it holds against these risks.

In calculating the HQLA, most assets the bank holds receive big discounts. For example, if a bank holds common equities, only half of the value of those equities can be considered in calculating this numerator. But a very few types of assets get full credit: Federal Reserve bank balances and Treasury securities chief among them.[1]

So, since big banks must maintain a certain LCR, and reserves are great HQLA assets, some observers have suggested that this means the Fed can’t really drain all of those excess reserves because they are, effectively, required. They’re not required because they need to be held against lending, but because they need to be held to satisfy the liquidity requirements.

If this is true, then against all my expectations the Fed has, effectively, done what I suggested in Chapter 10, “My Prescription” of What’s Wrong with Money? (Wiley, 2016). I quote an extended section from that book, since it turns out to be potentially spot-on with what might actually be happening (and, after all, it’s my book so I hereby give myself permission to quote a lengthy chunk):

“First, the Federal Reserve should change the reserve requirement for banks. If the mountain will not come to Mohammed, then Mohammed must go to the mountain. In this case, the Fed has the power (and the authority) to, at a stroke, redefine reserves so that all of the current “excess” reserves essentially become “required” reserves, by changing the amount of reserves banks are required to hold against loans. No longer would there be a risk of banks cracking open the “boxes of currency” in their vaults to extend more loans and create more money than is healthy for an economy that seeks noninflationary growth. There would be no chance of a reversion to the mean of the money multiplier, which would be devastating to the inflation picture. And the Open Markets Desk at the Fed would immediately regain power over short-term interest rates, because when they add or subtract reserves in open market operations, banks would care.

“To be sure, this would be awful news for the banks themselves and their stock prices would likely take a hit. It would amount to a forcible deleveraging, and impair potential profitability as a result. But we should recognize that such a deleveraging has already happened, and this policy would merely recognize de jure what has already happened de facto.

“Movements in reserve requirements have historically been very rare, and this is probably why such a solution is not being considered as far as I know. The reserve requirement is considered a “blunt instrument,” and you can imagine how a movement in the requirement could under normal circumstances lead to extreme volatility as the quantity of required reserves suddenly lurched from approximate balance into significant surplus or deficit. But that is not our current problem. Our current problem cries out for a blunt instrument!

“While the Fed is making this adjustment, and as it prepares to press money growth lower, they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise.

“Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. It is possible that, as this happens, reserve requirements could be edged incrementally back to normal as well. But those decisions are years away.”

If, in fact, the implementation of the LCR is serving as a second reserve requirement that is larger than the reserve requirement that is used to compute required and “excess” reserves, then the amount of excess reserves is less than we currently believe it to be. The Fed, in fact, has made some overtures to the market that they may not fully “normalize” the balance sheet specifically because the financial system needs it to continue to supply sufficient reserves. If, in fact, the LCR requirement uses all of the reserves currently considered “excess,” then the Fed is, despite my prior beliefs, actually operating at the margin and decisions to supply more or fewer reserves could directly affect the money supply after all, because the reserve requirement has in effect been raised.

This would be a huge development, and would help ameliorate the worst fears of those of us who wondered how QE could be left un-drained without eventually causing a move to a much higher price level. The problem is that we don’t really have a way to measure how close to the margin the Fed actually is; moreover, since Treasuries are a substitute for reserves in the LCR it isn’t clear that the margin the Fed wants to operate on is itself a bright line. It is more likely a fuzzy zone, which would complicate Fed policy considerably. It actually would make the Fed prone to mistakes in both directions, both over-easing and over-tightening, as opposed to the current situation where they are mostly just chasing inflation around (since when they raise interest rates, money velocity rises and that pushes inflation higher, but raising rates doesn’t also lower money growth since they’re not limiting bank activities by reining in reserves at the margin).

I think this explanation is at least partly correct, although we don’t think the condition is as binding as the more optimistic assessments would have it. The fact that M2 has recently begun to re-accelerate, despite the reduction in the Fed balance sheet, argues that we are not yet “at the margin” even if the margin is closer than we thought it was previously.


[1] The assumption in allowing Treasuries to be used at full value seems to be that in a crisis the value of those securities would go up, not down, so no haircut is required. Of course, that doesn’t always happen, especially if the crisis were to be caused, for example, by a failure of the government to pay interest on Treasuries due to a government shutdown. The more honest reason is that if the Fed were to haircut Treasuries, banks would hold drastically fewer Treasuries and this would be destabilizing – not to mention bad for business on Capitol Hill.

Inflation-Related Impressions from Recent Events

September 10, 2018 2 comments

It has been a long time since I’ve posted, and in the meantime the topics to cover have been stacking up. My lack of writing has certainly not been for lack of topics but rather for a lack of time. So: heartfelt apologies that this article will feel a lot like a brain dump.

A lot of what I want to write about today was provoked/involves last week. But one item I wanted to quickly point out is more stale than that and yet worth pointing out. It seems astounding, but in early August Japan’s Ministry of Health, Labour, and Welfare reported the largest nominal wage increase in 1997. (See chart, source Bloomberg). This month there was a correction, but the trend does appear firmly upward. This is a good point for me to add the reminder that wages tend to follow inflation rather than lead it. But I believe Japanese JGBis are a tremendous long-tail opportunity, priced with almost no inflation implied in the price…but if there is any developed country with a potential long-tail inflation outcome that’s possible, it is Japan. I think, in fact, that if you asked me to pick one developed country that would be the first to have “uncomfortable” levels of inflation, it would be Japan. So dramatically out-of-consensus numbers like these wage figures ought to be filed away mentally.

While readers are still reeling from the fact that I just said that Japan is going to be the first country that has uncomfortable inflation, let me talk about last week. I had four inflation-related appearances on the holiday-shortened week (! is that an indicator? A contrary indicator?), but two that I want to take special note of. The first of these was a segment on Bloomberg in which we talked about how to hedge college tuition inflation and about the S&P Target Tuition Inflation Index (which my company Enduring Investments designed). I think the opportunity to hedge this specific risk, and to create products that help people hedge their exposure to higher tuition costs, is hugely important and my company continues to work to figure out the best way and the best partner with whom to deploy such an investment product. The Bloomberg piece is a very good segment.

I spent most of Wednesday at the Real Return XII conference organized by Euromoney Conferences (who also published one of my articles about real assets, in a nice glossy form). I think this is the longest continually-running inflation conference in the US and it’s always nice to see old friends from the inflation world. Here are a couple of quick impressions from the conference:

  • There were a couple of large hedge funds in attendance. But they seem to be looking at the inflation markets as a place they can make macro bets, not one where they can take advantage of the massive mispricings. That’s good news for the rest of us.
  • St. Louis Fed President James Bullard gave a speech about the outlook for inflation. What really stood out for me is that he, and the Fed in general, put enormous faith in market signals. The fact that inflation breakevens haven’t broken to new highs recently carried a lot of weight with Dr. Bullard, for example. I find it incredible that the Fed is actually looking to fixed-income markets for information – the same fixed-income markets that have been completely polluted by the Fed’s dominating of the float. In what way are breakevens being established in a free market when the Treasury owns trillions of the bonds??
  • Bullard is much more concerned about recession than inflation. The fact that they can both occur simultaneously is not something that carries any weight at the Fed – their models simply can’t produce such an outcome. Oddly, on the same day Neel Kashkari said in an interview “We say that we have a symmetric view of inflation. We don’t mind if it’s 2.1 or 1.9, but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.” That’s ludicrous, by the way – there is no way in the world that the Fed would have done the second and third QEs, with the recession far in the rear view mirror, if the Fed was more concerned with high inflation. Certainly, Bullard showed no signs of even the slightest concern that inflation would poke much above 2%, much less 3%.
  • In general, the economists at the conference – remember, this is a conference for people involved in inflation markets – were uniform in their expectation that inflation is going nowhere fast. I heard demographics blamed (although current demographics, indicating a leftward shift of the supply curve, are actually inflationary it is a point of faith among some economists that inflation drops when the number of workers declines. It’s actually a Marxist view of the economic cycle but I don’t think they see it that way). I heard technology blamed, even though there’s nothing particularly modern about technological advance. Economists speaking at the conference were of the opinion that the current trade war would cause a one-time increase in inflation of between 0.2%-0.4% (depending on who was speaking), which would then pass out of the data, and thought the bigger effect was recessionary and would push inflation lower. Where did these people learn economics? “Comparative advantage” and the gain from trade is, I suppose, somewhat new…some guy named David Ricardo more than two centuries ago developed the idea, if I recall correctly…so perhaps they don’t understand that the loss from trade is a real thing, and not just a growth thing. Finally, a phrase I heard several times was “the Fed will not let inflation get out of hand.” This platitude was uttered without any apparent irony deriving from the fact that the Fed has been trying to push inflation up for a decade and has been unable to do so, but the speakers are assuming the same Fed can make inflation stick at the target like an arrow quivering in the bullseye once it reaches the target as if fired by some dead-eye monetary Robin Hood. Um, maybe.
  • I marveled at the apparent unanimity of this conclusion despite the fact that these economists were surely employing different models. But then I think I hit on the reason why. If you built any economic model in the last two decades, a key characteristic of the model had to be that it predicted inflation would be very low and very stable no matter what other characteristics it had. If it had that prediction as an output, then it perfectly predicted the last quarter-century. It’s like designing a technical trading model: if you design one that had you ‘out’ of the 1987 stock market crash, even if it was because of the phase of the moon or the number of times the word “chocolate” appeared in the New York Times, then your trading model looks better than one that doesn’t include that “factor.” I think all mainstream economists today are using models that have essentially been trained on dimensionless inflation data. That doesn’t make them good – it means they have almost no predictive power when it comes to inflation.

This article is already getting long, so I am going to leave out for now the idea I mentioned to someone who works for the Fed’s Open Market Desk. But it’s really cool and I’ll write about it at some point soon. It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.

So I’ll move past last week and close with one final off-the-wall observation. I was poking around in Chinese commodity futures markets today because someone asked me to design a trading strategy for them (don’t ask). I didn’t even know there was such a thing as PVC futures! And Hot Rolled Coils! But one chart really struck me:

This is a chart of PTA, or Purified Terephthalic Acid. What the heck is that? PTA is an organic commodity chemical, mainly used to make polyester PET, which is in turn used to make clothing and plastic bottles. Yeah, I didn’t know that either. Here’s what else I don’t know: I don’t know why the price of PTA rose 50% in less than two months. And I don’t know whether it is used in large enough quantities to affect the end price of apparel or plastic bottles. But it’s a pretty interesting chart, and something to file away just in case we start to see something odd in apparel prices.

Let me conclude by apologizing again for the disjointed nature of this article. But I feel better for having burped some of these thoughts out there and I hope you enjoyed the burp as well.

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