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Summary of My Post-CPI Tweets (April 2021)

April 13, 2021 2 comments

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

  • Good Morning #CPI observers! Prepare for what is potentially the most entertaining #inflation figure in a while.
  • Before I get started, let me first note that I’ll be a guest on tdameritradenetwork.com (http://tdameritradenetwork.com) with @OJRenick at around 10:20ET this morning. Tune in!
  • Today’s walk-up is a little different. I usually try and focus mostly on the y/y numbers because the m/m numbers are an accumulation of random distributions around 280 other numbers. That is a lot of noise compared to signal and so I don’t like to forecast monthlies.
  • However, on a y/y basis the noise tends to cancel so it’s a clearer reading. Median CPI is even better because it lessens the impact of the tails.
  • This month, however, and for the next few months the y/y number is a distraction. We KNOW it’s going to jump a lot because the comparisons to March, April, and May 2020 are super easy. So instead, we want to focus on what happens to the monthlies.
  • I warned about this back in February in “The Risk of Confusing Inflation Frames.” https://mikeashton.wordpress.com/2021/02/04/the-risk-of-confusing-inflation-frames/ And now…here we are.
  • So looking back at the last couple of months, we see that the core CPI figures were soft. Last month, core CPI (but not median CPI!) was soft because of surprising movements in goods, outside of housing. It had been goods pressing core inflation higher so that was surprising.
  • Turns out that some of that was (probably) due to the fact that the weather prevented the BLS from surveying certain prices. So we’d expect a little catch-up from last month’s +0.10% core, just as a null hypothesis.
  • Some of the places we are pretty sure to see strength are in autos, apparel, and the travel categories. Used car prices are nuts. But in the bigger picture, there are a lot of shortages out there and they all push prices the same way.
  • I talked about some of those shortages in my article at the end of March. https://mikeashton.wordpress.com/2021/03/30/how-many-shortage-anecdotes-equal-data/ How Many ‘Shortage’ Anecdotes Equal Data?
  • There are shortages in autos (due to semiconductors as well as lower fleet sales into the used car channel), packaging, cotton, containers, rental cars, Uber drivers, other goods…and shelter.
  • In shelter, rents have been artificially soft because of the eviction moratorium, which has made realized rents decelerate while asking rents are rising rapidly with home prices. That divergence is unusual and it’s due to the eviction moratorium.
  • The Biden Administration just extended that moratorium (was due to expire end of March) so that catch-up will come later. However there are SOME signs that rents are improving anyway. I’ll be looking for that. Rents were not as soft last month as they had been recently.
  • The economist consensus is for a core CPI m/m of about 0.2%. That seems low to me with all of the potential upside disturbances, and has got to mean that economists are expecting further shelter weakness. I don’t.
  • The market doesn’t either. Interbank trading of the (headline) price number implies about 0.1% higher than the economists expect. Most of that in core presumably. I would not be surprised in the slightest at +0.3% core.
  • We will see. Remember, the Fed doesn’t really care – and they’re working hard to tell you that you shouldn’t either. Eventually, the market will win. But not for a while. It will be late 2021 before the dust clears on the base effects.
  • So keep an eye on those underlying pressures and don’t get distracted by the y/y fog of war. I will talk today in terms of y/y figures, out of habit, but rest assured I’m watching the small ball too.
  • Thanks for coming along today on this crazy ride. Good luck! 6 minutes to print.
  • OK, core came in at 0.34% m/m, so quite a bit higher than estimates. y/y rose to 1.646%…so ALMOST rounded to a 2-tenth miss on the y/y figure.
  • Note in that chart, they’re not y/y. There’s no base effects there. In fairness, we probably should combine the last two figures, and get something like 0.22% per month, but that’s still faster than the Fed would like. Except they don’t care.
  • So Core Goods jumped back up to 1.70% y/y, where it had been 2 months ago before dropping to 1.3% y/y last month. Collection issues. Core Services up to 1.6%.
  • Primary rents +0.15%; OER +0.23%. Not as soft as a couple of months ago, but not overly strong either. Lodging Away from Home was +3.84% m/m, which pushed the Housing category to a +0.34% m/m rise…same as core, weirdly.
  • Apparel fell again. That’s a bit odd. Apparel had been doing well partly because cotton imports from part of China were being held up at the ports…maybe that’s lessening now. Anyway Apparel isn’t a big piece.
  • Pharmaceuticals: +0.08%. Doctors’ Services: +0.28%. Hospital Services +0.63%. First time I can remember them all three being positive in a while! Softness in Pharma is still surprising to me.
  • Doctors’ Services highest in years (y/y).
  • Hospital Services, despite this month’s jump…not so much.
  • Back to used cars. Part of what is happening here is that rental fleets shrunk last year so they are providing fewer cars to the used car markets. Part is the semiconductor shortage making new cars expensive. But Black Book says…this has a lot further to go in months ahead.
  • Ah. Core CPI ex Shelter jumped up to 1.61% y/y. Yeah, I know I said y/y. But that was at 1.7% last February BEFORE the COVID slide. Arguably it means price pressures are higher now than before COVID, and CPI is being held down by rents.
  • This isn’t from the CPI report but a reminder of what is happening in rents. If a landlord is unsure of being able to collect the rent, it goes in a zero. Doesn’t take many zeroes to lower measured rent. And the number of zeroes is higher when the gov’t says you can’t evict.
  • Other COVID categories: Airfares +0.44% m/m (fell 5% last month!), Lodging away from home I already mentioned +3.8% (-2.3% last month). Motor Vehicle Insurance +0.85% m/m.
  • New Cars, interestingly, was flat. That’s odd – there’s clearly a shortage of semiconductors so maybe this is more a situation of you can’t get ’em so the price doesn’t change? I’d expect that to rise going forward.
  • Car and truck RENTAL: +13.4% (SA) m/m. Here’s the m/m and y/y, which is now up to +31%. If you can’t buy ’em, you can try to rent ’em. Remember how I said fleets are smaller?
  • Now, Median CPI giveth and Median CPI taketh away. Hard to tell because median category will probably be a regional OER, but m/m will be probably 0.2-0.22%. Median y/y won’t change much b/c base effects were mainly from a few small categories with large moves.
  • That warrants further comment: the fact that we didn’t see a GENERAL deceleration in prices, but a very focused one, should make you wonder about output gap models. Most of the economy wasn’t in deflation. Hotels and airfares were though!
  • Only two core categories with more than a 10% annualized decline this month: Women & Girls’ Apparel (-28%), and Infants’ and Toddlers’ Apparel (-22%).
  • On the gainer side, tho: Car/Truck Rental as noted, Jewelry/Watches (+80.7% ann’lz), Lodging AFH (57%), Motor Vehicle Insurance (+47%), Men’s/Boys Apparel (+35%…hey!!), Misc Personal Svcs (+16%), Motor Vehicle Maintenance & Repair (+12%).
  • Core goods & Core services. Both rose, and remain atop one another. How long can goods stay elevated? Port traffic is improving, slowly. But materials prices remain stubbornly high and global trade remains fractious.
  • ok, gotta wrap it up and get to makeup for my appearance on @TDANetwork at 10:20. KIDDING, no makeup. You can dress a monkey in silk but it’s still a monkey. Anyway, I’ll do the four-pieces and then conclude. Will put out the diffusion indices later.
  • Piece 1: Food & Energy. No surprises here: it was expected to jump as gasoline prices continue to recover.
  • Piece 2: Core Goods. Back to the highs.
  • Core services less Rent of Shelter. This still remains bizarre to me. But medical finally showed some life this month and there’s sign of pressures in the PPI there so maybe it’s coming. Hard to see an uptrend here though unless you turn it upside-down.
  • Finally, Rent of Shelter. It seems it may be done going down, and there’s a lot of catch-up to do when the moratorium ends. But the last 2 months of rents have been more normal.
  • So at this hour, 10-year breakevens are +1bp and stocks are flat. Because the Fed doesn’t care, and the punch bowl remains. I guess that’s about the summary here. The base effects are going to obfuscate whatever is really happening underneath.
  • BUT, what is happening underneath (per the chart of core-ex-shelter) appears to be price pressures that are certainly no smaller than pre-COVID. Are they temporary? How will we know? If the Fed says they are, and are wrong…bad.
  • If the Fed says the pressures are NOT transitory, and are wrong, and over-tighten, that’s also bad – but for employment. And here’s the thing, this Fed has said repeatedly that full Employment is their main goal. So errors are designed into the system to be inflation-enhancing.

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

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

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

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

Money Illusion and Boiling Frogs

March 23, 2021 6 comments

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

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

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

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

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

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

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

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

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

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

Summary of My Post-CPI Tweets (August 2020)

August 12, 2020 4 comments

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

  • Well, it’s CPI day and I have to tell you I’m looking forward to this one and I’ll tell you why.
  • Used cars! The Black Book retention index jumped about 9% last month after 8.5% the prior month. There’s typically a 3-month lag before it gets into CPI, but w/ a big move it’s harder to say. Each of those jumps would be worth about 0.3% on core, and we have two of them coming.

  • That being said, (a) there is still one dip we haven’t seen yet so we COULD have a dip in used cars this month. It would be surprising, but it would mean we can prep for a couple of really good numbers. So I’m excited either way.
  • And it’s not just used cars. Now that things are opening up, we’re going to see pressures in other places. Medical care started to show some ups last month and I expect that to continue as hospitals are hurting for revenue.
  • Last month we also saw strong apparel, lodging away from home, and airfares, which were rebounding from the covid-induced swoon. I think that could continue, and it’s an interesting story line to watch.
  • On the other hand – this is next month’s story but college tuitions are likely to decline this year because colleges are giving discounts. Even though the product has changed in quality (e-learning not the same as in-person), the BLS has decided it can’t quality-adjust easily.
  • So CPI for college-tuition-and-fees – again, probably next month – will fall and then rebound hard next year. So that’s fun. It’s not right, but it’s okay, as the saying goes.
  • Shelter last month, ex-hotels, was soft. That’s the only fly in the inflationary ointment, but it’s a big one. So far it doesn’t look like rents are likely to decelerate much overall, nor housing prices fall – but if they do, that’s a big deal.
  • I will be looking at core-ex-housing to see if pressures are broadening, but looking at shelter b/c it’s a big, slow item. If shelter weakens appreciably, it will be news – historically, with the last recession being an exception, housing prices and rents almost never FALL.
  • But they can slow, and with incomes sketchy housing inflation probably SHOULD slow. If it doesn’t, that’s a real sign that the rising monetary tide is raising all assets. (And goods and services). FWIW, wages also aren’t slowing. Atlanta Fed wages are +3.8% y/y.
  • (There’s interesting stuff around the disconnect between wages and the unemployment rate right now, but I’ll save that for a blog post another time. Not really a CPI-day thing.)
  • Consensus today is for 0.2% on core CPI, but a soft 0.2% with y/y falling to 1.1%. I think there’s lots of upside to that if Used Cars pops, but a little downside if shelter is weak again. I’m in the “probably higher” camp.
  • Good luck! And if you’re curious about what an inflation guy does when it’s not CPI day, stop by Enduring Investments: http://enduringinvestments.com
  • Oh, yes.
  • I don’t think we need to worry much about the rounding this month. Core +0.6% m/m; y/y to 1.6% when it was expected to drop to 1.1%.
  • FWIW, that was rounded down. +0.62% m/m on core. Repeat: rounded down. I will have to check but that is the biggest monthly figure in decades.
  • I think I soiled myself.
  • There are going to be a lot of crazy charts like this one this month. This is the last 12 core CPI prints.

  • y/y core rose from 1.19% to 1.57%, in one month. Core goods were -1.10% y/y; now they are -0.5%. Core services were 1.90%; now they’re 2.3%.
  • Take that Keynesians. WHERE’S YOUR OUTPUT GAP MODEL NOW? …but I shouldn’t celebrate. All of those degrees…and poor Nomura forecasting outright deflation…
  • Now interestingly, Used Cars and Trucks was up, 2.33% m/m, but that’s not the big jump yet. (!)

  • Lodging Away from Home, another COVID-casualty, was +1.2% m/m. Same as last month. But the y/y is still -13.26% (was -13.92%).
  • Primary rents rebounded some, +0.19% vs +0.12% last month, and OER as well +0.21% from +0.09%. Those are m/m numbers, and the y/y are still softening though: 3.12% for primary rents and 2.80% for OER, down from 3.22%/2.84%. But not collapsing.
  • OK, I said I was going to be interested in core-ex-housing. It jumped from 0.35% y/y to +1.01% y/y. Now, that’s only the highest since March but again: the deflation dragon, if not slain, is pretty sick.
  • Apparel was +1.08% m/m, but y/y is still -6.4% (was -7.2%). Like the other belly-flop categories, there’s still a lot of recovery to come.
  • So how are the doctors doing? Medical Care was +0.41% m/m, but that actually dropped the y/y slightly to 5.02% from 5.08%. However, that’s mostly because Pharma remains weak.
  • CPI for Medicinal Drugs was flat again. +0.02% this month; -0.01% last month. The y/y is down to 1.1%.

  • But Physicians’ Services up to 2.58% y/y (up 0.67% this month)

  • And hospital services hanging out at around 5% y/y. Look, like many services these are all becoming more labor-intensive and that means…more expensive. Some of that might come back, some day.

  • Totally forgot airfares: +5.4% m/m after +2.6% m/m last month. But still down a lot from the peak. Here’s the y/y figure.

  • And a quick check of the markets: 10-year breakevens +3.5bps, kinda surprised it’s not more. 5y breakevens +5bps. Some of this might just be time for price discovery. I know when I was a CPI swaps dealer, it took some time before we knew wth was the right price.
  • BTW that core increase was the biggest monthly increase since 1991. That predates TIPS by 6 years.
  • Now, college tuition and fees rose to 2.09% y/y from 1.74% y/y. That’s interesting, as that serious ought to be declining next month. And for tuitions, that’s a largeish m/m change. Interesting.
  • Let’s see. Biggest m/m declines: misc personal goods (-41.7% annualized) and meats, poultry, fish & eggs (-36.9%, but it had been up a lot too).
  • The list of gains annualizing more than 10% has 14 categories. Includes motor vehicle insurance, car/truck rental, public transportation, used cars/trucks, communication, jewelry, footwear, lodging away from home…
  • Now, those who live by Median CPI ought to also die by Median CPI. I’ll convert you all, eventually. Median this month will be something like +0.21%, because it ignores the upside long tails like it did the downside ones. y/y will actually decline to 2.56%
  • The message there is just that the underlying trends are pretty stable. But it’s not insignificant that the tails shifted to the right side from the left side. As I’ve said before, that’s sort of what infl looks like in practice, just as disinflation has one-offs to the left.
  • Health insurance y/y is a little softer, down to 18.7% y/y from 19.4%. So we got that going for us.

  • This is the distribution of y/y changes in the CPI. There’s still a big left tail anchor which is why core is below median. But this is a much more balanced distribution than it has been in a while.

  • And here’s the weight of categories going up by more than 2.5% y/y. The weight is the highest since July 2008.

  • That doesn’t look very deflationary to me.
  • Putting together the four-pieces charts and then I’ll wrap up.
  • Piece 1 – food and energy. With all of the wild swings, it’s net-net kinda boring.

  • Piece 2, core goods. This was the piece that was getting a wind behind it because of trade frictions when the crisis hit. Big bounce this month. Much of that is autos, but as I pointed out early: the BIG jump in car prices hasn’t hit the data yet.

  • Piece 3, core services less rent of shelter. Also a big recovery, and some of this is airfares. Some also is medical care. But there are a number of other categories contributing here. Still kind of trendless last 5y, overall.

  • Piece 4, the biggest and slowest piece, and looks scary. Until you remember this includes hotels (lodging away from home). If you take that out, shelter has decelerated some but not a lot, and certainly not in a disturbing way like this appears. Don’t project this!

  • OK to sum up. I saw someone call this a “noisy” report. Well, only in the sense of clanging cymbals. The data here all swung in one direction – but there really weren’t a lot of surprises, per se. The only surprise was the synchony of the surprises to one side.
  • As I said up top, we still have a couple of +0.3% boosts (maybe +0.2% if we’re ahead of mode) coming from used cars. And a lot of the beaten-down categories haven’t really recovered (apparel, etc) fully.
  • THAT’S what’s surprising. This wasn’t the left tail snapping back, much. This was a much broader advance than the decline had been. The decline had been 4 categories: lodging AFH, used cars, airfares, apparel. Way more here.
  • There are lots of bumps ahead, including the question of whether home prices and rents decelerate when and if incomes decline. We aren’t seeing that yet. And with M2 growing at 23% per year, it’s hard to believe asset prices can decline very much. Including housing.
  • The fun thing to think about is: what is happening at the Fed today? Are they clapping wildly, that they succeeded in pushing prices up? Or are they somber, wondering if they might have overdone it? Or are they focusing on median CPI and saying, meh?
  • My guess is that there’s a bit of nervousness. The Fed wants to overshoot 2%, but they don’t want to put it at 6%. I’ve said for a long time: creating inflation is easy. Creating A LITTLE inflation is hard.
  • Well, that was fun. Thanks for tuning in. I’ll put a summary on my blog relatively shortly. Again, if today’s number makes you think ‘hey, maybe we should talk to an inflation guy and see if he can help us’, stop by our website: https://enduringinvestments.com Have a nice day.

I don’t know whether to be exhausted or energized. I think I’ll go with energized, because this is not likely to be the last surprise in inflation prints. We are entering a period, not only of higher inflation (probably), but also much higher inflation volatility. That’s important, because a key underpinning of the valuation argument for stocks and bonds is that inflation is not only low, it’s low and stable and therefore can be ignored in calculations. But if inflation is volatile, and especially if it’s high and volatile, then  companies and investors need to include it in their calculus. And if the inflation factor ends up becoming significant again, after more than a decade of irrelevance, then it means that (a) stocks and bonds will become increasingly correlated and (b) stock and bond valuations will be lower.

Now, I don’t know if the markets really understand what’s going on. In fact, this number was so outside of expectations I think that investors just dismissed it as a one-off, like April’s number. But it’s not. This was not just a snapback of the depressed categories; indeed, most of the categories that were depressed because of Covid (lodging away from home, airfares, e.g.) are still depressed although they’ve rebounded a little. This was much broader than that. But investors have pushed 10-year breakevens up only 3-4bps, to 1.66%. Stocks are soaring, and 10-year nominal yields are a mere 3.5bps higher. Commodities are flat. Gold, after a bloodbath yesterday, is flat today. The only way those reactions make sense is if investors are missing the significance.

When the unemployment rate shoots higher, then you can understand a positive market reaction because investors have come to count on the Fed supporting markets in that circumstance. But that reasoning doesn’t make sense here. Nothing about a 7.2% annualized rate of inflation (0.6% * 12) would make the Fed eager to add more liquidity. Ergo, it must be that investors just don’t care about the inflation numbers, or they think this is a random miss.

They should care. This isn’t a one-standard-deviation miss; it’s the biggest monthly print in thirty years and there was no big outlier. While it doesn’t guarantee that inflation is heading higher, the question is whether this print is consistent with our a priori model of the world.

If you’re a Keynesian, the answer is absolutely not. So economists who are output-gap focused are going to say that this number doesn’t matter; it’s ‘quirky’ or ‘noisy’ or ‘measurement error’; the output gap is going to drag down inflation. Maybe that’s why investors are nonchalant about this…because they’re being told by the bow-tie set to look through it.

But if you’re a monetarist, this is entirely consistent with your a priori model. The only surprising thing about this is that it is happening so soon. I was thinking we would see inflation rise starting in Q4 and it would get messy in 2021. I might have to move up the timetable. Because this number is entirely consistent with my model, I’m much less sanguine. This might be only the first shot over the bow… Indeed, over the next several months I can say that since we are confident that used car prices are going to add a lot to core inflation, we will probably have at least one or two more prints of 0.4%-0.5% on core over the next three months. If we get 0.4%, 0.2%, 0.4%, then in three months core CPI will be back to 2.25% y/y, and that with unemployment still in the high-single or low-double-digits. And it could actually be worse than that. Without home prices collapsing, it’s hard to see it being much better than that and absolutely no way to see how prices (or even the inflation rate) could be lower than that unless something really, really weird happens.

Well, 2020 is the year of really, really weird so I suppose I will never say never. But inflation hedges remain super cheap; if you’ve been waiting to scoop them up I can’t see any argument for waiting any more.

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 6 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.

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