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Summary of My Post-CPI Tweets

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. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Ah, CPI day!
  • Writing today from the skies above…Pennsylvania maybe? Hi Pennsylvania!
  • Not sure how well this will work…bear with me.
  • Street forecast for core is 0.182% or so m/m, rounding to 0.2% and 2.2% y/y.
  • But if core is only 0.187% m/m, y/y will rise to 2.3% after rounding. So a low hurdle for a “surprise”
  • Since this year core has averaged 0.208% (and 0.243% ex-March), I suspect a good chance of a 2.3% y/y print.
  • Over the next 2 months we have comparisons of 0.173% and 0.155% from year-ago, so core likely rises further.
  • As a reminder, median CPI is already at 2.53% and a 7-year high so such a move in core isn’t a shock.
  • But all that is in the future. We get today’s CPI in 14 minutes.
  • Note my response to tweet messages will be worse than normal today… from 35,000 feet this is a bit wonky.
  • 17% on core. y/y to 2.23% from 2.24%. Be still my heart.
  • Have to wait for the breakdown…not trusting numbers at this altitude. But looks like Medical Care jumped. Not sure what went dn then.
  • OK, Housing 2.39% from 2.38%. Apparel 0.42% from 0.53%; Medical Care – 3.65% from 3.17%! Small drips elsewhere.
  • Core services stayed 3.2% and core goods dripped to -0.6% y/y.
  • Within Housing: Primary rents 3.81% from 3.80%. Should keep rising. OER 3.25% from 3.26% ditto.
  • Big jump in Lodging Away from Home: small category and volatile but excites some people. Not me.
  • Motor vehicles -0.82% from -0.50%, still dragging on core goods.
  • In Medical Care: Drugs 3.40% from 2.34%. Yes, >1% acceleration in y/y. Volatile but…
  • Balancing that a bit was Professional Services 2.60% from 2.81%. But Hospital Services 4.12% from 3.25%.
  • And Health Insurance? +7.10% vs 6.30%. Thanks, ACA.
  • With drugs pushing core goods higher, not sure what was going the other way enough to make core goods decelerate some.
  • Good Lord they just said we’re over Wisconsin. Already?
  • Take this projection for Median CPI with a grain of salt, but looks to me like +0.19% and the annual rate stays 2.5%.
  • biggest monthly declines were toddlers’ apparel, jewelry and watches, footwear, and used cars/trucks.
  • biggest monthly gains in fuel oil, motor fuel, car and truck rental, and medical care commodities (drugs).
  • core ex-housing still fairly low at 1.37%.
  • Overall – core and median inflation still are in rising trends, but nothing particularly alarming about this month’s figure.
  • Certainly, nothing that is going to turn Pres. Mester from talking about helicopter drops to talking about tightening.
  • That’s all for now…thanks for bearing with me.
  • Be sure to look at our Crowdfunder equity raise: https://www.crowdfunder.com/enduring-investments-llc … The subscription package is up and live!

Last month’s core inflation number was not pretty. Medical care rose, rents jumped, and in general it was a sloppy mess. This month is not like that. The story is one of continuing trends: a trend to higher rents, higher medical care inflation; continued weakness in apparel and transportation and other core goods. The key point though is that there is no sign that inflation is about to fall. Whether bottom-up, aggregated from the detailed pricing data, or top-down, looking at money supply growth and possible velocity outcomes, the uptrend in prices looks steady.

While that could change, if interest rates continue to decline and depress money velocity even further, it can’t be the null hypothesis at this point. What is amazing is that the market, in its pricing of inflation, has made that the null hypothesis. Breakeven inflation is low, low, low for more than a decade in the future according to the market. Considerably lower than today’s core inflation. It is a bet that looks increasingly out-of-whack.

Categories: CPI, Tweet Summary

UK Property Price Declines – Rational or Overdone?

July 7, 2016 4 comments

A couple of weeks after Brexit, and the world has not ended. Indeed, in the UK the fallout seems relatively tame. Sterling has weakened substantially, which will increase UK inflation relative to global inflation; but it will also help UK growth relative to global growth. That’s not a bad tradeoff, compared to predictions of the end-of-days. Although I am not so sure I like the tradeoff from Europe’s perspective…

There are a number of UK property funds that have been gated – but this appears to be not so much a Reserve Fund moment, and certainly not a Lehman moment, but just a natural reaction when a fund gives broader liquidity terms than the market for the underlying securities offers.

I think the property panic is probably overdone. It is partly triggered by fears that the financial center is going to leave London. This strikes me as absurd, having worked for several of the institutions that have offices in Canary Wharf. I checked my gut reaction with a friend who actually headed up a large banking institution for a time. His answer was “you are right to be very skeptical: English, availability of workforce, taxation, labor laws, contract law and legal framework. There will be some shifting at the margin but that’s it.” Brittania is not about to sink beneath the waves, folks.

Were UK property values overinflated? At least UK home prices don’t appear much more out-of-whack than US home prices do. The chart below (source: Bloomberg) shows the UK national average home price from the Nationwide Building Society (in white) versus the US median existing home sales price.

USUKhomeprices

The picture looks more concerning if, instead of median home sales, you use the Case-Shiller Home Price Index as a comparison (see chart, source: Bloomberg). But while the CS20 is a superior measure of home prices, I’m always a bit wary of comparing two series that are constructed methodologically very differently. Still, this comparison would suggest UK prices have risen more than their US counterparts.

ukvsshiller

These comparisons are all on residential property, and I am comparing two markets which are likely both a bit overheated. But the scale of decline in the UK property funds seems to me to be too large relative to the overpricing that may exist, and I suspect it is more due (as I noted above) to the structure of the funds holding the property – which would suggest, in turn, that halting redemptions is the right thing to do to protect existing investors who would be disadvantaged if the portfolio was liquidated into a market that is not designed to have daily liquidity. Of course, the right answer is to not offer those liquidity terms in the first place…

One little niggling detail, however, deserves mention. I noted that UK home prices do not appear terribly out-of-whack relative to US home prices. The problem is that US home prices themselves appear out-of-whack by roughly 15-20%. The chart below (source: Bloomberg; Enduring Investments calculations and estimates) shows median home prices as a multiple of median incomes. What is apparent is that for many years these two series moved in lock-step, until the bubble; the popping of the bubble sent everything back to “normal” but we’re back to looking bubbly.

darndata

That said, I don’t believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it’s probably a good opportunity for cool-headed investors…and, more to the point, cool-headed investors who aren’t expecting to liquidate investments overnight.

Categories: Housing, UK

Summary of My Post-CPI Tweets

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. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI coming up in 15 mins. Consensus is +0.3% headline +0.2% core, putting y/y core up to 2.2% again.
  • Base effects for core suggest better chance for y/y rise for next 4mo or so.
  • Stay tuned, 10mins to CPI. In the meantime why not check out our Crowdfunding campaign? https://www.crowdfunder.com/enduring-investments-llc … (Accredited inv only)
  • Core CPI +0.203% m/m; y/y rises to 2.235%.
  • Core goods remains at -0.5% y/y; core services rises to 3.2%, highest since 2008.
  • Housing jumped to 2.37% y/y from 2.11%. Looking at breakdown to see if that’s in rents or elsewhere in housing.
  • Medical Care had fallen from 3.29% y/y to 2.98% last month. Back up to 3.17%, which is the general trend: higher.
  • Apparel flipped to +0.58% y/y vs -0.57% y/y. Only about 5% of core CPI, but a bellwether we’ve been watching (with little result so far).
  • tweeted this earlier…note that strong base effects lifted y/y CPI but next 3 months comparison also easy.

last12

  • Within Housing, Primary rents rise to 3.80% from 3.73%. OER jumps HUGE, to 3.264% from 3.147%. Big jump for a big part of basket.
  • …and that’s not a misprint. All pressures on rents are higher, and remain higher.
  • Lodging away from home is small, but was a drag last mo. Not this mo: rises to 3.83% y/y from 1.32%
  • In Medical Care, drugs actually fell to 2.34% y/y from 2.84%. But professional svcs 2.81% from 2.26%; Hospital svcs 3.25% v 3.15%
  • Health insurance 6.30% y/y from 5.80%.
  • y/y change in Health Insurance CPI

bfmE9AC

  • y/y in med care services – resuming uptrend

medcaresvcs

  • optimists can look at core ex-housing and see a rise to only 1.42%. But that’s b/c goods carry much more weight in that look.
  • W/in transportation, new and used vehicles was actually a drag, -0.50% y/y from -0.27%. That’s in core goods.
  • y/y core hasn’t been above 3% for 20 years. But will be in 2017.
  • y/y core hasn’t been above 3% for 20 years. But will be in 2017.
  • Early estimate of Median CPI…+0.26% m/m with y/y going to 2.53%, a new cycle high.
  • Probably a good time to mention the crowdfunding for Enduring Investments again: https://www.crowdfunder.com/enduring-investments-llc… Own an inflation manager!
  • Bottom line for today: nothing at all soothing in this report. Upward inflation trend continues.

Nothing at all soothing, indeed. A day after the FOMC chose to stand pat on interest rates, core inflation pushed back higher and median inflation is about to push above 2.5% for the first time since 2009 (when it was on the way down). Of course, nothing about this inflation picture, and the rotten internals that suggest higher figures are in store, would have changed the Fed’s decision yesterday. As noted previously in this space, the Yellen Fed fundamentally does not believe that inflation is a threat; if it is a threat, they believe a little inflation is okay if allowing inflation to run hot helps the overall economy and the little guy; and if they later decide inflation does need to be addressed, it can be easily reined in.

They are wrong on all three counts, and we may well be seeing the beginnings of a colossal error. Honestly, the question here is between whether it is only a bad error that is fixable or a colossal error that isn’t fixable without much pain. Inflation is headed higher.

And yet, ironically, standing pat on interest rates will slow down the near-term rise in inflation since it will keep money velocity from rising as rapidly as it would if interest rates were rising. The best way to keep cash inert is for alternative investment opportunities to remain poor! But money growth around 7% is too fast, even if velocity merely flatlines. Inflation will continue to rise for the balance of this year and into 2017 (at least).

Categories: CPI, Tweet Summary

Summary of My Post-CPI Tweets

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. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • In prep for CPI: Econs forecasting about 0.15% core; Cleveland Fed’s Nowcast is 0.18%; avg of last 4 months is 0.20%.
  • So, econs which have been too bullish on econ for a year (see citi surprise index) are bearish on CPI.
  • If we get any m/m core less than 0.20% (even 0.19%), y/y will round to 2.1% b/c dropping off high 2015 April.
  • But after that, next 8 months from 2015 were <0.20% so any downtick wouldn’t be start of something new.
  • Hard to tell but the core CPI print was SLIGHTLY above expectations. 0.195%, so y/y was 2.147%.
  • In other words, if someone charged another nickel for a candy bar somewhere we would have had 2.2% again. <<hyperbole
  • That 0.195% m/m was lower than April 2015, but higher than May, June, July, Aug, Sep, Nov, and Dec.
  • Core services unch at 3.0%; core goods downticked to -0.5% y/y.
  • y/y Medical Care decelerated for second month in a row, down to 2.98% y/y; still looks to be in a broad uptrend from 2% in 2014. [ed note: chart added for clarity]

medcarecpi

  • Within Medical Care, medicinal drugs accelerated, prof svcs was flat. Hospital svcs dropped from 4.33 to 3.15% y/y
  • Hospital services oscillates – we’ll probably get that back to 4%-4.5% which will push med care back up.
  • Primary Rents 3.73% from 3.66%. OER 3.15% from 3.12%. Some were expecting deceleration there. Not us!
  • Lodging Away from Home dropped to 1.32% from 2.27%. That, and various home furnishings, is why Housing subcat went to 2.12 vs 2.14.
  • But Rents and OER are the stable measures…not Lodging, not furnishings.
  • Core ex-housing fell to 1.39% from 1.48%, but again that’s due to elements of med care and housing that are likely to rebound.
  • Lots of movement within Apparel but overall nothing. The February pop looks like a one-off.
  • Overall, a more buoyant number than expected and the stuff holding core CPI down are the transient things.
  • Biggest m/m declines: infants’/toddlers’ apparel (-26.5% annualized), fresh fruits & veggies; women’s apparel; Lodging away from home.
  • Biggest m/m outliers: Motor Fuel (+152.3% annualized), Fuel Oil, Processed Fruits & Veggies; Motor Vehicle Insurance.
  • My estimate of median CPI is actually 0.28% m/m and 2.46% y/y. But…
  • …but the median category this month may be affected by regional housing, and I don’t have the BLS factors. So grain of salt needed.
  • This summarizes the inflation story. Rents and Services ex-rents both rising ~3%. Core goods is the anchor.

threecat

Discussion: after last month’s surprising m/m core CPI print of +0.07%, many were questioning whether that was the outlier, or whether the +0.29% and +0.28% of January and February were the outliers. The answer might be that they are all outliers, as this month’s print was very close to the 4-month average. But even so, +0.2% m/m would produce a 2.4% core inflation number by the year’s end. That’s consistent with what we are being told by Median inflation. Both figures would suggest core PCE, after all of the temporary effects are removed, is essentially at or slightly above the Fed’s 2% target.

There are two pertinent questions at this juncture. The first is whether the Fed will feel any urgency to raise rates more quickly because of this data. The answer to that, I think, is clearly “no.” This Federal Reserve’s reaction function seems to be overly (and overtly) tilted towards growth indicators – and even more than that, their forecast of growth indicators. The majority of the Committee also believes that inflation expectations are “anchored” and so inflation can’t really move higher very quickly. They only pay lip service to inflation concerns, and honestly they aren’t even very good at the lip service.

The second question is where inflation goes next. Whether the Federal Reserve raises the target overnight rate or not, the question of inflation is relevant for markets. And the indicators seem to be fairly clear: the larger and more persistent categories are seeing price increases of around 3% or more, while the main drag comes from a “core goods” component that is highly influenced by the lagged effect of dollar strength (see chart, source Bloomberg).

coregoodsvsusd

Recently, the dollar has been weakening marginally but still is in a broad uptrend (looking at the broad, trade-weighted dollar). But if the buck merely goes flat, core goods will start to move higher. And that means even if core services remain steady, core inflation should push towards 3% later this year.

This doesn’t sound like much but it would be highly significant (and surprising) for many observers, investors, and consumers. Core inflation has not been above 3% for two decades (see chart, source Bloomberg).

coreCPIunder3

This means – incredibly – that many students in college today have never seen core inflation above 3%, and more importantly many investors have not seen core inflation above 3% during their investment lives. When core inflation breaches that level, it will feel like hyperinflation to some people! And I do not think markets will like it.

Inflation with Deflationary Overtones?

The Employment report was weak, with jobs coming in below consensus with a downward revision to prior months. It wasn’t abysmally weak, and not enough to change the a priori trajectory of the Fed. If the number had been 125k below expectations or 125k above it, then it may have had implications for the FOMC. But this is a number that has big swings and is revised multiple times. Getting 160k rather than 200k isn’t cause for celebration, but neither is it cause for panic. So whatever the Fed was getting ready to do didn’t change because of this number.

To be sure, no one knows what the Fed was planning to do, so this mainly has implications for the day’s volatility…which is to say that the market quickly went to sleep for the day.

Now, interestingly the Average Hourly Earnings number ticked higher to 2.5%, continuing the post-crisis upswing. At 2.5%, hourly earnings growth is slightly higher than median inflation and thus potentially “supportive of the inflation dynamic” from the standpoint of the Committee. Yes, wages follow inflation but not in the Fed models – so, while I don’t think this has any implications for future inflation it will eventually have implications for Fed policy. But this is a dovish Fed, and 2.5% earnings growth is not going to scare another tightening out of them…unless they were already planning to tighten.

Wages are actually a bit higher than that. Back in April I highlighted the Atlanta Fed’s Wage Growth Tracker and summarized how this measures is better than Hourly Earnings. I hadn’t been aware of this index previously but I follow it now. It stands at 3.2%. The difference between average hourly earnings and the Atlanta Fed Wage Tracker is summarized below (Source: Bloomberg). Again, though: I don’t think we have seen anything today which will change the Fed’s collective opinion about the need for different monetary policy.

wages

Earlier this week, I promised that I would revisit the question of how we can have both deflation and inflation, and how these concepts are confused. I first posted an article summarizing this point in January 2014, and in re-reading it I think it is good enough to pretty much cut-and-paste with only mild edits. So here it is:

How Inflation and Deflation Can Peacefully Coexist

In the discussion about whether the economy is exhibiting “inflationary tendencies” or “deflationary tendencies,” I find that many, many observers grow confused by the fact that we measure prices in dollars, which are themselves subject to changes in relative value due to supply and demand.

It helps to forget about dollars as the unit of measure. Just because it says “One Dollar” does not mean that it is an ever-fixed mark. With apologies to Shakespeare, dollars are not the star to every wandering bark, whose worth’s unknown although its dollar price be taken.[1]  There are two ways to look at the “inflation/deflation” debate. Depending on which one you are referring to, deflationary tendencies are not inconsistent with price inflation, and price inflation is not inconsistent with deflationary tendencies.

One is the question of dollar price; and here we are mainly concerned with the supply of dollars and the number of times they are spent, compared to the amount of stuff there is to buy. More dollars chasing the same goods and services imply higher prices. Of course, this is just another way of stating the monetarist equation: P ≡ MV/Q. This is an identity and true by definition. Moreover, it is true in practice: rapid money growth over some moderate length of time always corresponds with rapid deterioration in the purchasing power of the money unit – in other words, inflation. At least, we have no examples of (a) extremely high money growth without high inflation, or (b) extremely high inflation without high money growth.

But this is not the same discussion as saying that “the aging demographic [or debt implosion in a recession] means we will have deflation,” as many economists will have it. Deflation, in that sense, can still happen: if you have fewer workers making the same amount of GDP, then goods (and services) prices will fall relative to wages, which would be deflation the way we typically mean it if the overall price level was otherwise unchanged. However, if the money supply increases by a factor of 10, then nominal prices will increase no matter what else is going on. It may be, though, that in this case wages will increase slightly more than prices, so that there will be “deflation” in the unitless sense.

So, these are not inconsistent statements: (a) there will be increasing inflation next year, and (b) large amounts of private debt and demographic “waves” around the world are a deflationary force. The resolution to the seeming inconsistency is that (b) causes downward pressure on certain prices relative to other prices or, if you ignore the unit of exchange, it causes downward pressure in the ratio of one good that can be exchanged for another. Yet at the same time (a) implies that the overall increase in output in goods and services will be outstripped by the number of dollars spent on them, driving prices higher.

So you should cheer for the “good” sort of deflation. At least, you should cheer for it if you are still earning wages. But do not confuse that concept with the notion that prices in dollar terms will fall. That is wholly different, and unless central banks screw up pretty badly it is not going to happen. Indeed, despite all of the so-called “deflationary tendencies” – most of which I agree are important – I believe prices are going to rise in dollar terms and in fact they are going to rise at increasing rates (higher inflation) over the next few years.[2]

P.S. Don’t forget to buy my book! What’s Wrong with Money: The Biggest Bubble of All. Thanks!

[1] See Sonnet 116, in case you missed out on a liberal arts education and don’t get the reference!

[2] I kept this sentence…it was true in January 2014, as median inflation moved from 2.06% in Dec 2013 to 2.4% today, but I also believe this to be still true. Only the next leg will probably be faster.

A Broken Clock That is Persistently Wrong

Durable goods orders, ex-transportation, showed a negative print today for the second time in a row. This was expected, in most senses of the word, but while I don’t put too much weight on short-term wiggles in Durables it is hard to ignore the fact that the year/year change in Durables has now been negative for more than a year (see chart, source Bloomberg).

coredurables

So the weakness in Durables is not new. But it bears noting that the last time core Durables went negative, in August 2012, the Fed followed with QE3 almost immediately. To be sure, at the time core inflation was all the way down at 1.9%, whereas today it is a heady 2.2%…

Look, any Fed watcher right now is and should be confused. Conditions which provoked QE just four years ago are now apparently spurring a tightening bias. Bill Gross can be excused for thinking that the Fed will go back to the old playbook and employ new QE, as he apparently did in his latest Investment Outlook – it is harder to excuse his saying that the Fed should drop money, given that it hasn’t worked yet.

But clearly, something is different in the way the central bank is approaching monetary policy. After all, nothing about this weakness is new. As noted, Durables have been negative on a year-over-year basis for a full year, and the Citi Economic Surprise index shows that economists have managed to be surprised on the negative side for an unprecedented fifteen months in a row (see chart, source Bloomberg).

cesi

Okay, the index technically turned positive once or twice for a day or two, but this is still the longest run of persistently optimistic errors that economists have had in a very long time. So this isn’t new – the economy is weak.

Unless…unless what is different is that in 2012, economists were pessimistic (the Citi Economic Surprise index turned positive right before the Fed started QE, which means that either the data was too strong or economists were too negative) whereas today they are more generally optimistic? It would be entirely consistent with how the Fed has been run for the last couple of decades if monetary policy was not being guided by actual data, but by forecasts of data. (See my book for more on monetary policy errors!)

Evidence is pretty clear that recently economists as a whole have not only been wrong, but wrong in a biased way, which is much worse. If you are merely a bad shot, you miss the target in all kinds of directions. But if you persistently miss the target in one direction, then it may well be that your weapon sights are not properly calibrated. The first sort of unbiased miss is not as dangerous, even if too much confidence is placed on the shot, because the errors will even out over time. You might eventually hit the target, by accident. But if the target sights are biased, then you will never hit the target until you realize you’re wrong. You would be tightening when you should be easing. A broken clock is right twice per day, but only if it is stopped and not just systematically two hours off.

Now, regular readers of these columns will understand that I don’t think the Fed should be easing. I don’t think the Fed can fix what ails growth, since monetary policy only affects the price variable, and easy money has only created the conditions for the inflationary upswing we are currently experiencing (Gross also acknowledges this, but sees the inflationary upswing somewhere in the unthreatening future while in fact it is here now). The Fed should have eschewed QE2 and QE3, and have long since begun to drain excess reserves. But what I think the Fed should do and forecasting what I think they will do are two very different things.

I suspect Gross is close to right. Absent some recovery in the real economy – something other than payrolls, which as we know lag – it strikes me as unlikely the Fed will be hiking rates again. Ironically, that may help keep inflation leashed for longer since it will help keep monetary velocity constrained – but I am not confident of that, given how low interest rates already are. Since inflation is very unlikely to wane any time soon, I think we are more likely to see the yield curve steepen from these levels, rather than flatten. A yield curve inversion is not a prerequisite for recession. Inverted yield curves tend to precede recessions only because the Fed is typically slow to lower interest rates in response to obvious weakness. In this case, rates are already low and the Fed isn’t likely to raise them and force a curve inversion. Yield curve inversions are not causal! This next recession may catch some people wrong-footed because they keep waiting for the inversion that never comes.

In my next article, I am going to revisit an issue I first addressed a couple of years ago and which might be especially relevant as recession possibilities increase: the question of how we can have both deflation and inflation, and how these concepts are often confused by those people who are stuck in the nominal world.

Irrational Lugubriousness on Inflation

Today the 1-year CPI swap rate closed at 1.77%, the highest rate since 2014 (see chart, source Bloomberg).

1ycpiswap

The CPI swap (which, as an aside, is a better indicator of expected inflation than are breakevens, for technical reasons discussed here for people who truly have insomnia) indicates that headline inflation is expected to be about 1.77% over the next year. That’s nearly double the current headline inflation rate, but well below the Fed’s target of roughly 2.3% on a CPI basis. But at least on appearances, investors seem to be adjusting to the reality that inflation is headed higher.

Unfortunately, appearances can be deceiving. And in this case, they are. The headline inflation rate is of course the combination of core inflation plus food inflation and energy inflation; as a practical matter most of the volatility in the headline rate comes from the volatility endemic in energy markets. I’ve observed before that this leads to unreasonable volatility in long-term inflation expectations, but in short-term inflation expectations it makes perfect sense that they ought to be significantly driven by expectations for energy prices. The market recognizes that energy is the source of inflation volatility over the near-term, which is why the volatility curve for inflation options looks strikingly like the volatility curve for crude oil options and not at all like the volatility curve for LIBOR (see chart, source Enduring Investments).

volcompar

The shape of the energy futures curves themselves also tell us what amount of energy price change we should include in our estimate of future headline inflation (or, alternatively, what energy price change we can hedge out to arrive at the market’s implied bet on core inflation). I am illustrating this next point with the crude oil futures curve because it doesn’t have the wild oscillations that the gasoline futures curve has, but in practice we use the gasoline futures since that is closer to the actual consumption item that drives the core-headline difference. Here is the contract chart for crude oil (Source: Bloomberg):

crudeccrv

So, coarsely, the futures curve implies that crude oil is expected to rise about $4, or about 9%, over the next year. This will add a little bit to core inflation to give us a higher headline rate than the core inflation rate. Obviously, that might not happen, but the point is that it is (coarsely) arbitrageable so we can use this argument to back into what the market’s perception of forward core inflation is.

And the upshot is that even though 1-year CPI swaps are at the highest level since 2014, the implied core inflation rate has been steadily falling. Put another way, the rise in short inflation swaps has been less than the rally in energy would suggest it should have been. The chart below shows both of these series (source: Enduring Investments).

ImpliedCore

So – while breakevens and inflation swaps have been rallying, in fact this rally is actually weaker than it should have been, given what has been happening in energy markets. Investors, in short, are still irrationally lugubrious about the outlook for price pressures in the US over the next few years. Remember, core CPI right now is 2.2%. How likely is it to decelerate 1.5% or more over the next twelve months?

(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)

Categories: Commodities, CPI, Good One, Theory
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