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CPI, Your Way

January 21, 2016 2 comments

For those of you on the East coast, looking for something fun to do with your weekend between shoveling turns, I thought this might be a good time to introduce our “personal CPI calculator.”

Sounds exciting, right?

It is an old idea: one of the reasons that people don’t like the Consumer Price Index is that no one is an “average” consumer. Everyone consumes more or less than the “typical” amounts; moreover, everyone notices or cares more about some costs than they do for others. It turns out that for most people, the CPI is a decent description of their consumption, at least close enough to use the CPI as a reference…but that answer varies with the person.

Moreover, CPI turns out to be a very poor measure for a corporate entity, which cares much more about some costs than others. Caterpillar cares a lot about grain prices, energy prices, and most importantly tractor prices, but they don’t care much about education. (This is one reason that corporate entities don’t issue inflation-linked bonds…it isn’t really a hedge for them. Which is why I have tried for years to get inflation subindices quoted and traded, so that issuers could issue bonds linked to their particular exposures, and investors could construct the precise exposure they wanted. But I digress.)

The BLS makes available many different subindices, and the weights used to construct the index from these subindices. Last year, the Federal Reserve Bank of Atlanta published on their macroblog an article about what they call “myCPI.” They constructed a whole mess of individualized market baskets, and if you go to the blog post they will direct you to a place you can get one of these market baskets emailed to you automatically every month. Which is pretty good, and starting to be what I think we need.

But what I wanted was something like this, which has been available from the Federal Statistical Office of Germany for years. I want to chart my own CPI, and be able to see how varying the weights of different consumption would result in different comparative inflation rates. The German FSO was very helpful and even offered their code, but in the end we re-created it ourselves but tried to preserve some of the look-and-feel of the German site (which is itself similar to the French site, and there are others, but not for US inflation).

Here is the link to Enduring’s “Personal CPI Calculator.” I think it is fairly self-explanatory and you will find it addicting to play around with the sliders and see how different weights would affect the effective price inflation you experience. You can also look at particular subindices, through the “products” button. Some of these are directly BLS series (but normalized to Jan 1999=100), and some are collections of subindices that I did to make the list manageable.

I think you’ll find it interesting. If you do, let me know!

Categories: CPI, New Products

Summary of My Post-CPI Tweets

January 20, 2016 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 with interests in this area be sure to stop by Enduring Investments. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.

  • So I guess the good news this morning is that the market has bigger worries than CPI. Wait, is that good news?
  • OK, remember this morning we’re dropping off some lousy numbers so core should rise to 2.1% just on base effects.
  • But Dec CPI is always weird, like many Dec numbers. It’s the only month that has a strong seasonal effect on prices (in the US).
  • Headline CPI will also rise, y/y, simply because of base effects. Don’t think the Fed didn’t know this when they tightened!
  • OK, +0.1% on core a bit weaker than expected, but y/y still rose to 2.1%. y/y headline to 0.7%, though I don’t care about headline.
  • Core month/month was 0.13% to 2 decimal places, and forecasters were really looking for 0.18%ish, so not horrible miss.
  • y/y core is 2.09% to 2 decimals. I really thought it would go to 2.2% this month, but like I said, Dec is wacky.
  • Next mo we compare to +0.18% in Jan 2015 (on core), so uptick to 2.2% will be more difficult. But core should converge with median.
  • OK, in big categories Housing and Medical care decelerated while Apparel, Transp, and Educ/communication accelerated.
  • In Medical Care (which is only 7.7% of CPI but high-angst for people), big drop in medicinal drugs to 1.66% from 2.68%.
  • That smacks of a seasonal maladjustment. But it’s only 1.7% of the basket.
  • In Housing, Primary Rents and OER both accelerated, which is what matters. Primaries 3.68% from 3.64%; OER 3.14% from 3.08%.
  • Those are the pendulous categories, between them almost half of core CPI, that matter. And they keep going up.
  • Lodging Away from Home (small category) dropped to 1.88% from 2.78% y/y. Again, smacks of bad seasonal adjustment.
  • Household Energy was also lower. So there you have it – the rent and implied rents continue to go up; the cost of piped gas e.g. not.
  • In Transp, Motor Fuel did better on base effects (only -19.5% y/y!) but insurance, repair, and new cars/trucks were all up.
  • Overall, core services remained at +2.9% y/y; core goods rose to -0.4% from -0.6%.
  • The continued rally in the dollar probably means core goods will continue to drag on overall CPI. It’s not a huge effect but it’s there.
  • Core inflation ex-housing rose, 1.28% y/y by my calculation, highest since mid-2014. Hasn’t been MUCH higher since 2012-13.
  • Sorry that’s core ex-shelter, not ex-housing.
  • So you can think of core CPI as (rents) + (core goods) + (core services ex-rents) + (food & energy). Each roughly equal weight.
  • Rents are over 3% and rising. Food & energy weak, core goods weak, core svcs ex-rents rising.
  • Rents will continue to rise. And so median CPI should also. But I am less sure than I have been that the $ will stop strengthening.
  • …and less sure that interest rates will rise, pulling up money velocity. So, I will be pulling my forecasts for 2016 lower.
  • They will still be higher than everyone on the Street, I am sure. Because they think growth matters a lot for inflation.
  • Proportion of CPI that is inflating faster than 3% is at 42.7%. So main body is still between 3%-4% with long negative tails.
  • But at least inflation hasn’t broadened FURTHER over the last few months. It’s been around 42-47% inflating over 3%.
  • ..fairly close call, looks like 0.147% on my back-of-envelope, which would make y/y median CPI drop to 2.43% from 2.46%.
  • Bottom line is that broad inflation is around 2.5%, but more than 40% of CPI is above 3% and rising.

The broad themes this month are very much in keeping with the (somewhat longer) post-CPI post I wrote last month – the analysis there is worth re-reading as several of these points keep coming up.  These broad themes are that (a) rents remain steadily accelerating, and likely will continue to do so because home prices continue to rise between 5-7% per year and rents tend to be driven largely by home prices over time. The chart below (Source: Enduring Investments) shows that the ratio of median home prices to the level of Owners’ Equivalent Rent is again rising. This means that either housing is entering into bubble-pricing territory again, or that OER is going to continue to be pulled higher for a while, or both.

ratiomedoer

Our models have OER continuing to rise to at least 3.5% (from 3.08%) although our more speculative model has it headed over 4%. Still, if that’s as bad as housing inflation gets, and the dollar continues to strengthen, then median inflation will probably not go much higher than 3% because core goods inflation will remain soft while core services inflation will eventually pause.

And the continued – and, to me, confounding – strength of the broad trade-weighted dollar is the real question. The chart below (Source: Enduring Investments) illustrates the connection between the dollar and core commodities. On the one hand, note that even large changes in the dollar have only a small effect on core goods (and on GDP), and essentially no effect outside of core commodities. And, if the dollar merely stops strengthening, then we would expect core goods prices to start rising around 0.5%-1.0%, which would add another few tenths to core CPI.

dollarvscore

But, on the other hand, note that the current weakness in core goods is consistent with the dollar’s recent pattern of strength, and some deeper analyses/regressions we look at suggest we could even get a bit more core goods weakness over the next 3-6 months. And is there any reason to expect the dollar’s strength to reverse? The dollar is the best house in a bad neighborhood, as it is said…for now. So I am no longer so confident that the greenback will start weakening soon.

Moreover, I am also less sure that interest rates are going to rise in the near term. While the Fed has begun to raise short-term interest rates, the economy is evidently weakening and the stock market isn’t doing very well recently to put it mildly. A further hike of rates this month is virtually out of the question, and further hikes this year are hardly assured. While higher inflation this year should cause nominal rates to eventually leak higher, I am not sure how soon that will happen. And if it doesn’t happen, then money velocity will probably not rise substantially. If velocity merely flatlines, then 5%-6% money supply growth with 2% GDP growth gives you 3%-4% inflation, which is still fairly perky compared with what most analysts are currently expecting but hardly alarming in the big picture.

The big picture concern – which is merely held in abeyance, since money velocity cannot stay permanently low unless interest rates also stay permanently low – is that interest rates and velocity must eventually return to some semblance of normalcy, if the economy is to be considered back in normalcy, and unless the Fed removes all of the excess reserves so that it is able to then start to shrink the money supply, rising velocity in the context of 5%-6% money supply growth produces pretty ugly inflation outcomes. (Go to our monetary inflation calculator to see what can happen with even a modest rebound in velocity.)

 

Categories: CPI, Tweet Summary

Back From the Moon

January 6, 2016 2 comments

Economics is too important to be left to economists, apparently.

When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!

Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.

A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.

It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.

medcpi

Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”

In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”

Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.

Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:

  • Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
  • As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
  • Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.

Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.

And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.

Homes for the Holidays

December 22, 2015 Leave a comment

It is not usually a very productive endeavor to write an article on December 22nd. In the past, I have made it more or less a rule not to post anything after about the middle of the month, unless it was a greatest-hits repost series or something. However, today’s Existing Home Sales number was striking enough that it is worth at least a brief comment.

November Existing Home Sales was reported at 4.76mm units (seasonally-adjusted annualized rate), which was considerably below expectations for a nearly-unchanged 5.35mm. The chart (Source: Bloomberg) below makes graphically clear the magnitude of this disappointment.

ehsl

Recently, sales of existing homes had been back to something like normal, around 5.5mm units at an annualized rate. The big selloff will cause consternation in some quarters. It wasn’t the weather: November’s weather was, if anything, warmer than usual and so one wouldn’t have thought foot traffic and closings would have been slower. And it wasn’t payback, like in 2010 when the collapse followed the tax-incentive-expiration-induced spike of 2009. We can’t really even shrug it off as “December economic data;” I am always skeptical of economic figures from December and January because it’s just a mess to seasonally adjust most of them – especially those related to employment and income. But this was a November figure.

It was just a really bad number.

The potential significance is this: so far, analysts pointing to weakness in economic data have had to be careful about drawing too-strong conclusions because a lot of the weakness was confined to the oil and gas extraction industries, and spots of weakness in traditional manufacturing where a higher dollar hurt. Housing, however, is wholly domestic. It doesn’t depend on oil and gas extraction, and the strength of the dollar is irrelevant.

Housing data are also notoriously volatile, although that complaint is less true of Existing Home Sales than New Home Sales (which is a much smaller figure, and depends much more on what inventory of homes is being offered). I would simply ignore this figure if it was New Home Sales. It’s harder to shrug off Existing.

I don’t believe a collapse is coming, though. Despite the fact that I have just made several observations that tend to increase the significance of this number, keep in mind that unlike in 2005-2007, there is no apparent bubble in the inventory of existing homes (see chart, source Bloomberg – note it is not seasonally adjusted so there is a distinct annual pattern).

etslhafs

The National Association of Realtors blamed the drop on a new regulation affecting closing documents, which is leading to a longer time-to-close for sales. If that is true – keep in mind that the NAR produces the existing home sales figure, but also keep in mind that they have an incentive to downplay declines – then we should see Existing Home Sales rebound in the months ahead. But even if we do not, the fact that there is no bubble in inventory means that we should not necessarily expect the rate of increase of existing home sales prices (which has been running around 6.5%, as the chart below shows) to decelerate any time soon. And that, of course, helps to drive a big piece of the CPI.

etslmedpriceyoy

All in all, this is a disturbing number and one that bears watching. My intuition is that this is not a sign of broadening weakness in the US economy. While I expect such a broadening, I don’t think we have seen it yet.

Categories: Housing

A Good Time to Remember

December 16, 2015 7 comments

Some days make me feel so old. Actually, most days make me feel old, come to think of it; but some days make me feel old and wise. Yes, that’s it.

It is a good time to remember that there are a whole lot of people in the market today, many of them managing many millions or even billions of dollars, who have never seen a tightening cycle from the Federal Reserve. The last one began in 2004.

There are many more, managing many more dollars, who have only seen that one cycle, but not two; the previous tightening cycle began in 1999.

This is more than passing relevant. The people who have seen no tightening cycle at all might be inclined to believe the hooey that tightening is bullish for stocks because it means a return to normalcy. The people who have seen only one tightening cycle saw the one that coincided with stocks’ 35% rally from 2004-2007. That latter group absolutely believes the hooey. The fact that said equity market rally began with stocks 27% below the prior all-time high, rather than 32% above it as the market currently is, may not have entered into their calculations.

On the other hand, the people who dimly recall the 1999 episode might recall that the market was fine for a little while, but it didn’t end well. And you don’t know too many dinosaurs who remember the abortive tightening in 1997 in front of the Asian Contagion and the 1994 tightening cycle that ended shortly after the Tequila crisis.

Moreover, it is a good time to remember that no one in the market today, or ever, can remember the last time the Fed tightened in an “environment of abundant liquidity,” which is what they call it when there are too many reserves to actually restrain reserves to change interest rates. That’s because it has never happened before. So if anyone tells you they know with absolute certainty what is going to happen, to stocks or bonds or the dollar or commodities or the economy or inflation or anything else – they are relying on astrology.

Many of us have opinions, and some more well-informed than others. My own opinion tends to be focused on inflationary dynamics, and I remain very confident that inflation is going to head higher not despite the Fed’s action today, but because of it. I want to keep this article short because I know you have a lot to read today, but I will show you a very important picture (source: Bloomberg) that you should remember.

coreandfedfunds

The white line is the Federal Funds target rate (although that meant less at certain times in the past, when the rate was either not targeted directly, as in the early 1980s, or the target was represented as a range of values). The yellow line is core inflation. Focus on the tightening cycles: in the early 1970s, in the late 1970s, in 1983-84, in the late 1980s, in the early 1990s, in 1999-2000, and the one beginning in 2004. In every one of those episodes, save the one in 1994, core inflation either began to rise or accelerated, after the Fed began to tighten.

The generous interpretation of this fact would be that the Fed peered into the future and divined that inflation was about to rise, and so moved in spectacularly-accurate anticipation of that fact. But we know that the Fed’s forecasting abilities are pretty poor. Even the Fed admits their forecasting abilities are pretty poor. And, as it turns out, this phenomenon has a name. Economists call it the “price puzzle.”

If you have been reading my columns, you know this is no puzzle at all for a monetarist. Inflation rises when the Fed begins to tighten because higher interest rates bring about higher monetary velocity, because velocity is the inverse of the demand for real cash balances. That is, when interest rates rise you are less likely to leave money sitting idle; therefore, investors and savers play a game of monetary ‘hot potato’ which gets more intense the higher interest rates go – and that means higher monetary velocity. This effect happens almost instantly. After a time, if the Fed has raised rates in the traditional fashion by reducing the growth rate of money and reserves, the slower monetary growth rate comes to dominate the velocity effect and inflation ebbs. But this takes time.

And, moreover, as I have pointed out before and will keep pointing out as the Fed tightens: in this case, the Fed is not doing anything to slow the growth rate of money, because to do that they would have to drain reserves and they don’t know how to do that. I expect money growth to remain at its current level, or perhaps even to rise as higher interest rates provoke more bank lending without and offsetting restraint coming from bank reserve scarcity. By moving interest rates by diktat, the Fed is increasing monetary velocity and doing nothing (at least, nothing predictable) with the growth rate of money itself. This is a bad idea.

No one knows how it will turn out, least of all the Fed. But if market multiples have anything to do with certainty and low volatility – then we might expect lower market multiples to come.

 

Summary of My Post-CPI Tweets

December 15, 2015 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 with interests in this area be sure to stop by Enduring Investments. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.

  • #CPI +0.0%/+0.2%. Y/y on headline goes to +0.5%, highest since December. Welcome to base effects!
  • Core was actually +0.18% m/m, a bit higher than expected. y/y on core goes to 2.02% from 1.91% as we dropped off a weak mo.
  • Next month, core #CPI will go to 2.1% or 2.2% y/y, simply because we drop off last December’s +0.06% aberration.
  • The rise in core seems dramatic (highest since 2012 now), but it’s just catching up with Median. Expected.

coremed

  • Primary Rents actually decelerated to 3.64% from 3.74%, and OER roughly unch at 3.08% from 3.09%. So core was held DOWN somewhat.
  • Even with that, overall Housing subindex was 2.14% y/y from 2.12% y/y. Big jump in Lodging Away from Home helped that.
  • Medical Care 2.95% from 2.98%. Boost to core came from “Other” (2.08% from 1.86%) and Education/Communication (1.32% from 0.97%).
  • Core #CPI, ex-housing, 1.18% from 1.00%. That’s the story here. Highest since mid-2014.
  • Core services 2.9%, highest since Nov 2008; core goods -0.6%, partial retrace from last month but still very weak.
  • The internals here not pleasant. We know housing will continue to accelerate. Core goods will not deflate forever.
  • Love this picture of core goods and core services. Note services is usually the stickier piece.

coregoodsserv

  • Early guess at Median CPI: 0.18%, keeping y/y at 2.47%. But median component looks like South Urban housing; hard to seasonally adj.
  • The categories that are mainly non-core: Food & Beverages 1.2% from 1.6% y/y; Transportation -6% from -7.9%.
  • Transport improvement notjust fuel (-24.2% from -27.9%), but also insurance (5.5% v 4.7%) and new/used vehicles (-0.1% v -0.4%)
  • …and airline fares (-3.8% v -5.2%), which is astonishing given the decline in jet fuel prices: down 67% v mid-2014.
  • Nothing in the #CPI today is soothing. But nothing here could change the Fed outcome tomorrow anyway.
  • FOMC has done nothing to dissuade the market from assuming a tightening. But important to remember the surprise risk is asymmetrical.
  • That is, the FOMC is much more likely to be willing to surprise the market dovishly than hawkishly. I do think they will tighten tho.
  • Last fun chart of the day. Weight of #CPI components rising faster than 3% per annum.

wgtover3

The CPI report today was mainly interesting because while core rose as expected – actually, a little bit more than expected – that was not due to primary rents and Owners’ Equivalent Rent, which have been the driving force for some time. Indeed, Primary Rents actually decelerated, so the rise in core CPI came despite sluggishness in one of the formerly-leading components.

So what happened? Well, other elements of core services took the reins. Un-sexy elements like Information and Information Processing (-0.8% from -1.5%, and compared to a 2-year compounded rate of -1.3%), Personal Care Services (3.1% vs 2.7%), Medical Care – Professional Services (2.0% vs 1.8%), and Health Insurance (3.6% vs 3.0% – see chart below, source Bloomberg).

healthins

It is worth pointing out that health insurance is only 0.75% of the CPI because the BLS measures the costs of medical provision more directly. This is a residual. But still very interesting given what we know anecdotally is happening in the ACA marketplace.

Here is the chart of core inflation, ex-shelter (Source: Enduring Investments).

corexshelt

This doesn’t look alarming, but the story of the low core inflation over the last few years can be thought of this way: shelter prices going up; core services ex-shelter decelerating somewhat; core goods deflating. We can’t count on core goods deflating forever (although our models have them deflating at roughly this pace for a little while yet), and they tend to move around more than core goods. But the core services ex-shelter piece, filled with things like medical care, has played a major role. Those pieces are now re-accelerating.

Nothing that happened today, as I note in the tweet-feed, will change what the Fed does tomorrow. While I was long skeptical that the Committee would tighten in December, the market priced it in and no Fed speaker (with any weight) tried to signal otherwise. That tacit agreement with market pricing has historically meant that the FOMC was prepared to do what the market had priced in. But there are four caveats worth noting.

First, as I said in the tweet-stream the Fed is always more likely to surprise on the dovish side than on the hawkish side. Thus, if the market was pricing in no action but the Committee wanted to tighten, they would be much more aggressive about speaking out so as not to surprise the markets. They never seem to care about surprising them in the dovish direction. So there’s that.

Second, this would be the first tightening of the Yellen regime. We don’t know that she operates in the same way that prior Fed Chairmen have operated; perhaps she is less worried (or aware) about surprising the markets. It is worth keeping in mind although I doubt very much she wants to be a rebel in this way, especially with high yield markets in what can generously be called “disarray.”

Third, whatever happens tomorrow the second tightening is very much up in the air. We are starting to see failures of high yield funds and we will see failures of high yield companies. If this gets particularly ugly, it is possible the Fed will take a pass in the first or possibly the first couple of meetings in 2016. If that happens, it will be harder to get started again. So I’d be careful to price a long string of tightening actions here.

Fourth, and finally: I have been calling it “tightening” but the Fed of course is not tightening policy. They are only raising interest rates. There will still be plenty of money in the system, and rates will be going up not because demand for money outstrips its supply, but because the Fed says so. The result of this will be very different from the results that followed prior Fed tightenings. Inflation will rise, because velocity rises when interest rates rise and that leads to higher inflation – and this generally happens when the Fed starts to tighten – but since the Fed will not be reining in money growth inflation will continue to rise. That’s unusual, but it will happen because the deviation from the script is important: ordinarily, it is the slowing of money growth rather than the increasing of interest rates that restrains inflation; the increase of interest rates actually accelerates inflation. The Fed has no plans to slow money growth, nor any way to really do it – so inflation will continue to rise.

Sometimes I Just Sits

December 1, 2015 6 comments

An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”[1]

The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.

That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)[2]

More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.

The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.

I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.

pmi

To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.

domdebt

Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.

In 2016, if the Fed goes forward with tightening, we will see:

  • Lower corporate earnings
  • Rising corporate default rates
  • Rising inflation
  • Lower equity prices; higher commodity prices
  • Banks vilified. I am not sure why, but it seems this always happens so there will be something.

All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.

To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.

The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.

[1] This story is attributed variously to A.A. Milne and to Punch magazine, among others.

[2] Cotton is +3% or so versus 1 year ago.

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