Archive

Archive for the ‘Federal Reserve’ Category

A Real Concern About Over(h)eating

I misread a headline the other day, and it actually caused a market analogy to occur to me. The headling was “Powell Downplays Concern About Overheating,” but I read it as “Powell Downplays Concern About Overeating.” Which I was most delighted to hear; although I don’t normally rely on Fed Chairman for dietary advice[1] I was happy to entertain any advice that would admit me a second slice of pie.

Unfortunately, he was referring to the notion that the economy “has changed in many ways over the past 50 years,” and in fact might no longer be vulnerable to rapidly rising price pressures because, as Bloomberg summarized it, “The workforce is better educated and inflation expectations more firmly anchored.” (I don’t really see how an educated workforce, or consumers who have forgotten about inflation, immunizes the economy from the problem of too much money chasing too few goods, but then I don’t hang out with PhDs…if I can avoid it.) Come to think of it, perhaps the Chairman ought to stick to dietary advice after all.

But it was too late for me to stop thinking about the analogy, which diverges from what Powell was actually talking about. Here we go:

When a person eats, and especially if he eats too much, then he needs to wait and digest before tackling the next course. This is why we take a break at Thanksgiving between the main meal and dessert. If, instead, you are already full and you continue to eat then the result is predictable: you will puke. I wonder if it’s the same with risk: some risk is okay, and you can take on more risk up to a point. But if you keep taking on risk, eventually you puke. In investing/trading terms, you rapidly exit when a small setback hits you, because you’ve got more risk on than you can handle. Believe me: been there, done that. At the dinner table and in markets.

So with this analogy in place, let’s consider the “portfolio balance channel.” In the aftermath of the Global Financial Crisis, the Fed worked to remove low-risk securities from the market in order to push investors towards higher-risk securities. This was a conscious and public effort undertaken by the central bank because (they believed) investors were irrationally scared and risk-averse, and needed a push to restore “animal spirits.” (I’m not making this up – this is what they said). It was like the Italian grandmother who implores, “Eat! Eat! You’re just skin and bones!” And they were successful, just like Grandma. The chart below (source: Enduring Investments) plots the slope of the securities market line relating expected real return and expected real risk, quarterly, going back to 2011. It’s based on our own calculations of the expected real return to stocks, TIPS, Treasuries, commodities, commercial real estate, residential real estate, corporate bonds, and cash, but you don’t have to believe our calculations are right. The calculation methodology is consistent over time, so you can see how the relative value in terms of risk and reward evolved.

The Fed succeeded in getting us to eat more and more risky securities, so that they got more and more expensive relative to safer securities (the amount of additional risk required to get an increment of additional return got greater and greater). Thanks Grandma!

But the problem is, we’re still eating. Risk is getting more and more expensive, but we keep reaching for another cookie even though we know we shouldn’t.

Puking is the body’s way of restoring equilibrium quickly. Abrupt market corrections (aka “crashes”) are the market’s way of restoring equilibrium quickly.

This isn’t a new idea, of course. One of my favorite market-related books, “Why Stock Markets Crash” by Didier Sornette, (also worth reading is “Ubiquity” by Mark Buchanan) talks about how markets ‘fracture’ after bending too far, just like many materials; the precise point of fracture is not identifiable but the fact that a fracture will happen eventually if the material continues to bend is indisputable.

My analogy is more colorful. Whether it is any more timely remains to be seen.


[1] To be fair, I also don’t rely on Fed Chairman for economic advice.

Advertisements

Summary of My Post-CPI Tweets (June 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Until the end of June, you can get $9.99 off (one month free, or a discount off the already-discounted annual plan) by using code “tryme”. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. 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.

  • 27 minutes to CPI! Here are my pre-figure thoughts:
  • Last month (April CPI) was a big surprise. The 0.098% rise in core was the lowest in almost a year, rewarding those economists who see this recent rise as transitory. (I don’t.)
  • But underneath the headlines, April CPI was nowhere near as weak as it seemed. The sticky prices like housing were stronger and much of the weakness came from a huge drop in Used Cars and Trucks, which defied the surveys.
  • Medical Care and Apparel were also both strong last month.
  • Now, BECAUSE the weakness was concentrated in a small number of categories that had large moves, median inflation was still +0.24% last month, which drives home the fact that the underlying trend is much stronger than 0.10% per month.
  • The question this month is: do we go back to what we were printing, 0.18%-0.21% per month (that’s the 2 month and 6 month avg prior to last month, respectively), or do we have a payback for the weak figure last month?
  • To reiterate – there were not really any HIGH SIDE upliers to potentially reverse. Maybe housing a touch, but not much. To me, this suggests upside risk to the consensus [which is around 0.17% or so and a bump up (due to base effects) to 2.2% y/y].
  • I don’t make monthly point forecasts, but I would say there’s a decent chance of an 0.21% or better…which number matters only since it would accelerate the y/y from 2.1% to 2.3% after rounding. So I agree with @petermcteague here, which is a good place to be.
  • Note there’s also the ongoing risk each month of seeing tariffs trickle through or trucking pressures start to diffuse through to other goods prices. Watch core goods.
  • So those are my thoughts. Put it this way though – I don’t see much that would cause the Fed to SLOW the rate hike plans, at least on the inflation side. Maybe EM or something not US economy-related, but we’d have to have a shockingly broadly weak number to give the FOMC pause.
  • Starting to wonder why we even both with an actual release. Economists nailed it, 0.17% m/m on core, 2.21% y/y.
  • That’s a 2.05% annualized increase. Which would be amazing if the Fed could nail that every month.

  • Core goods accelerated to -0.3% from -0.4%, so the jump there hasn’t happened. Core services moved up to 3.0% from 2.9%. That is the highest core services since Feb 2017, but not absurd.
  • still waiting on core goods acceleration…

  • Used cars and trucks again dropped sharply. -0.89% after -1.59% last month. That’s m/m. The y/y is -1.68%. Again, that’s at odds with all of the private surveys and is a big disconnect. I can’t explain it.
  • Owners’ Equiv Rent put in another solid month +0.25% m/m, up to 3.41% y/y. Starting to get a bit ahead of our model again.

  • Large jump in lodging away from home, 2.93% m/m. That takes the y/y to 4.29%. LAFH is only 0.9% of CPI, but that’s an outlier that will probably come back next month.
  • Medical Care scored a solid 0.2%, accelerating to 2.38% y/y.

  • Pharma (3.73% vs 2.65%), Doctor’s Services (0.55% vs 0.31%), and Hospital Services (4.74% vs 4.49%) all accelerated.
  • Apparel was flat on the month, but that moved y/y up to 1.4% vs 0.8%.
  • Neither stocks nor breakevens care about this figure. Summer has set in. It used to be that the summer lull was a couple of weeks in August. Then it went to all of August as the US mirrored Europe. Now it pretty much starts in June and lasts until Labor Day.
  • I forgot to mention Primary Rents, by the way. They actually decelerated to 3.63% y/y from 3.70%, which takes some the sting out of a potential OER reversal. The Primary Rents move was countertrend so it should also retrace next month. But only 1/3 of the weight of OER.
  • The Primary Rents move does tend to reinforce the message of our model, that OER is a tiny bit out over its skis. However as that chart illustrated, it can diverge a bunch from our model.
  • Biggest m/m declines were in Car and Truck Rental and Public Transportation (what’s up with vehicles??), followed by Mens and Boys’ Apparel. I’ve mentioned Used Cars and Trucks. Household Furnishings also weak.
  • Biggest m/m increases are the aforementioned Lodging Away from Home, Infants and Toddlers’ Apparel, Motor Fuel, and Medical Care Commodities (mostly Pharma).
  • All of the median categories are Rent and OER subcategories which are hard to get a read on, but median should again be mid-0.2s, probably 0.26-0.27% m/m pushing y/y to nearly 2.7% on Median CPI! Last mo was highest since 1/09; this would be highest since 2008.
  • This is median BEFORE today’s figure, which will come later. And I could be wrong about it.

  • Core ex-housing, something worth watching especially since housing seems back in an uptrend, rose to 1.29% from 1.21%. That’s the highest since Jan 2017, but it hasn’t been higher than 1.61% since early 2013. Right now can still claim it’s a housing story.
  • Putting together the four-pieces charts.
  • Still not much action in inflation markets. From the swap curve: US #Inflation mkt pricing: 2018 2.2%;2019 2.2%;then 2.3%, 2.4%, 2.4%, 2.4%, 2.5%, 2.5%, 2.4%, 2.5%, & 2028:2.5%.
  • Four Pieces: Food & Energy first. Roughly 21% of CPI.

  • Core Goods, about 19% or so of CPI. Rising very slowly. If core inflation is to reach ‘escape velocity’ this needs to rise a fair amount. Tariffs will help that, eventually.

  • Core services, less rent of shelter. About 27% of overall CPI. Lot of medical care here, which as we expected has been pulling this higher. Again, for CPI to reach escape velocity you’d want to see this above 3%.

  • And the big kahuna, housing, about 1/3 of overall CPI. Had a steady run-up, got ahead of itself and came back to model, and now is accelerating again. Housing indeed looks tight, and this should continue especially if wages continue to accelerate.

  • Diffusion look at inflation is still pretty dull. Slightly less than half of all categories of CPI are accelerating faster than 3%. But that’s been very consistent between 40% and 50% (obviously at ~50%, median CPI would be at 3%).

  • OK, last overall point. May was an easy hurdle to get an acceleration in y/y, as May 2017 was only +0.08. June and July of last year were both +0.143%, so again we should see more acceleration. Y/y core CPI should be at 2.3% next mo & hit 2.4% in Sept just on base effects.
  • …that’s merely assuming 0.2% per month from core CPI, which is between what TTM core says it is and what median stays it is. If we print just a smidge above 0.2% per month we could hit 2.5% in November. Again, that’s assuming no big acceleration in underlying pressures.
  • I happen to believe there ARE some underlying pressures so I think we’ll hit 2.5% sooner than that and median will press 3%. Nothing super alarming for the Fed, but somewhat discomfiting. The real test will be once we hit Dec and Jan and those hard comps.
  • That’s all for today. Thanks for tuning in, and thanks for subscribing to the modestly-priced premium channel. I really appreciate your voting with your dollars in this way!

Breakevens eventually did care a little bit, rising a tick or so. Market-wise, today’s number continues to do two things. First, it doesn’t really give any reason for the Fed to arrest or delay its current plans to gradually hike overnight rates. There was no surprise here – this is still all very much in the realm of base effects as we drop off the strange deceleration from last year. Second, there’s really no reason for interest rates in the US to stay below 3%. In an expanding economy with accelerating inflation which is already at 2.2%, or 2.7% on median, a 3% nominal yield makes little sense. Real yields, and nominal yields, are too low. So, honestly, are breakevens…inflation swaps are showing forward expected inflation rates of no more than 2.5% out for many years, even though median inflation (and headline inflation!) is already above that level. You have to have a great deal of faith in an untested hypothesis – the idea that inflation expectations will be ‘anchored’ and overwhelm any effects from tariffs, actual production bottlenecks, and monetary largesse, to keep inflation low and steady – to be actively shorting inflation at these levels, and if you’re buying Treasuries at yields below 3% you are actively betting on inflation declining.

If it seems a strange time to be making that bet, I agree with you. But market sentiment is clearly biased in favor of a belief that the weather will always be sunny and warm and that neither inflation nor commodities will go higher, or equities or bonds lower, from these levels. The contrary evidence about inflation, anyway, continues to build and to my mind it requires an increasing effort of will to ignore that evidence.

Why the M2 Slowdown Doesn’t Blunt My Inflation Concern

April 12, 2018 1 comment

We are now all good and focused on the fact that inflation is headed higher. As I’ve pointed out before, part of this is an illusion of motion caused by base effects: not just cell phones, but various other effects that caused measured inflation in the US to appear lower than the underlying trend because large moves in small components moved the average lower even while almost half of the consumption basket continues to inflate by around 3% (see chart, source BLS, Enduring Investments calculations).

But part of it is real – better central-tendency measures such as Median CPI are near post-crisis highs and will almost certainly reach new highs in the next few months. And as I have also pointed out recently, inflation is moving higher around the world. This should not be surprising – if central banks can create unlimited amounts of money and push securities prices arbitrarily higher without any adverse consequence, why would we ever want them to do anything else? But just as the surplus of sand relative to diamonds makes the former relatively less valuable, adding to the float of money should make money less valuable. There is a consequence to this alchemy, although we won’t know the exact toll until the system has gone back to its original state.

(I think this last point is underappreciated. You can’t measure an engine’s efficiency by just looking at the positive stroke. It’s what happens over a full cycle that tells you how efficient the engine is.)

I expect inflation to continue to rise. But because I want to be fair to those who disagree, let me address a potential fly in the inflationary ointment: the deceleration in the money supply over the last year or so (see chart, source Federal Reserve).

Part of my thesis for some time has been that when the Fed decided to raise interest rates without restricting reserves, they played a very dangerous game. That’s because raising interest rates causes money velocity to rise, which enhances inflation. Historically, when the Fed began tightening they restrained reserves, which caused interest rates to rise; the latter effect caused inflation to rise as velocity adjusted but over time the restraint of reserves would cause money supply growth (and then inflation) to fall, and the latter effect predominated in the medium-term. Ergo, decreasing the growth rate of reserves tended to cause inflation to decline – not because interest rates went up, which actually worked against the policy, but because the slow rate of growth of money eventually compounded into a larger effect.

And so my concern was that if the Fed moved rates higher but didn’t do it by restraining the growth rate of reserves, inflation might just get the bad half of the traditional policy result. The reason the Fed is targeting interest rates, rather than reserves, is that they have no power over reserves right now (or, at best, only a very coarse power). The Fed can only drain the inert excess reserves, which don’t affect money supply growth directly. The central bank is not operating on the margin and so has lost control of the margin.

But sometimes they get lucky, and they may just be getting lucky. Commercial bank credit growth (see chart, source Federal Reserve) has been declining for a while, pointing to the reason that money supply growth is slowing. It isn’t the supply of credit, which is unconstrained by reserves and (at least for now) unconstrained by balance sheet strength. It’s the demand for credit, evidently.

Now that I’ve properly laid out that M2 is slowing, and that declining M2 growth is typically associated with declining inflation (and I haven’t even yet pointed out that Japanese and EU M2 growth are both also at the lowest levels since 2014), let me say that this could be good news for inflation if it is sustained. But the problem is that since the slowing of M2 is not the result of a conscious policy, it’s hard to predict that money growth will stay slow.

The reason it needs to be sustained is that we care about percentage changes in the stock of money plus the percentage change in money velocity. For years, the latter term has been a negative number as money velocity declined with interest rates. But M2 velocity rose in the fourth quarter, and my back-of-the-envelope calculation suggests it probably rose in Q1 as well and will rise again in Q2 (we won’t know Q1’s velocity until the advance GDP figures are reported later this month). If interest rates normalize, then it implies a movement higher in velocity to ‘normal’ levels represents a rise of about 12-14% from here (see chart, source Bloomberg.[1])

If money velocity kicks in 12-14% over some period to the “MVºPQ” relationship, then you need to have a lot of growth, or a pretty sustained decline in money growth, to offset it. The following table is taken from the calculator on our website and you can play with your own assumptions. Here I have assumed the economy grows at 2.5% per year for the next four years (no mean feat at the end of a long expansion).

The way to read this chart is to say “what if velocity over the next four years returns to X. Then what money growth is associated with what level of inflation?” So, if you go down the “1.63” column, indicating that at the end of four years velocity has returned to the lower end of its long-term historical range, and read across the M2 growth rate row labeled “4%”, you come to “4.8%,” which means that if velocity rises to 1.63 over the next four years, and growth is reasonably strong, and money growth remains as slow as 4%, inflation will average 4.8% per year over those four years.

So, even if money growth stays at 4% for four years, it’s pretty easy to get inflation unless money velocity also stays low. And how likely is 4% money growth for four years? The chart below shows 4-year compounded M2 growth rates back thirty or so years. Four percent hasn’t happened in a very long time.

Okay, so what if velocity doesn’t bounce? If we enter another bad recession, then it’s conceivable that interest rates could go back down and keep M2 velocity near this level. This implies flooding a lot more liquidity into the economy, but let’s suppose that money growth is still only 4% because of tepid credit demand growth and velocity stays low because interest rates don’t return to normal. Then what happens? Well, in this scenario presumably we’re no longer looking at 2.5% annual growth. Here’s rolling-four-year GDP going back a ways (source: BEA).

Well, let’s say that it isn’t as bad as the Great Recession, and that real growth only slows a bit in fact. If we get GDP growth of 1.5% over four years, velocity stays at 1.43, and M2 grows only at 4%, then:

…you are still looking at 2.5% inflation in that case.

I’m going through these motions because it’s useful to understand how remarkable the period we’ve recently been through actually is in terms of the growth/inflation tradeoff, and how unlikely to be repeated. The only reason we have been able to have reasonable growth with low inflation in the context of money growth where it has been is because of the inexorable decline in money velocity which is very unlikely to be repeated. If velocity just stops going down, you might not have high inflation numbers but you’re unlikely to get very low inflation outcomes. And if velocity rises even a little bit, it’s very hard to come up with happy outcomes that don’t involve higher inflation.

I admit that I am somewhat surprised that money growth has slowed the way it has. It may be just a coin flip, or maybe credit demand is displaying some ‘money illusion’ and responding to higher nominal rates even though real rates have not changed much. But even then…in the last tightening cycle, the Fed hiked rates from 1% to 5.25% over two years in 2004-2006, and money growth still averaged 5% over the four years ended in 2006. While I’m surprised at the slowdown in money growth, it needs to stay very slow for quite a while in order to make a difference at this point. It’s not the way I’d choose to bet.


[1] N.b. Bloomberg’s calculation for M2 velocity does not quite match the calculation of the St. Louis Fed, which is presumably the correct one. They’re ‘close enough,’ however, for this purpose, and this most recent print is almost exactly the same.

Summary of My Post-CPI Tweets (Apr 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. 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.

  • After a couple of weeks of relative quiet on the inflation theme, it seems people the last few days are talking about it again. Big coverage in the Daily Shot about the underlying pressures.
  • I don’t normally pay much attention to PPI, but it’s hard to ignore the momentum that has been building on that side of things. In particular, the medical care index that PCE uses has been rising rapidly in the PPI. Doesn’t affect us today w/ CPI but affects the Fed convo.
  • But back on CPI. Of course the main focus this month for the media will be the dropping off of the -0.073% m/m figure from March 2017, which will cause y/y CPI to jump to around 2.1% from 1.8%. It’s a known car wreck but the reporters are standing at the scene.
  • That year-ago number of course was caused by cell phone services, which dropped sharply because of the widespread introduction of ‘unlimited data’ plans which the BLS didn’t handle well although they stuck to their methodology.
  • Consensus expectations for this month are for 0.18% on core, which would cause y/y to round down to 2.1%. (Remember that last month, core y/y was very close to rounding up to 1.9%…that shortfall will make this month look even more dramatic.)
  • It would only take 0.22% on core to cause the y/y number to round UP to 2.2%, making the stories even more hyperventilated.
  • I don’t make point estimates of monthly numbers, because the noise swamps the signal. We could get an 0.1% or an 0.3% and it wouldn’t by itself mean much until we knew why. But I will say I think there are risks to a print of 0.22% or above.
  • First, remember the underlying trend to CPI is really about 0.2% anyway. Median inflation is 2.4% and after today core will be over 2%. So using the last 12 months as your base guess is biased lower.
  • Also, let’s look back at last month: Apparel was a big upside surprise for the second month in a row, while shelter was lower than expected. But…
  • But apparel was rebounding from two negative months before that. We’re so used to Apparel declining but really last month just brought it back up to trend. And with the trade tensions and weak dollar, am not really shocked it should be rising some.
  • Apparel is only +0.40% y/y, so it’s not like it needs to correct last month.
  • On the other hand, OER decelerated to 0.20 from 0.28 and primary rents decelerated to 0.20 from 0.34, m/m. But there’s really no reason yet to be looking for rent deceleration – housing prices, in fact, are continuing to accelerate.

  • No reason to think RENTAL costs should be decelerating while PURCHASE costs are still accelerating. Could happen of course, but a repeat of last month’s numbers is less likely.
  • Finally – this gets a little too quanty even for me, but I wonder if last month’s belly flop in CPI could perturb the monthly seasonal adjustments and (mistakenly) overcorrect and push this month higher. Wouldn’t be the first time seasonals bedeviled us.
  • I don’t put a lot of weight on that last speculation, to be clear.
  • Market consensus is clearly for weakness in this print. I’m just not so sure the ball breaks that way. But to repeat what I said up top: the monthly noise swamps the signal so don’t overreact. The devil is in the details. Back up in 5 minutes.
  • ok, m/m core 0.18%. Dang those economists are good. y/y to 2.12%.
  • After a couple of 0.18s, this chart looks less alarming.

  • OK, Apparel did drop again, -0.63% m/m, taking y/y to 0.27%. So still yawning there. Medical Care upticked to 1.99% from 1.76% y/y, reversing last month’s dip. Will dig more there.
  • In rents, OER rose again to 0.31% after 0.20% soft surprise last month, and primary rents 0.26% after a similar figure. y/y figures for OER and Primary Rents are 3.26% and 3.61% respectively. That primary rent y/y is still a deceleration from last mo.
  • Core services…jumped to 2.9% from 2.6%. Again not so surprising since cell phone services dropped out. So that’s the highest figure since…a year ago.
  • Core goods, though, accelerated to -0.3% from -0.5%. That’s a little more interesting. It hasn’t been above 0 for more than one month since 2013, but it’s headed that way.

  • Within Medical Care…Pharma again dragged, -0.16% after -0.44% last month…y/y down to 1.87% from 2.39% two months ago. So where did the acceleration come from?
  • Well, Hospital Services rose from 5.01% to 5.16% y/y, which is no big deal. But doctors’ services printed another positive and moved y/y to -0.83% from -1.27% last month and -1.51% two months ago. Still a long way to go there.

  • Oh wait, get ready for this because the inflation bears will be all about “OH LODGING AWAY FROM HOME HAD A CRAZY ONE-MONTH 2.31% INCREASE.” Which it did. Which isn’t unusual.

  • Interestingly those inflation bears who will tell us how Lodging Away from Home will reverse next month (it will, but hey folks it’s only 0.9% of the index) are the same folks always telling us that AirBnB is killing hotel pricing. MAYBE NOT.
  • Finally making it back to cars. CPI Used cars and trucks had another negative month, -0.33% after -0.26% last month. That really IS a surprise: we’ve never seen the post-hurricane surge that I expected.

  • Sure, used cars are out of deflation, now +0.37% y/y. New cars still deflating at -1.22% vs -1.47% y/y last month. But that really tells you how bad the inventory overhang is in autos. Gonna suck to be an auto manufacturer when the downturn hits. As usual.
  • Leased cars and trucks, interestingly (only 0.64% of CPI) are +5.26% y/y. Look at that trend. Maybe that’s where the demand for cars is going.

  • Oh, how could I forget the star of our show! Wireless telephone services went to -2.41% y/y from -9.43% y/y last month. Probably will go positive over next few months – a real rarity! But after “infinity” data where does the industry go on pricing? Gotta be in the actual price!
  • College tuition and fees: 1.75% y/y from 2.04%. Lowest in a long time. This is a lagged effect of the big stock and bond bull market, and that effect will fade. Tuition prices will reaccelerate.
  • Bigger picture. Core ex-housing rose to 1.23% from 0.92%. Again, a lot of that is cell phone services. But deflation is deep in the rear-view mirror.
  • While I’m waiting for my diffusion stuff to calculate let’s look ahead. We’re at 2.1% y/y core CPI now. The next m/m figures to “roll off” from last year are 0.09, 0.08, 0.14, and 0.14.
  • In other words, core is still going to be accelerating optically even if there’s no change in the underlying, modestly accelerating trend. Next month y/y core will be 2.2%, then 2.3%, then 2.4%. May even reach 2.5% in the summer.
  • This is also not in isolation. The Underlying Inflation Gauge is over 3% for the first time in a long time. Global inflation is on the rise and Chinese inflation just went to the highest level it has seen in a while.
  • One of the stories I’m keeping an eye on too is that long-haul trucker wages are accelerating quickly because new technology has been preventing drivers from exceeding their legal driving limits…which has the effect of restraining supply in trucking capacity.
  • …and that feeds into a lot of things. Until of course the self-driving cars or drone air force takes care of it.
  • The real question, of course, is whence inflation goes after the summer. I believe it will continue to rise as higher interest rates help to goose money velocity after a long time. But it takes time for that theme to play out.
  • time for four-pieces. Here’s Food & Energy.

  • Core goods. Consistent with our theme. it’s going higher.

  • OK, here’s where cell phone services come in: core services less rent of shelter. So the recent jump is taking us back to where we were a year ago. Real question here is whether medical rallies. Some signs in PPI it may be.

  • Rent of Shelter continues to be on our model. Some will look for a reversal in this little jump – not me.

  • Another month where one of the OER subindices will probably be the median category so my guess won’t be fabulous. It will probably either be 0.26% m/m on median (pushing y/y to 2.49%), or 0.20% (y/y to 2.44%). Either way it’s a y/y acceleration.
  • Oh, by the way…10y breakevens are unchanged on the day. This is the second month of data that was ‘on target,’ but surprised the real inflation bears. There isn’t anything really weird here or doomed to be reversed…at least, nothing large.
  • Bottom line for markets is core CPI will continue to climb; core PCE will continue to climb. For at least a few more months (and probably longer, but next 3-4 are baked into the cake). Even though this is known…I don’t know that the Fed and markets will react well to it.
  • That’s all for today, unless I think of something in 5 minutes as usually happens. Thanks for subscribing!!

As I said in the tweet series – this was at some level a ham-on-rye report, coming in right on consensus expectations. But some observers had looked for as low as 0.11% or 0.13% – some of them for the second month in a row – and those observers are either going to have to get religion or keep being wrong. There are a couple of takeaways here and one of them is that even ham-on-rye reports are going to cause y/y CPI to rise over the next four months. This is entirely predictable, as is the fact that core PCE will also be rising rapidly (and possibly more rapidly since medical care in the PCE seems to be turning up more quickly). But that doesn’t mean that the market won’t react to it.

There are all sorts of things that we do even though we know we shouldn’t. I would guess that most of us, noticing that our sports team won when we wore a particular shirt or a batter hit a home run when we pet the dog a certain way, have at some point in the past succumbed to the “well, maybe I should do it just in case” aspect of superstition. But there’s more to it than that. In the case of markets, it is well and good to say “I know this isn’t surprising to see year-on-year inflation numbers rising,” but there’s the second-level issue: “…but I don’t know that everyone else won’t be surprised or react, so maybe I should do something.”

By summertime, core CPI will have reached its highest level since the crisis. Core PCE will probably also have reached its highest level since the crisis. Median CPI has been giving us a steadier reading and so perhaps will not be at new highs, but it will be near the highest readings of the last decade. I believe that whether we think it should happen or not, the dot plots will move higher (unless growth stalls, which it may) and markets will have to deal with the notion that additional increases in inflation from there would be an unmitigated negative. So we will start to price that in.

Moreover, I am not saying that there aren’t underlying pressures that may, and indeed I think will, continue to push prices higher. In fact, I think that there is some non-zero chance of an inflationary accident. And, in the longer run, I am really, really concerned about trade. It doesn’t take a trade war to cause inflation to rise globally; it just takes a loss of momentum on the globalization front and I think we already have that. A bona fide trade war…well, it’s a really bad outcome.

I don’t think that just because China has been making concessionary noises that a trade spat with China has been averted. If I were China, then I too would have made those statements: because the last half-dozen Administrations would have been content to take that as a sign of victory, trumpet it, and move on. But the Trump Administration is different (as if you hadn’t noticed!). President Trump actually seems hell-bent on really delivering on his promises in substance, not in mere appearance. That can be good or bad, depending on whether you liked the promise! In this case, what I am saying is – the trade conflict is probably not over. Don’t make the mistake of thinking the usual political dance will play out when the newest dancer is treating it like a mosh pit.

And all of this is pointed the same direction. It’s time, if you haven’t yet done it, to get your inflation-protection house in order! (And, one more pitch: at least part of that should be to subscribe to my cheapo PremoSocial feed, to stay on top of inflation-related developments and especially the monthly CPI report! For those of you who have…I hope you feel you’re getting $10 of monthly value from it! Thanks very much for your support.)

The Fed’s Accidental Preoccupation with Housing

March 5, 2018 3 comments

I have neglected to post here the links to recent TV appearances. Here’s one on TD Ameritrade network from February 12th; here’s one from Bloomberg TV on February 14th, the day of the shocking CPI.


I get asked frequently about Core PCE inflation. Because the Fed obsesses over Core PCE, as opposed to one of the many flavors of CPI (core, median, trimmed-mean, sticky-price), investors therefore obsess over it as well.

My usual response is that I don’t pay much attention to Core PCE, for several reasons. First, there are no market instruments that are remotely tied to PCE, so you can’t trade it (and, for the conspiracy-minded among you, that means there is no instrument whose market price can call shenanigans if the government figure is ‘massaged’). Second, while PCE is interesting and useful for some uses – it measures prices from a different perspective, mainly from the supplier-side of the equation so that, for example, it captures what Medicare pays for care as opposed to just what consumers pay – those aren’t my uses. Markets respond to inflation, and to perceptions of inflation, but what the government pays for healthcare isn’t something we perceive directly.

So, I care about PCE more than, say, PPI, but only just. The only reason I care about PCE is that the Fed cares about it.

Now,  PCE differs from CPI in a couple of key ways – apart from the philosophical way mentioned above, that one measures the price of things businesses sell and one measures the price of things people buy. But those key ways are mostly interesting to pointy-head economists who are interested in calculating the third decimal point. Me, I’m just trying to get “higher” or “lower” correct. (Ironically, those folks who are interested in the third decimal point are the same folks who miss the big figure in front). So they wail at the following chart (source: Bloomberg), and moan about how the Fed has been unable to get inflation higher because of this persistent shortfall of PCE compared to CPI. Try harder!

The pocket-protector set can keep their ‘formula differences.’ There’s really only one important difference that has caused the gap between PCE and CPI over the last half-dozen years: the difference in the weight allocated to housing. In the PCE, “Rental of tenant-occupied nonfarm housing” and “Imputed rental of owner-occupied nonfarm housing” add up to about 16% of the overall PCE. In the CPI, “Rent of primary residence” and “Owners’ equivalent rent of residences,” the corresponding categories, sum to about 32% of overall CPI.

Housing is both the largest weight in CPI, as well as one of the most stable parts of CPI. So, when shelter costs are running ahead of “the rest of CPI”, then Core CPI tends to be above core PCE. I’m actually soft-pedaling that. Given how shelter inflation has been relatively elevated now for some time, it is far and away the most important difference in CPI and PCE. So much so that I can create the following chart in a couple of minutes: I merely took Core CPI and backed out half of the weight of housing inflation, and compare that to Core PCE.

Remarkably, making that simple, back-of-the-envelope adjustment puts core CPI right smack on top of core PCE.

The implication is that in choosing to focus on Core PCE, rather than Core CPI[1], the Fed is saying that housing is just not as important as it seems to consumers. Although you spend about a third of your money on shelter (about 40%, after we take out food and energy), the Fed is behaving as if that inflation only matters about half that much. I don’t think the central bankers are doing this on purpose; I think they believe that the PCE is a more-pure economic statistic that perhaps gives them a better read on ‘overall’ inflation. But in this case, they’re effectively biasing their monetary policy looser for one reason: because housing costs are already going up faster than overall inflation.

Now, to me that sounds like they’re biased the wrong way. But the academics will write a paper in five or ten years and explain why that’s wrong, even though it turned out badly.


[1] Median CPI is better yet, but let’s take baby steps.

Categories: CPI, Federal Reserve

John Mauldin and Long Soapy Showers

February 27, 2018 Leave a comment

I feel like I am falling behind in my articles and commenting on other articles that people have recently written about inflation. After years – literally, years – in which almost no one wrote anything about inflation, suddenly everyone wants to opine on the new shiny object they just found. At the same time, interest in the solutions that we offer – investment strategies, consulting, bespoke inflation hedges, etc – has abruptly picked up, so it feels like the demand for these articles is rising at the same time that my time to write them is shrinking…

But I try.

I want to quickly respond to an article that came out over the weekend, by widely-read author John Mauldin. I’ve corresponded over the years from time to time about inflation, especially when he got way out on the crazy-person “CPI is made up” conspiracy theory limb. To be fair, I think he considers me the crazy person, which is why he’s never referred to me as the inflation expert in his articles. C’est la vie.

His recent article “State of Inflationary Confusion”, though, was much more on-point. Honestly, this is the best article Mauldin has written on this topic in years. I don’t agree with all of it but he at least correctly identifies most of the issues correctly. He even seems to understand hedonic adjustment and the reason we need it, and the reason the PCE/CPI debate exists (which is no easy thing – it depends on what you’re trying to do, which one is ‘better’), and that hasn’t always been the case.

Where I agree with him is when he says that ‘None of us are average’. This is obviously true, and is one reason that we have on our website a calculator where you can look at your own CPI by adjusting the components for what you personally spend (though it doesn’t take into account where you live, which is one reason your experience differs).

But I disagree with him when he says “Reducing this complexity to one number and then using that number to guide monetary policy is asking for trouble.” What an odd remark. We do that for every other piece of data: GDP, home sales, home prices, durable goods sales, retail sales, unemployment, and so on, and we use that information to guide all sorts of policy. Why would it be the case that CPI, of all of the figures, isn’t very useful for this reason? Look, your personal unemployment number is not 4%. It is either 0% or 100%. Totally binary. If Mauldin was making a compelling argument here, you’d throw out the Unemployment Rate long before you’d throw out CPI.

Indeed, if you play with the numbers on our calculator you will find that unless your consumption basket is wildly different, your CPI is likely to be fairly similar to the average. This is why TIPS make sense for many investors – it’s “close enough” to what your consumption basket is actually doing. And it is certainly close enough for policy.

The problem with monetary policy isn’t that they’re using PCE or CPI when they should be using the other, or that neither PCE nor CPI reflects the exact experience of most people. The problem with monetary policy is that policymakers don’t know what the right policy response is given the numbers because they don’t believe in monetarism any more. So their models don’t work. And that’s the problem.

Here’s an analogy (and you know I love analogies). You’re taking a shower, and your impression is “hey, this seems too hot.” It doesn’t really matter if you are using Celsius or Fahrenheit, or just a general visceral sense that it’s too hot. You simply think the water is too hot. So, to solve your problem you apply more soap.

That’s what the Fed is doing. The water is too hot, so they’re applying soap. And they’re really confused when that doesn’t seem to make the water any colder. So they say “gosh, our model must be wrong. The water temperature must be somewhat less sensitive to the amount of soap applied than we thought it was. So let’s recalibrate and apply more soap.” It never occurs to them that they’ve got the wrong model.

That’s the problem with central banking. It isn’t what you use to measure the water temperature, as long as you’re close; it’s how you respond to it that matters. And policymakers don’t understand inflation and, as a result, don’t understand how to affect it.

Re-Blog: Limits on the 500-pound Gorilla

February 22, 2018 5 comments

With interest rates flirting with 3% on the 10-year Treasury note, and the potential (and eventuality) that they will go significantly higher, I thought it might be timely to review a blog post from February 10, 2013 called “Limits on the 500-pound Gorilla.” (It’s worth reading that original post for some of the comments attached thereto.)


Well, here’s an interesting little tidbit. (But first, a note from our sponsors: some channels didn’t pick up my article from  last Wednesday, “Fun With The CPI,” so follow that link if you’d like to read it.)

The Fed adds permanent reserves by buying securities, as we all know by now. The Open Market Desk buys securities and credits the Fed account of the selling institution. Conversely, when the Fed subtracts reserves permanently, it sells securities and debits the account of the buying institution.

As of February 6th, the Fed owned $1.782 trillion in face value of Treasury and agency mortgage-backed securities. At the closing prices from Friday, those securities are worth $2.069 trillion, plus accrued interest which I didn’t bother to calculate.

So let’s revisit for a second the question of how the Fed would unwind the quantitative easing and actually tighten policy. In order to do that, the Fed would first need to vaporize the $1.58 trillion that exists in excess reserves, before they could actually affect the required reserves which is where the rubber meets the road for monetary policy (at least, in the absence of the “portfolio balance channel”).

We have reviewed some of the options before: sell the securities held in the System Open Market Account (SOMA); conduct massive and long-dated repo operations; sell bills or pay interest on deposits at the Fed (or raise IOER). Some people have suggested that the Fed could just “let the securities in the SOMA roll off”: i.e., let the bonds mature and don’t reinvest the proceeds. I was curious how long, after Operation Twist, such a passive approach would take.

The current value of Excess Reserves is $1.58 trillion. If Excess Reserves did not move for any other reason, it would take until November of 2039 before we saw that many bonds mature. To be fair, with coupon payments and such it would take less time, but we’re still looking at a couple of decades. So that’s not an option, at least by itself.

Then I noticed something interesting. Some economists have suggested that when the economy begins to improve, the Desk could simply start selling securities into the market, since with a stronger economy the Treasury would presumably be running a smaller deficit (now, that’s blind faith if ever there was such a thing) and auctioning fewer securities, so the Fed could take up the slack without impacting the market very much. Leaving aside the question that it isn’t clear that market rates would be in the range they are now if the Fed actually stopped buying (after all, that’s the whole point of the portfolio balance channel – that investors won’t pay the high price the Fed has set so they buy riskier securities), I’m not sure it’s even possible that the Fed could drain the excess reserves even if they sold every single bond on their balance sheet. Here’s why.

The SOMA portfolio has a DV01 of approximately $1.56billion, based on the reported holdings and Bloomberg’s calculated modified duration. For those unfamiliar with bond math, this means that every 1/100th of 1% rise in interest rates causes the value of the Fed’s holdings to decline $1.56bln.

The current market value of the portfolio, as I said, is $2.07 trillion, while Excess Reserves are $1.58 trillion. But the problem is that the ‘market value’ of the portfolio assumes the portfolio is liquidated at mid-market prices. Ask the London Whale how well that works when you are a big player. Ask Long Term Capital.

But forget about the market impact. Suppose interest rates were to rise 300bps, so that the 10-year was around 5% and, with expected inflation remaining (again, let’s go with the blind faith argument) around 2.5%, real interest rates were up to around 2.5%. That would be a fairly neutral valuation for an economy with decent prospects and contained inflation, growing at its sustainable natural growth rate.

The SOMA portfolio, valued 300bps higher in yield, would be worth $2.07T – $1.56B * 300 = 1.60T. In other words, if the Fed sold every single bond in its portfolio, 300bps higher, it would just barely be able to drain all of the excess reserves. Yes, I did ignore the question of convexity, but since the MBS tend to have negative convexity that balances the positive convexity of the Treasuries, I suspect that isn’t a huge effect over this small a move.

So the Fed, in this circumstance, would have used all of its gunpowder just getting back to the point where traditional tools would begin to work again. This is an entirely natural outcome, by the way! If a behemoth market participant lurches into the market to buy securities, and then lurches to sell them, and repeats that pattern over and over, it loses value because it is consuming liquidity in both directions. It is going to be buying high (and again, that’s the Fed’s goal here: to pay more than anyone else wants to pay) and selling low. So in this case, if rates rise 300bps, the Fed will be unwinding its entire portfolio and have no securities left to sell to actually drain the liquidity that matters.

This is obviously a thought experiment – I can’t imagine the Fed could unwind that sort of portfolio with only a 300bp market impact. But it just highlights, for me, the fact that the ‘end game’ for the FOMC almost must involve raising the interest paid on excess reserves – the other tools aren’t only impractical in size, but may be de facto impotent (because, remember, the first thing that needs to happen is that Excess Reserves are drained, before policy has traction again through the traditional channels).

I am sure someone else has pointed out this little mathematics dilemma before, but I don’t think it had previously occurred to me. I guess I’d always stopped at the mechanics/feasibility of selling $2 trillion in securities, and never asked whether that would actually do the job. I don’t think it would! It is not actually true that a 500-lb gorilla sits “anywhere he wants,” as the old joke goes – he can’t sit anywhere that won’t hold a 500-lb gorilla.

Now, the Committee doesn’t really seem to believe in traditional monetary policy any more, so it may be that they figure the reverse of the “portfolio balance channel” effect will be good enough: raise the returns to the ‘less risky’ part of the market enough to pull capital out of the risky parts of the market. But I find it hard to convince myself that, as much as they clearly intended to push housing and equity market prices higher, they’d be willing to do the opposite. And I do believe that other stakeholders (e.g., Congress) would be less accommodating in that direction. Which brings me back again to the conclusion I keep coming to: does the Fed theoretically have the tools to reverse QE? Yes, although they have one fewer than I thought yesterday. But is it plausible that the Fed will have the will to use those tools, to the degree they’d need to be used, to reverse QE? I really don’t believe they’d be willing to crash the housing and stock markets, just to cool down inflation.

We do live in interesting times. And they will remain interesting for a long, long time.

%d bloggers like this: