Archive

Archive for the ‘Federal Reserve’ Category

Summary of My Post-CPI Tweets (February 2020)

February 13, 2020 1 comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments (updated site coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

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

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

  • Hospital Services…

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

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

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

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

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

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

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

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

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

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

Summary of My Post-CPI Tweets (January 2020)

January 14, 2020 3 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 or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • The first CPI day of 2020! Although technically, this is the last print from the 20-teens.
  • The next decade ought to be very different from the last decade, from an inflation perspective. No more wondering if deflation is sneaking up on us, which is how 2010 began. I suspect we will spend more time worrying about how to put the inflation genie back in the bottle.
  • As the saying goes, letting the cat out of the bag is a heck of a lot easier than gettin’ him back in.
  • But let’s be more myopic for now: month on month. Consensus on core CPI is for +0.18% or so, which would keep y/y at 2.3% unchanged from last month.
  • To tick y/y core back to rounding to 2.4%, we only need 0.22% m/m on core CPI, so that’s more likely than the weakness we would need to see it tick down to 2.2%.
  • Last month in fact we saw 0.23%, which is right on the 6-month average core print. The only reason y/y is as low as it is, is because Feb-May last year were all 0.11-0.15% prints. Which is to say that the comps get easier starting in March (with Feb’s number).
  • Last month’s +0.23% came with softish housing, too. So there are some underlying upward pressures beyond housing. Medical Care has been getting the most attention so we will be attentive to any continued upward pressure there.
  • Also watch this month for an apparel bounce-back. Big drop last month, most likely due to the placement of Thanksgiving and the BLS’s new methodology which has induced lots of volatility to the series.
  • Downwardly, Used Cars remain a risk with private surveys showing softness there. And we’ll watch housing again. A sea change in housing would be a big deal. No real sign of that yet, and in fact housing has been running hotter than our forecasts by a tiny bit.
  • That’s all for now…good luck with the number. 5 minutes.
  • Weak CPI print, +0.11% on core…y/y just barely rounded up to 2.3% y/y. I said a downtick would be hard…but this was weak enough that it was very close.

  • Used Cars was quite weak, at +0.76% m/m, but that’s not super-surprising. The y/y at -0.68% (from -0.44%) is roughly in line.
  • Another usual suspect, Lodging Away from Home, plunged -1.75% m/m, putting the y/y to -0.28% from +3.26%. So a big, anti-seasonal move there. But LAfH is only 1% of CPI.
  • Overall housing was okay…OER +0.24% and Primary Rents +0.23% m/m, meaning that they upticked slightly y/y to 3.28% (vs 3.26%) and 3.69% (vs 3.66%) respectively. So it isn’t the big components there.
  • Yet Housing as a whole subgroup was only +0.10%. Was that all LAfH? Need to check.
  • Medical Care accelerated further, +0.57% m/m.

  • Medical care jump led by a large +1.25% m/m rise in Pharma (Medicinal Drugs).

  • The increases in the broad medical care components tends to support my prior suspicions that the big rise in CPI for health care insurance was a case of BLS not catching what was actually moving, so it appeared to show up in the insurance residual. That residual is still high…

  • Struggling finding anything (other than used cars and lodging away from home) that was really weak. Apparel was +0.40% m/m, so we got some of the bounceback. Recreation was a little weak, +0.15% m/m, and “Other” was -0.13% m/m…I need to dig deeper in housing though.
  • Overall core goods was steady at +0.10% y/y; overall core services was steady at +3.0% y/y. So no super clues there.
  • Here’s supporting chart for what I said about the weakness in Used Cars. Weak, but not surprisingly weak.

  • Well, in Housing…Shelter, which includes rents but also includes Lodging Away from Home, decelerated to 3.25% from 3.32% y/y. Fuels and Utilities is -0.23% y/y vs +0.74%. And Household Furnishings/Operations +0.98% vs 1.61%.
  • Looks like major appliances were heavy, down 1% m/m or so. But we’re talking a pretty small weight.
  • So biggest m/m decliners (and annualized changes) were Lodging AfH (-19.1%), Public Transport (-16.3%), Car and Truck Rental (-14.7%), and Personal Care Products (-12.9%). Cumulatively that’s only 2.8% of the CPI, but big changes.
  • Biggest m/m gainers aren’t in core: Motor Fuel (+39.6%) and Fuel Oil/Other Fuels (+27.4%). Medical Care Commodities (drugs) were +19.3%, and are in core, but as we have seen probably not a one-off. Then Meat, Poultry, Fish, and Eggs (can we just call this “protein?”) +16.7%.
  • So we’re talking about a lot of left-tail things in core especially. Median looks to be over 0.2% again, though a little hard to say because one of the regional OERs looks like the median category. But y/y Median CPI should stay roughly steady at 2.92% is my guess.
  • So core ex-shelter dropped a bit to 1.55% from 1.61% y/y. Still well off the lows. But if these left-tail one-offs are really one-offs, we would expect to see that rebound next month. Bottom line though is that 1.55% from non-housing isn’t very alarming yet.
  • To kinda state the obvious, nothing here will have the slightest impact on the Fed. They’ve basically said they don’t care about inflation at these levels. “Wake me when it hits 3% on core PCE, then hit the snooze button for a year.”
  • “In order to move rates up, I would want to see inflation that’s persistent and that’s significant. A significant move up in inflation that’s also persistent before raising rates to address inflation concerns: That’s my view.” – Powell, Dec 11 2019
  • Let’s look at the four pieces charts in order from most-volatile to least. First, Food and Energy.

  • Second, Core goods. This includes pharma, but also used cars, so right now the cars are beating drugs. (Don’t drink and drive, kids.)

  • Core Services less Rent of Shelter. Now, this month overall was weak but this is starting to look more concerning thanks to Medical Care. I think we might be seeing this over 3% before long, given the signals from health care.

  • And 4th piece: rent of shelter. So, flip side of the other core services is that rents might be softening..but at least aren’t showing an urgency to accelerate further. This was the reason I thought we’d see core peak in the 1st part of this year. I’m no longer confident.

  • Ever feel like inflation was giving you the finger? Here is the distribution of price changes. The big one in the middle is OER. The one at the far right is gasoline. You can see there are a lot of left tail events still.

  • Last one. Same data as the last chart, but this just sums all the categories over 3% y/y inflation. Obviously, when this goes over 50%, median is at least 3%. Because of rents, this is going to be close to 50%…but enough other categories are starting to scooch it there.

  • Scooch being a technical term.
  • OK, that’s all for today. The summary is that while the monthly number was soft, the underlying pressures are if anything getting a little firmer. Of course, the summary if you’re on the FOMC is, “CPI came out today? Really?”

As I said, nothing here will affect the Fed, at least for a while. I am sure some of them still pay attention to the CPI but they’ve made very clear that the only way inflation would affect monetary policy is if it went a lot higher, or a little bit lower. It may go a lot higher, but it won’t get there quickly. And core PCE, which is what the Fed supposedly focuses on (insider tip: they focus on whichever index is confirming their thesis), is more likely to accelerate from here since it overweights medical care – which is now trending higher – and underweights housing – which is looking soft – compared to private consumption. So, write off the Fed.

However, the “cyclical” ebbing of inflationary pressures that I had been expecting in Q1-Q2, mainly because I expected more softening in rents and I thought bond yields would be declining more in reaction to the slowdown in growth, aren’t apparent. It looks as if inflation might peak later than I had expected. Now, I never thought such a peak would mean inflation rolls over and goes to the lows of the last recession. Absent another collapse in housing, which does not appear to be in the offing, that isn’t going to happen. I thought inflation would stage a small retreat and then move to new highs when rates headed back up again. So far, though, I don’t even see much reason to think the peak is about to happen. Yes, rents are squishier than they were but it appears that medical care is moving fairly aggressively higher and interest rates don’t appear to be responding to the global slowdown in growth. So we might well be looking at a recession where inflation doesn’t slow very much.

In any event, the Fed’s response function make potential tail events a mostly one-way affair right now. They’ve warned you. Take appropriate precautions – which is relatively easy now as most inflation hedges (exception precious metals) are quite cheap!

Summary of My Post-CPI Tweets (November 2019)

November 13, 2019 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Another CPI day dawns bright and cold. But will inflation get heated up again, with a fourth 0.3% print on core, out of five? Or stay cold like last month’s +0.13% on core?
  • Last month, core goods was pressured a little bit, although still +0.7% y/y, by softness in Used Car prices and a big drop in pharma prices.
  • Apparel also fell as the new methodology is adding more volatility to that series than we had previously seen.
  • I suspect we will see more softness from Used Cars (maybe not as much as last month), as sales surveys have been consistently soggy recently.
  • I also continue to wait for the other shoe to drop with Medical Care. The Health Insurance part, which is a residual, has been running really hot. But that probably just signals that survey prices of the other parts need to catch up with reality. At least that’s my speculation.
  • Although core CPI was soft last month, Median was +0.25% and a new cycle high of 2.97% y/y. So the underlying pressures are steady and that probably means we aren’t about to see a major turn lower yet.
  • Really, the major change since last month has been the Fed’s tone – Powell saying that the Fed won’t even consider addressing higher inflation until they see “a really significant move up in inflation that’s persistent.”
  • That changes the calculation for investors and we have seen a meaningful move higher in breakevens recently as a result.
  • Consensus for today’s number is +0.3% headline, +0.2% on core, with the y/y core staying at 2.4%. And they’re really calling for an 0.2% or above, not a ‘soft’, rounded-up, core figure.
  • We are rolling off 0.196% from last October, so to have the y/y rise we need another pan-0.2% print. And to keep y/y at 2.4% on core it can’t be much softer than that.
  • That’s all for now. Except for this: after the figure I will be on @TDANetwork with @OJRenick. About 9:15ET is when we are scheduled to go to air. Tune in! And good luck today.
  • Soft one, +0.16% on core that rounds up to +0.2%. The y/y core dripped from 2.36% to 2.32%, which caused the rounded figure to go 2.4% to 2.3%.
  • So, what happened in June-July-August? Three months is a lot for an outlier.

  • OK, wow, -3.84% m/m drop in Lodging Away from Home. Looks like a seasonal distortion as the prior month was +2.09%. LAfH is only 1% of consumption, but that means it’s ~4bps of the m/m figure.
  • Used Cars and Trucks rebounded to 1.32% m/m, but the y/y dropped to 1.44% from 2.61%. It may have a little further to drop but that’s not surprising.
  • Apparel -1.8% m/m, so again more volatility from the new methodology. Core goods y/y dropped from +0.7% to +0.3%, but some part of that was Apparel going from -0.3% y/y to -2.3% y/y.
  • In the big pieces, Primary rents were +0.14%, a little soft (y/y to 3.74% from 3.83%) and Owner’s Equivalent +0.19%, also soft, to 3.32% from 3.40% y/y. Along with Lodging Away from Home it meant the Housing subindex, 42% of CPI, decelerated to 2.89% from 3.03%.
  • That’s potentially big on a couple of fronts, if it indicates actual slowing in rent inflation. As a big piece of CPI, a modest slowing there will help turn Median too.
  • Belated but here’s the chart on used cars and trucks. You can see the y/y is back in line, but some more softness likely.

  • So, core inflation ex-housing actually rose to 1.60% from 1.55%. Pretty minor move but it hasn’t been higher since Feb 2016, with the exception of two months ago when it hit 1.70%.

  • So the spread of shelter inflation over core, non-shelter inflation, has been extreme and one question has been whether housing inflation would slow or other inflation would rise. Answer this month is: both.

  • Not to belabor Lodging Away from Home but here is the y/y. The monthly volatility is not helpful, but at least it’s only 0.9% of CPI.

  • Weirdly, I haven’t mentioned Medical Care. M/M, Medicinal Drugs rose 1.05% after declining -0.79% last month. Y/y rose to +1% from -0.3%. Doctors’ Services rose to 1.16% y/y from +0.93%. But Hospital Services jumped to 3.46% from 2.08% y/y.
  • Hospital Services is 2.2% of consumption, and that +1.38% m/m jump is the reason that Core Services rose to 3% y/y from 2.9% DESPITE the deceleration in housing.
  • y/y hospital services. So is that part of what wasn’t being captured and thus showing up in the health insurance residual? Maybe, but Health Insurance still went to +20.1% y/y from 18.8%. Even knowing that’s a residual doesn’t keep it from being scary.

  • It’s measuring a REAL COST INCREASE, it’s just not really in the price of insurance policies that Americans are paying. Yes, they’re rising, but not at 20% y/y.
  • Insurance chart

  • Early guess on Median is that it will be a softish +0.19%, which will keep y/y basically unch.
  • Biggest annualized declines this month were Lodging Away from Home, Women/Girls’ Apparel, Infants’/Toddlers’ Apparel, and Men’s/Boys Apparel. Biggest increases: Car/Truck Rental, Motor Fuel, Misc Personal Goods, Energy Services, Used Cars/Trucks, Med Care Commodities.
  • Those are biggest annualized MONTHLY declines, Sorry.
  • About to get ready to air on @TDANetwork, so four-pieces charts might have to wait until later.
  • Summary today is that as usual there are lots of moving pieces but the interesting bit is the big housing pieces. They’re slow but there’s some anecdotal signs of softness developing and if that’s real, it could cap core inflation for now. Not sure of that yet.
  • I still think inflation is likely to peak for this cycle in early 2020, but again I admonish that the downside won’t be nearly as low as we have seen downsides and the next upside will be worse than this one. Higher highs and higher lows from here.

I still owe you the four-pieces charts, so here they are. First, Food & Energy.

Next, Core Goods. It suffered a big setback today but it still looks generally uptrending. I don’t think this is about to go to 4, but something between 0.5% and 1.0% for a while is not hard to imagine especially if pharma prices stabilize.

Core services, ex rent-of-shelter. Now, this starts to look a little more interesting? Medical Care showing some perkiness and as the second-most-stable piece here, core services less rent of shelter is worth monitoring for the longer-term macro inflation picture.

Finally, Rent of Shelter. Still in the same general vicinity, but there are starting to be some anecdotal reports of softness in home prices in certain areas so it’s worth monitoring. It’s not about to plunge as in 2007-09, but it just needs to back off a little to change how concerned we are about inflation.

That said, inflation seems to be broadening a bit and also becoming more volatile. The volatility is partly because the BLS is changing the way they do certain things but it’s also a consequence of fractious trade relationships where firms are changing their sourcing, prices are responding to tariffs and tariff threats, etc. To the average consumer who encodes price increases as inflation and price decreases as good shopping, volatility in prices feels very much like inflation so if this continues then inflation expectations could rise just on the volatility (unless it’s all measurement volatility, of course).

I do think that the investment implication of today’s inflation numbers is muted compared to the implication of what the Fed has said about the inflation numbers. To wit, the Fed won’t even consider hiking to restrain inflation unless they see “a really significant move up in inflation that’s persistent.” So far we haven’t seen that, and in fact recently the upper tails have been coming down just as the fast as the lower tails have been going up. The chart below shows what proportion of the CPI is inflating faster than 4% y/y.

But from an investor’s standpoint and more importantly from an advisor’s standpoint, the Fed stance changes how you approach a portfolio if you are a professional-risk-minimizer (as most advisors are). In the old days, an uptick in inflation that caught an advisor flat-footed might be forgiven because we assumed the Fed was working hard in our direction – to keep inflation low. But now, even if you don’t think inflation is going to rise, the professional risk on the downside is bigger because clients will say to the advisor “why didn’t we have any inflation hedges? The Fed told you they wanted expectations to go higher!” Maybe this is too subtle, but breakevens are up 20-25bps over the last few weeks and I think no small part of that is because investors and advisors are now on their own with respect to inflation. In my experience, people who think they might be shot at can usually be trusted to dig their own foxholes.

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

October 31, 2019 12 comments

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

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

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

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

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

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

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

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

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

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

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


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

The Fed’s Reserves Management Problem

October 22, 2019 Leave a comment

There has been a lot written about the Fed’s recent decision to start purchasing T-bills to re-expand its balance sheet, in order to release some of the upward pressure on short-term interest rates in the repo market. Some people have called this a resumption of Quantitative Easing, while others point out that it is merely an adjustment to a technical condition of reserves shortage. The problem is that both perspectives may be right, under different circumstances, and that is the underlying problem.

The triggering issue here was that overnight repo rates had been trading tight, and in fact briefly spiked to around 10%. It isn’t surprising that the Federal Reserve responded to this problem by adding lots of short-term liquidity: that’s how they respond to every issue. Banks in trouble? Add liquidity. Economy slightly weak? Add liquidity. “Stranger Things” episode somewhat disappointing? Add liquidity.

Traditionally, the Fed’s response would have been correct. In the “old days,” the overnight interest rate was how the Open Markets Desk gauged liquidity in the interbank market. If fed funds were trading above the Fed’s desired target (which was not always announced, but which could always be inferred by the Desk’s actions in response to reserves tightness or looseness), the Fed would come in to do “system” repos and add short-term liquidity. If fed funds were trading below the target, then “matched sales” was the prescription. It was fairly straightforward, because the demand for reserves was relatively easy to monitor and the adjustments to the supply of reserves small and regular.

But the problem today goes back to something I wrote about back in March, and that’s that reserves no longer serve just one function. In those aforementioned “old days,” the function of reserves was to support a bank’s lending activities in a straightforward statutory formula that was easy for a bank to calculate: this amount of lending required that amount of reserves, calculated over a two-week period ending on a Wednesday. Under that sort of regime, spikes in funds and repo rates (other than occasionally over the turn of year-end) were very rare and the Desk could easily manage them.

This is no longer the case. Reserves now serve two functions, as both lending support and as “High Quality Liquid Assets” (HQLA) that systemically-important banks can use in calculating its Liquidity Coverage Ratio (LCR). This has two really critical implications that we will only gradually learn the importance of. The first implication is that, because the amount of reserves needed to support lending activities is unlikely to be exactly the amount of reserves needed for a bank to achieve its HQLA, at any given time one of these two effects will dictate the amount of reserves the system needs. For example if banks need more reserves for HQLA reasons, then it means they will have more reserves than needed for their existing loan books – and that means economic stability and inflation control will in those cases take a back seat to bank stability. So, as the Fed has struggled to keep up with HQLA demand, year-over-year M2 growth (which is partly driven by reserves scarcity or plenty) has risen fairly quickly to 2-year highs (see chart, source Bloomberg).

The second implication is that, because the demand for each of these two functions of reserves changes independently in response to changes in interest rates and other market forces, it is not entirely knowable or forecastable by the Desk how many reserves are actually needed…and that number could change a lot. For example, there are other assets that also serve as HQLA; so if, for example, T-bill yields were a bit higher than the interest paid on reserves a bank might choose to hold more Tbills and only as much reserves as needed to support its lending activities. But if Tbill rates then fall, or customers lift those bills away from the bank’s balance sheet, or the denominator of the LCR (the riskiness of the bank’s activities, essentially) changes due to market conditions, the bank may suddenly choose to hold lots more reserves. And so rates might suddenly spike or plummet for reasons that have to do with the demand and supply of reserves for the HQLA function, with the Fed struggling to add or subtract large amounts of reserves over short periods of time.

In such a case, targeting a short-term interest rate as a policy variable is going to be exquisitely more difficult than it used to be, and honestly it isn’t clear to me that this is a solvable problem under the current framework. Either you need to declare that reserves don’t qualify as HQLA (which seems odd), or you need to require that a bank hold a certain amount as HQLA and set that number high enough that reserves are essentially the only HQLA a bank has (which seems punitive), or you need to accept that the central bank is either going to have to surrender control of the money supply (which is scary) or of short-term interest rates (which is also scary).

But simply growing the balance sheet? That’s the right answer today, but it might be the wrong answer tomorrow. It does, though, betray that the central bank has a knee-jerk response to err on the side of too much liquidity…and those of us who remember that inflation is actually a real thing see that as a reason for concern. (To be fair, central banks have been erring on the side of too much liquidity for quite some time. But maybe they’ll keep being lucky!)

Summary of My Post-CPI Tweets (September 2019)

September 12, 2019 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI day again! And this time, we are coming off not one but TWO surprisingly-high core CPI prints of 0.29% for June and July respectively.
  • But before I get into today’s report, I just want to let you know that I will be on TD Ameritrade Network @TDANetwork with @OJRenick at 9:15ET today. Tune in!
  • And I’m going to start the walk-up to the number with two charts that I don’t often use on CPI day. The first shows the Atlanta Fed Wage Tracker, and illustrates that far from dead, the Phillips Curve is working fine: low unemployment has produced rising wages.

  • The second chart, though, is why we haven’t seen the rising wage pressure in consumer prices yet. It shows that corporate margins are enormous. Businesses can pay somewhat higher wages and accept somewhat lower (but still ample) margins and refrain from price increases.

  • This won’t last forever, but it’s the reason we haven’t felt the tariffs bite yet, too. Something to keep in mind.
  • As for today: last month we saw core goods inflation at +0.4% y/y, the highest since 2013. I suspect that trend will continue for a bit longer, because tariffs DO matter. It’s just that they take longer to wash through to consumer prices than we think.
  • In general, last month’s rise was mostly surprising because it was fairly broad-based. Nothing really weird, although the sustainability of retracements in apparel/hospital services/lodging away from home may be questioned.
  • In fact, the oddest thing about last month’s figure is that “Other Goods and Services” jumped 0.52% m/m. OGaS is a jumble of stuff so it’s unusual to see it rising at that kind of rate. It’s only 3% of CPI, though.
  • Consensus today is for a somewhat soft 0.2% on core. We drop off 0.08% from last August from the y/y numbers so the y/y will almost surely jump to at least 2.3% (unless there’s something weird in August seasonals). Good luck.
  • Oh my.
  • Well, it’s a soft 0.3% on core, at 0.26% m/m, but that’s the third 0.3% print in a row. The fact that none of them was actually as high as 0.3% is not terribly soothing.
  • y/y core goes to 2.4% (actually 2.39%), rather than the 2.3% expected. Again, oh my.
  • Last 12 core CPIs.

  • Subcomponents trickling in but y/y core goods up to +0.8% y/y. Maybe those tariffs are having an impact. But this seems too large to be JUST tariffs.

  • Core services also rose, to 2.9% y/y. But that’s less alarming.

  • A big piece of the core goods jump was in Used Cars and Trucks, +1.05% m/m and up to +2.08% y/y.
  • The used cars figure isn’t out of line, though.

  • Primary Rents at +0.23% (3.74% y/y from 3.84%) and OER at +0.22% (3.34% vs 3.37%) are actually slightly dampening influences from what they had been. The contribution from their y/y dropped and the overall y/y still went up more than expected.
  • Between them, OER and Primary Rents are about 1/3 of CPI, so to have them decelerate and still see core rise…
  • Lodging Away from Home -2.08% m/m…lightweight, but certainly not a cause of the upside surprise. But Pharmaceuticals rose 0.61% m/m, pushing y/y back to flat (chart).

  • …and hospital services jumped 1.35% m/m to 2.13% y/y. So the Medical Care subindex rose 0.74% m/m, to 3.46% y/y from 2.57%. Boom.

  • Biggest m/m jumps are Miscellaneous Personal Goods, Public Transportation, Footwear, Used Cars & Trucks, and Medical Care Svcs. Only the last two have much weight and we have already mentioned them.
  • It is going to be VERY close as to whether Median CPI rounds up to 3.0% y/y. I have it at 0.23% m/m (right in line with core) and 2.94% y/y.

  • It’s time to wonder whether this rise in inflation is “actually happening this time.” Core ex-shelter rose from 1.3% y/y to 1.7% y/y. That’s the highest since Feb 2013. To be fair, it wasn’t “actually happening that time.”

  • To be honest, I’m having trouble finding disturbing outliers. And that’s what’s disturbing.
  • Quick four pieces charts. Food & Energy

  • Core goods. This is the scary part.

  • But Core Services is also showing some buoyancy. Again, look at the core-ex-shelter chart I tweeted just a bit ago.

  • Lastly, Rent of Shelter. Still not doing anything…

  • Got to go to ‘makeup’ for the @TDANetwork hit (I don’t really get makeup), but last thought. Fed is expected to ease next week. I think they still will. But this sets up a REALLY INTERESTING debate at the FOMC.
  • Growth is fading, and worse globally, but it’s still okay in the US. And inflation…it’s hard to not get concerned at least a little…so there’s a chance they DON’T ease. A small chance, but not negligible.
  • That’s all for today! It was worth it!

My comment that the Fed might not ease got more heated reaction than I have seen in a while. Clearly, there are a lot of people who are basing their investment thesis on the Fed providing easy money. I suppose it is impolitic to point out that that is exactly one great reason the Fed should not ease, even though the market is pricing it in.

But let’s look at the Fed’s pickle (er, not sure I like that imagery but we’ll go with it). The last ease from the FOMC was positioned as a ‘risk management’ sort of ease, with the Fed wanting to get the first shot in against slowing growth. I am completely in agreement that growth is slowing, but there are plenty of people who don’t agree with that. Globally, growth looks plainly headed into (or is already in) recession territory, but US protectionism has preserved US growth relative to the rest of the world. Yes, that comes at a cost in inflation to the US consumer, but so far we’ve gotten the protection without the side effects. That might be changing.

If the Fed believes that the inflation bump is because of tariffs, and they believe that lower rates will stimulate growth (I don’t, but that’s a story for another day), then the right thing to do is to ignore the rise in prices and ease anyway. If they do ease, I suspect they will include some language about the current increase in prices being partly attributable to higher import costs due to tariffs, and so temporary. But I don’t think there’s a ton of evidence that the rise in core inflation is necessarily tied exclusively to tariffs. So let’s suppose that the Fed believes that tariffs are not causing the current rise in median inflation to about 3% and core inflation the highest since the crisis. Then, if in fact the last ease really was for risk management reasons, then what’s the argument to ease further? Risks have receded, growth looks if anything slightly better than it did at the last meeting, and inflation is higher and in something that looks disturbingly like an uptrend. And, there is the question about whether reminding the world that they are independent from the Administration is worth doing. I really don’t think this ease is a slam-dunk. The arguments in favor were always fairly weak, and the arguments against are getting stronger. Maybe they don’t want to surprise the market, but if you can’t surprise the market with both bonds and stocks near all-time highs then when can you surprise the market? And if the answer is “never,” then why even have a Federal Reserve? Just leave it to the market in the first place!

And I’d be okay with that.

Summary of My Post-CPI Tweets (August 2019)

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 or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Welcome to another CPI day. The tone going into this one is soooo much different than last month. We are coming off of a surprising jump in core CPI of 0.29%, rather than three straight weak numbers, for starters.
  • For another, the Fed is already in easing mode; last month we were just preparing for it. Despite the high inflation print, and median CPI near its highs y/y (2.84%), the Fed eased anyway.
  • (If you needed any more evidence that the Fed cares more about the stock market and “risk management” of forward growth expectations, than about inflation, that was an exhibit for you.)
  • With global growth sliding, protests in Hong Kong, the Argentinian peso collapsing…this CPI number today won’t change the Fed’s trajectory. They’re going to keep easing for a while.
  • I expect inflation to peak later in Q4 or in Q1, but in the meantime it may make the Fed feel a bit uncomfortable. List 4 tariffs being implemented will probably finally result in a tariff effect (not for a few months, as they take effect Sep 1).
  • As for today: last month’s jump was fueled by housing, and by used (not new, not leased) cars and trucks. Most of that was catch-up although housing’s strength is a little surprising.
  • I don’t expect retracements there. And there’s upside risk from medical care, especially hospital services, though it’s hard to time.
  • Recent increases in the CPI for health insurance, which is a residual, may indicate coming acceleration in inflation for drugs and/or hospital services, which are due. Hard to time this though.
  • Consensus on the Street is for roughly 0.19% on core CPI. That would keep y/y steady, right at 2.1%. Good luck.
  • Well whoopsie. Another 0.29% on core CPI. That brings y/y core to 2.21%
  • This makes the lull earlier this year look decidedly different.

  • Let’s see. Lodging Away from Home jumps out, retracing a -0.64% fall last month to +0.94% this month, but that’s only 1% of CPI.
  • Primary Rents and OER both were better behaved this month, +0.28% and +0.25%, but that actually lowers the y/y for both of them.
  • Heh heh…did someone say hospital services? It rose 0.46% m/m, pushing the y/y to 0.77% from 0.50%. No real victory lap for me yet…it’s got a long way to go.

  • Pharma was also positive, +0.29% m/m versus -0.46% m/m last. Overall, Medical Care rose to 2.57% y/y versus 1.96% last month. Medical Care is about 9% of CPI.
  • Used cars and trucks accelerated to 1.47% y/y versus 1.25%. So no retracement to the bounce last month. I hadn’t expected any since the move last month looked like a return to fair.
  • Apparel +0.44% m/m. That takes the y/y to -0.55% versus -1.29% last month. Couple of months ago there was a sharp fall as BLS shifted to a new methodology. Looks like this is catching up. Still mild deflation in apparel, no tariff effects.
  • Overall, Core Goods was +0.40% y/y. Wait, what?? About time! HIGHEST Y/Y CORE GOODS SINCE 2013. The persistent-deflation-in-goods narrative just took a hickey.

  • However, hold the victory lap on that. Model says we may be close to the highs on core goods. (But the model doesn’t know about tariffs.)

  • This is rare…Other Goods and Services, the eighth of eight major subgroups in CPI, rose 0.52% m/m. That category (only 3% of CPI) is a dog’s breakfast so unusual to see a m/m jump that large. Will be worth looking into.
  • Core inflation ex-shelter rose to 1.31% y/y from 1.16% last month.
  • New Vehicles and Leased Cars and Trucks both decelerated further. So if anyone ‘blames’ used cars for the strong print, point out that overall “New and used motor vehicles” decelerated to 0.30% y/y from 0.43%. This kind of talk will make you popular at parties.
  • CPI for health insurance continued to surge, now up 15.88% y/y. Remember, this is a residual, but I think that means it may signal changes that the BLS hasn’t picked up yet. It’s the highest on record.

  • Back to that dog’s breakfast of “Other”. Nothing really stands out. This category has cigarettes, personal care products (cosmetics, etc), personal care services (haircuts, e.g.), funeral expenses, legal services, financial services, dry cleaning…pretty balanced increases.
  • Biggest declines this month are jewelry and watches (-17% annualized) and infants’ and toddlers’ apparel (-12.8% annualized). Bunch of annualized >10% gains tho: Mens’ & boys’ and womens’ & girls’ apparel, public transportation, lodging away from home, tobacco, motor fuel.
  • Early look at median CPI…my estimate is 0.28% m/m, which would put y/y to 2.88% and a new high.
  • OK, time for the four-pieces charts. And then a wrap-up. First, Food & Energy.

  • Second piece: Core goods. This is really where the story is, and where it’s likely to be going forward. A reminder here about how long the inflation process can take! Folks were looking for tariff effects the moment they went into effect. But businesses wait-and-see first.

  • Now businesses have seen, and the tariffs look to be pretty sturdy, and they’re moving prices. And more to come probably.
  • Core services less rent of shelter. Medical Care maybe has stopped going down, but it isn’t going up yet.

  • And the stable Rent of Shelter. A little surprised it’s so buoyant still.

  • Well, the wrap-up is obvious here. Second 0.3% core month in a row, and no obvious outliers. The acceleration seems to be concentrated in core goods, but fairly broad. I still think we will see inflation peak later 2019 or early 2020, but…there are no signs of it yet.
  • So this is what the Fed faces: slowing global growth, political unrest, and rising inflation. In that circumstance, will they keep easing? OF COURSE THEY WILL, THEY DON’T CARE ABOUT INFLATION. Haven’t for a decade at least.
  • And what about markets? 10-year inflation swaps are shown below, compared to Median CPI (last point estimated). There’s a serious disconnect here.

  • So as Porky says, “That’s all, folks!” Thanks for tuning in. I’ll put the summary of these tweets up on my site mikeashton.wordpress.com within the hour.

What is amazing about inflation is both how slowly it changes and also how quickly it changes. Three months ago we were looking at four soft months in a row on core CPI and people were starting to chirp about the coming deflation. Then we get two of the highest core prints in a long time – and broad-based at that – and the story will be 180 degrees different. (Another reason to watch Median CPI rather than Core CPI is that the head fakes aren’t very good in Median – there was never much question that the broad trend was staying higher).

To be sure, the Fed doesn’t really care about inflation, and markets don’t much care either. Unless, that is, it causes the Administration to slow its march toward tariffs. As I write this, the Trump Administration has announced they will delay the tariffs on “some” products – including cell phones, laptops, video game consoles, some toys, and some apparel – until December 15th (just in time for Christmas, but it means that these goods won’t see prices higher during the holiday shopping season since everything on store shelves will have already been imported. Thanks Wal-Mart!). Stocks have taken that as a signal to rip higher because the fact that inflation is rising on 98% of the consumption basket is so one-hour-ago. Happy days are here again!

But make no mistake. The inflation pressures are not all from tariffs. In fact, few of them seem to be specifically traceable to tariffs. This is a continuation of a broad accelerating trend we have seen for several years. See above: inflation changes slowly. The Federal Reserve will ignore this because they believe the slower global growth will restrain inflation so that there is nothing they need to do about it. In some sense they are right, because the market has already lowered interest rates by so much it is likely to push money velocity lower again. I still think inflation will peak later this year or early next year, but if I were on the FOMC…I’d be somewhat nervous about that projection today.

%d bloggers like this: