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Summary of My Post-CPI Tweets (April 2021)

April 13, 2021 2 comments

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

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

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

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

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

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

Average-Inflation Targeting, In a Nutshell

August 26, 2020 1 comment

Let the bow-tie set argue about the niceties and the nuances. Here is what I can tell you about inflation targeting so that we can all understand the debate: suppose they changed the rules of baseball in an analogous way.

A new pitcher comes in to the game. He throws a pitch over the batter’s head. His next pitch skips behind the batter. His third pitch sails 2 feet high and outside. His fourth pitch almost hits the mascot.

“Yer out!” barks the umpire. Because the four pitches averaged out to strikes. My questions:

  1. I don’t know that the new rule gives me any greater confidence in the pitcher.
  2. It isn’t clear to me how that rule would help the batter.
  3. Maybe this helps a bad pitcher. But I wonder why a good pitcher would need that rule.

That is all.

And Now Their Watch is Ended

August 3, 2020 3 comments

At one time, fiscal deficits mattered. There was a time when the bond market was anthropomorphized as a deficit-loathing scold who would push interest rates higher if asked to absorb too much new debt from the federal government. The ‘bond vigilantes’ were never an actual group, but as a whole (it was thought) the market would punish fiscal recklessness.

Of course, any article mentioning the bond vigilantes must include the classic account by Bob Woodward, describing how then-President Bill Clinton reacted to being told that running too-large deficits would cause interest rates to rise and tank the economy: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ****** bond traders?’”

Truth be told, this was always a bit of a crock in the big scheme of things. Although the bond market occasionally threw a tantrum when Big Government programs were announced, the bond traders have always been there when the actual paper hit the street. The chart below shows 10-year yields versus the rolling 12-month federal deficit. Far from being deficit scolds, bond market investors have always behaved more as if bonds were Giffen goods (whose price gets higher when there is more supply, and lower when there is less supply, in the opposite manner from ‘normal’ microeconomic dynamics). I guess so long as we are doing a walk down economic history lane, we could also say that the bond market followed a financial version of Say’s law: that supply creates its own demand…

Well, if ever there was a time for the market to get concerned about deficits, now is surely it. While the Fed continues to buy massive quantities of paper (to “ensure the smooth functioning of the markets”, as it surely does since if they were not buying such quantities the adjustment may be anything but smooth), there is still an enormous amount of Treasury debt in private hands. And it all yields far less than the rate of inflation. Clearly, these private investors are not alarmed by the three-trillion-dollar deficit, nor of the effect that the Fed buying a large chunk of it could have on the price level.

If investors are not alarmed by a $3T deficit – and, aside from market action being so benign, consider whether you’ve read any such alarm in the financial press – then it’s probably fair to say that there isn’t a deficit amount that would alarm them. Always before, if the market absorbed an extra-large deficit there was always at least the concern that it might choke on all that paper. Or, if it didn’t, that surely we were at the upper level of what could be absorbed. I don’t sense anything like the unease we’ve seen in prior deficit spikes. And that’s what alarms me. Because, as I tell my kids: a rule without enforcement means there isn’t a rule. Investors are not putting any limitation on the federal balance; ergo there is no limit.

Well, perhaps by itself that’s not a big deal. Heck, maybe deficits really don’t matter. But what bothers me is that the risk to that possibility is one-sided. If deficits don’t matter, then no biggie. But if they do matter, and the bond vigilantes are dead so that there is no push-back, no enforcement of that rule, then it follows that the only speed limit that will be enforced is when the car hits the tree. That is, if there is no alarm that causes the market to discipline the government spenders before there’s a crack-up, then eventually there will be a crack-up with 100% probability (again, assuming that deficits do matter at some level, and maybe they don’t).

While the vigilantes kept watch, there was scant worry that a government auction would fail. Although, as I’ve pointed out, the vigilantes weren’t macro-enforcers there were sometimes micro-aggressions: sudden interest rate adjustments where yields would jump 100bps in six weeks, say. This doesn’t happen any longer. So, while there’s plenty of money floating about right now to buy this zero-yielding debt, the larger the bond market gets the more of that money it will be sucking up. Unless, that is, the amount of money expands faster than the amount of debt (so that the debt shrinks in real terms), which is another way to say that the price level rises sharply. In that case, in order to keep the markets “orderly” the Federal Reserve will have to take more and more of that zero-yielding debt out of the market, replacing it with cash. It’s easy to see how that could spiral out of control quickly, as well.

I am not sure how close we are to such a crack-up. It could be years away; it could be weeks. But without the bond vigilantes, there’s no law in this town at all.

Half-Mast Isn’t Half Bad

April 28, 2020 1 comment

As I watch the stock market, implausibly, rise to levels no one expected so soon after the crash, I am also sickened by the cheerleading from those whose fortunes – not to mention egos – are wrapped up in the level at which the Dow trades. Stock market fetishism always fascinates me as much as it repels me. Although my experience as a trader (and a short-term options trader, at that) would seem to suggest otherwise, my makeup is as a long-term investor. I want to buy value, and the mathematics of investing for me is that I want (a) high intrinsic value at (b) a low price. While people who are buy-and-hold investors of a certain age clearly benefit from higher prices, young investors clearly benefit from lower prices since they’re going to be net buyers for a long time. And the price at which you acquire intrinsic value matters. So does the price at which you sell, but not until you sell.

So to me, there’s nothing great about a price that’s high relative to intrinsic value, unless I am preparing to sell. In a broader sense, the idea that we should cheer for higher prices (as opposed to higher intrinsic values) is not only unseemly, but destructive and I’ll explain why in a minute. I will note that the fascination with watching prices ticking every second goes back a long ways: you can read in Reminiscences of a Stock Operator about the bucket shops of the early 1900s where speculators would watch and trade the stock market tape. The general increase in investor twitchiness and short-termism that has accompanied the growth of financial news TV, online investing, and the development of ETFs to trade broad market exposures intraday certainly adds numbers to the cheerleading crowd. But it isn’t new. Depressing, but not new.

The most fascinating example of this belief in the (non-intuitive, to me) connection between the value of the stock market and the value of ‘Merica was presented to me in the aftermath of 9/11. When we first trudged back to lower Manhattan, there were people handing out these cards:

Fight Osama! Buy Cisco! I never did see the connection, and it seemed to me at the time either delusional (the terrorists win if my investment in Lucent goes down) or nakedly self-serving. Certainly the way I feel about my country has nothing to do with where I’m able to buy or sell eBay today. And actually, they really weren’t coming for our 401(k)s, they were coming for our lives. But I digress.

The point I actually want to make is that when the Fed works to stabilize market prices, they’re having a negative effect by destabilizing economic variables. An analogy from manufacturing might be an entry point to this explanation: a truism in manufacturing is that you can stabilize inventory, or you can stabilize production, but you can’t stabilize both (unless your customers are accommodating and provide very smooth demand). If you want to stabilize inventory levels, then you need to produce more when business is high and less when business is low, so you’re on the production roller-coaster. If you want to keep production level, then inventory will be low when business is high and high when business is low, so you’re on the inventory roller-coaster. Only if business itself is stable – which is rare – can you do both.

A similar thing happens in capital markets. You can stabilize the cost of capital, but then you destabilize growth rates. Or you can stabilize growth rates, and the cost of capital (stock and bond prices) will fluctuate. This is true unless you can do away with the business cycle. If you choose, as the Fed has in recent years, to try and stabilize market prices at very high levels (stabilizing the cost of capital at very low levels), then when underlying activity is strong you’ll get a ton of speculative investment in capacity, new ventures that depend on the availability of cheap capital, and strong growth. And then when economic activity heads lower, you’ll find that lots of businesses go bust and the recession is deeper. In fact, it’s not just the speculative businesses that go bust, but the overbuilding in the expansion can cause even prudent enterprises to have more difficulties in the downturn.

The Fed’s historical response to this has been to let the speculative activity happen when the cost of capital is held too low, but not let companies go bust when economic activity wanes…so they lower the cost of capital even further.

I’m obviously not the first person to point out that the Fed’s constant intervention has deleterious effects and tends to increase the amplitude of boom and bust. And, for what it’s worth, I’m not blaming the current recession on the Fed. Clearly, the proximate cause of this recession was COVID-19 and the global economic shutdown. What made it worse was that the Fed, by holding down the cost of capital, had previously precipitated the development and preserved the success of many more speculative enterprises. And the fetishism about stock prices, and about how important it is to have lots of money “working for you” in the stock market, is also one of the reason that people don’t save enough.

Of course, right now is probably not the time for the Fed and Congress to pull back and let huge numbers of people and companies go bankrupt. There’s a case to be made for the sort of government response we are having in this episode, in which personal income is being replaced by money creation while workers are ordered to stay home. There will be a piper to pay for that policy – a loss of price stability which is a consequence of trying to preserve output stability, but a consequence that it’s arguably acceptable to pay. Afterwards, though, I hope that central banks can start to let natural rhythms replace the autocratic ones. I am not hugely optimistic on that score, but one place to start is this: stop lowering the bar for central banks to intervene in markets. Stop targeting equity prices and interest rates. It’s okay to let the Dow trade at half-mast, and the bull will come back without the Fed’s help.

In fact, if we don’t keep trying to artificially increase the length of the mast, the Dow might never need to trade down to half-mast in the first place. Certainly, intrinsic values don’t retrace 50% in a recession!

Last Time Was Different

April 4, 2020 6 comments

They say that the four most dangerous words in investing/finance/economics are “This time it’s different.”

And so why worry, the thinking goes, about massive quantitative easing and profound fiscal stimulus? “After all, we did it during the Global Financial Crisis and it didn’t stoke inflation. Why would you think that it is different this time? You shouldn’t: it didn’t cause inflation last time, and it won’t this time. This time is not different.”

That line of thinking, at some level, is right. This time is not different. There is not, indeed, any reason to think we will not get the same effects from massive stimulus and monetary accommodation that we have gotten every other time similar things have happened in history. Well, almost every time. You see, it isn’t this time that is different. It is last time that was different.

In 2008-10, many observers thought that the Fed’s unlimited QE would surely stoke massive inflation. The explosion in the monetary base was taken by many (including many in the tinfoil hat brigade) as a reason that we would shortly become Zimbabwe. I wasn’t one of those, because there were some really unique circumstances about that crisis.[1]

The Global Financial Crisis (GFC hereafter) was, as the name suggests, a financial crisis. The crisis began, ended, and ran through the banks and shadow banking system which was overlevered and undercapitalized. The housing crisis, and the garden-variety recession it may have brought in normal times, was the precipitating factor…but the fall of Bear Stearns and Lehman, IndyMac, and WaMu, and the near-misses by AIG, Fannie Mae, Freddie Mac, Merrill, Goldman, Morgan Stanley, RBS (and I am missing many) were all tied to high leverage, low capital, and a fragile financial infrastructure. All of which has been exhaustively examined elsewhere and I won’t re-hash the events. But the reaction of Congress, the Administration, and especially the Federal Reserve were targeted largely to shoring up the banks and fixing the plumbing.

So the Federal Reserve took an unusual step early on and started paying Interest on Excess Reserves (IOER; it now is called simply Interest on Reserves or IOR in lots of places but I can’t break the IOER habit) as they undertook QE. That always seemed like an incredibly weird step to me if the purpose of QE was to get money into the economy: the Fed was paying banks to not lend, essentially. Notionally, what they were doing was shipping big boxes of money to banks and saying “we will pay you to not open these boxes.” Banks at the time were not only liquidity-constrained, they were capital-constrained, and so it made much more sense for them to take the riskless return from IOER rather than lending on the back of those reserves for modest incremental interest but a lot more risk. And so, M2 money supply never grew much faster than 10% y/y despite a massive increase in the Fed’s balance sheet. A 10% rate of money growth would have produced inflation, except for the precipitous fall in money velocity. As I’ve written a bunch of times (e.g. here, but if you just search for “velocity” or “real cash balances” on my blog you’ll get a wide sample), velocity is driven in the medium-term by interest rates, not by some ephemeral fear against which people hold precautionary money balances – which is why velocity plunged with interest rates during the GFC and remained low well after the GFC was over. The purpose of the QE in the Global Financial Crisis, that is, was banking-system focused rather than economy-focused. In effect, it forcibly de-levered the banks.

That was different. We hadn’t seen a general banking run in this country since the Great Depression, and while there weren’t generally lines of people waiting to take money out of their savings accounts, thanks to the promise of the FDIC, there were lines of companies looking to move deposits to safer banks or to hold Treasury Bills instead (Tbills traded to negative interest rates as a result). We had seen many recessions, some of them severe; we had seen market crashes and near-market crashes and failures of brokerage houses[2]; we even had the Savings and Loan crisis in the 1980s (and indeed, the post-mortem of that episode may have informed the Fed’s reaction to the GFC). But we never, at least since the Great Depression, had the world’s biggest banks teetering on total collapse.

I would argue then that last time was different. Of course every crisis is different in some way, and the massive GDP holiday being taken around the world right now is of course unprecedented in its rapidity if not its severity. It will likely be much more severe than the GFC but much shorter – kind of like a kick in the groin that makes you bend over but goes away in a few minutes.

But there is no banking crisis evident. Consequently the Fed’s massive balance sheet expansion, coupled with a relaxing of capital rules (e.g. see here, here and here), has immediately produced a huge spike in transactional money growth. M2 has grown at a 64% annualized rate over the last month, 25% annualized over the last 13 weeks, and 12.6% annualized over the last 52 weeks. As the chart shows, y/y money growth rates are already higher than they ever got during the GFC, larger than they got in the exceptional (but very short-term) liquidity provision after 9/11, and near the sorts of numbers we had in the early 1980s. And they’re just getting started.

Moreover, interest rates at the beginning of the GFC were higher (5y rates around 3%, depending when you look) and so there was plenty of room for rates, and hence money velocity, to decline. Right now we are already at all-time lows for M2 velocity and it is hard to imagine interest rates and velocity falling appreciably further (in the short-term there may be precautionary cash hoarding but this won’t last as long as the M2 will).  And instead of incentivizing banks to cling to their reserves, the Fed is actively using moral suasion to push banks to make loans (e.g. see here and here), and the federal government is putting money directly in the hands of consumers and small businesses. Here’s the thing: the banking system is working as intended. That’s the part that’s not at all different this time. It’s what was different last time.

As I said, there are lots of things that are unique about this crisis. But the fundamental plumbing is working, and that’s why I think that the provision of extraordinary liquidity and massive fiscal spending (essentially, the back-door Modern Monetary Theory that we all laughed about when it was mooted in the last couple of years, because it was absurd) seems to be causing the sorts of effects, and likely will cause the sort of effect on medium-term inflation, that will not be different this time.


[1] I thought that the real test would be when interest rates normalized after the crisis…which they never did. You can read about that thesis in my book, “What’s Wrong with Money,” whose predictions are now mostly moot.

[2] I especially liked “The Go-Go Years” by John Brooks, about the hard end to the 1960s. There’s a wonderful recounting in that book about how Ross Perot stepped in to save a cascading failure among stock brokerage houses.

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 14 comments

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

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

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

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

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

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

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

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

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

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

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


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

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!)

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